Larry Summers' blog

Breaking new ground on neutral rates


Lukasz Rachel and Thomas Smith have a terrific new paper on world neutral real rates. The fact that it supports a variety of arguments that I have been making on secular stagnation for the last two years may contribute to my enthusiasm but the paper breaks new ground in a number of respects.

First, Rachel and Smith document compellingly the near universality of sharply declining real rates and also the length and breadth of the decline. They show the phenomenon is a very broad based 450 basis point trend decline in real rates occurring over 25 years. Framing the problem this way is significant because it shows the inadequacy of shorter-term explanations of low neutral real rates such as those of Ken Rogoff that focus on the financial crisis and its aftermath. It also suggests the need to look beyond monocausal.

Second, Rachel and Smith do not find that slowing growth is the main explanation for declining real rates. Rather they attempt to quantify most of the factors that I and others have enumerated in accounting for declining real rates. They note that since the global saving and investment rate has not changed much even as real rates have fallen sharply there must have been major changes in both the supply of saving and demand for investment. They present thoughtful calculations assigning roles to rising inequality and growing reserve accumulation on the saving side and lower priced capital goods and slower labor force growth on the investment side. They also note the importance of rising risk premia associated in part with an increase financial frictions. Rachel and Smith’s work is not the last word but it is the first important word on decomposing the causal factors behind declining real rates.

Third, Rachel and Smith use their analysis of the determinants of neutral real rates to predict their future evolution. Here they reach the important conclusion that there is little basis for assuming a significant increase in neutral real rates going forward. This conclusion differs sharply from the “headwinds” orthodoxy prevailing in the official community. As the figure below illustrates, in the United States at least the Fed and the forecasting community has been consistently far behind the curve in recognizing that the neutral real rates has fallen. If, as I suspect, Rachel and Smith are right there will be much less scope to raise rates in the industrial world over the next few years than the world’s central banks suppose.

neutral rate news







Fourth, Rachel and Smith recognize that their findings are highly problematic for the existing central banking order. They imply that the zero lower bound is likely to be a major issue at least intermittently going forward. After all, we will have future recessions and when we do, there will be a need to drop rates by 300 basis points or more. Perhaps QE or negative rates or forward guidance will be availing. I am skeptical that they will be efficacious if a recession comes in an economy without a heavily disrupted financial system in need of repair.

Rachel and Smith also share my concern that a world of chronic very low real rates is going to be a world of high volatility, imprudent risk taking, excessive leverage and frequent financial accident. We may be about to get a taste of this in emerging markets and US high yield markets. It is fashionable to invoke the brave new world of macro-prudential policy in response. To borrow from Wilde, I fear that enthusiasm for macroprudential policy is the triumph of hope over experience. In the last wave of enthusiasm for such policies the poster-child was Spain’s countercyclical capital requirements. They did not work out so well. As best I can tell US macroprudential policy as currently practiced has meaningfully impaired liquidity in some key markets and damaged the credit availability for small and medium sized businesses while not touching excessive flows to emerging markets and high yield corporate issuance. To work, macroprudential policy has to reduce financial vulnerabilities without to an equal extent reducing credit flows that stimulate demand. This is logically possible. I doubt that actual regulators who after all were proclaiming the health of the banking system in mid 2008 are capable of pulling it off consistently given the pressures they face.

There are no certainties here. It is possible that neutral real rates will rise over the next several years. But there is a high enough chance that they will not to make contingency planning an urgent priority. That has been and is the main thrust of the secular stagnation argument.

This $13 trillion question is more important than ever


The Hutchins Center for Fiscal and Monetary Policy at Brookings is having a conference launching an important new volume on federal debt management policy.  Just as in the Great War in became clear that war is too important to be left to generals, so too in the Great Recession it became clear that (government) debt management is too important to be left to the parochial world debt managers. The composition of federal debt is itself often a useful tool for economic policy, particularly in the current low rate environment in which the Federal Reserve will frequently be unable to cut rates as much as it would like and will instead be reliant on “unconventional” policies intended to effect the price of government debt.

Edited by David Wessel the volume contains two chapters that I coauthored with Robin Greenwood, Sam Hanson, and Josh Rudolph as well as some separate comments of mine.  There is also a provocative paper by John Cochrane and a variety of perceptive commentaries by people with experience in debt management policy.

I think the volume makes a case for quite radical revisions in thinking about debt management policy.  Here are my 10 main takeaways starting where I am most confident.

  1. Debt management is too important to leave to Federal debt managers and certainly to leave to the dealer community. This is because, especially when interest rates are near zero, it implicates directly monetary and fiscal policy and economic performance in the short run, and questions of financial stability in the medium run.
  2. Whatever one’s view about desirable policy, it is fairly crazy for the Federal Reserve and Treasury, which are supposed to serve the national interest, to pursue diametrically opposed debt management policies. This is what has happened in recent years with the Federal Reserve seeking to shorten outstanding maturities and the Treasury seeking to term them out.
  3. Standard discussions of QE — which focus on the size of Fed purchases of long term bonds and ignore the scale of Treasury sale of these instruments — are intellectually incoherent. It is the total impact of government activities on the stock of debt that the public must hold that should impact financial markets.
  4. The preceding point is highly significant for the United States. Despite QE the quantity of long term debt that the markets had to absorb in recent years was well above, rather than below, normal.  This suggests that if QE was important in reducing rates or raising asset values it was because of signaling effects regarding future monetary policies not because of the direct effect of Fed purchases.
  5. The standard mantra that Federal debt management policies should seek to minimize government borrowing costs is some combination of wrong and incomplete. It is wrong because it is risk adjusted expected costs that should be considered.  It is incomplete because it is hard to see why the effects of debt policies on levels of demand and on financial stability should be ignored.
  6. The tax smoothing aspect, which is central to academic theories of debt policy, is of trivial significance. Even far larger levels of tax variability than we observe, or than could be offset by altered debt management policies, have only trivial impacts on levels of income.  It is much more important to understand debt management policy impacts on financial stability than on tax variability.
  7. The idea of rollover risk that is ever present in policy discussions is very confused. If there is the possibility that a period will come when the government’s borrowing rate will be very high this obviously needs to be considered in setting policy.  But the problem is not one of rollover.  To see this, think about long term floating rate debt.  Such debt does not offer insulation in the hypothetical circumstance where rollover would be difficult, because in such a situation floating rate debt yield will rise precipitously.
  8. Yield curves typically slope upward. The “carry trade” of borrowing short and lending long is a hedge fund staple.  Rather than providing this opportunity Treasury should reverse the trend towards terming out the debt.  Issuing shorter term debt would also help meet private demands for liquid short term instruments without encouraging risky structures like banks engaged in maturity transformation.
  9. Institutional mechanisms should be found to insure that in the future the Fed and Treasury are not pushing debt durations in opposite directions. The Treasury terming out the debt which the Fed then buys in an effort to quantitatively ease serves only to enrich the dealer community.
  10. Now that we are in a “secular stagnation” world of low interest rates, it is likely that debt management tools will be more important to stabilization policies in the future than in the past.

Advanced economies are so sick we need a new way to think about them


An ebook containing the papers and presentations from the European Central Bank’s central banking forum conference in Sintra Portugal is now available. Mario Draghi and his colleagues are to be greatly commended for running a forum that is so open to profound challenges to central banking orthodoxy.

The volume contains a paper by Olivier Blanchard, Eugenio Cerutti and me on hysteresis and separately some of my reflections asserting the need for a new Keynesian economics that is more Keynesian and less new. Here I summarize these two papers.

Hysteresis Effects

Blanchard Cerutti and I look at a sample of over 100 recessions from industrial countries over the last 50 years and examine their impact on long run output levels in an effort to understand what Blanchard and I had earlier called hysteresis effects. We find that in the vast majority of cases output never returns to previous trends. Indeed there appear to be more cases where recessions reduce the subsequent growth of output than where output returns to trend. In other words “super hysteresis” to use Larry Ball’s term is more frequent than “no hysteresis.”

This finding does not in and of itself establish the importance of hysteresis effects. It might be that when underlying growth rates fall recessions follow but that recessions have no causal impact going forward. In order to address this issue we look at the impact of recessions with different precursors. We find that even recessions that are associated with disinflationary monetary policies or the drying up of credit have substantial long run output effects suggesting the presence of hysteresis effects.

In subsequent work Antonio Fatas and I have looked at the impact of fiscal policy surprises on long run output and long run output forecasts using a methodology pioneered by Blanchard and Leigh. Since fiscal policy effects operate primarily through aggregate demand, this provides a way to avoid the causation question. We find that fiscal policy changes have large continuing effects on levels of output suggesting the importance of hysteresis.

I was struck that in a vote taken at the conference close to 90 percent of the participants indicated that they believe there are significant hysteresis effects. While there is much more work to be done, I believe that as of right now the right presumption is in favor of hysteresis effects despite their exclusion from the standard models used in almost all central banks.

Towards a New Macroeconomics

My separate comments in the volume develop an idea I have pushed with little success for a long time. Standard new Keynesian macroeconomics essentially abstracts away from most of what is important in macroeconomics. To an even greater extent this is true of the DSGE (dynamic stochastic general equilibrium) models that are the workhorse of central bank staffs and much practically oriented academic work.

Why? New Keynesian models imply that stabilization policies cannot affect the average level of output over time and that the only effect policy can have is on the amplitude of economic fluctuations not on the level of output. This assumption is problematic at a number of levels.

First, if stabilization policies cannot effect average levels of employment and output over time they are not nearly as important as if they can. Beginning the study of stabilization with this assumption takes away much of the motivation for doing macroeconomics.

Second, the assumption is close to absurd.  It is surely reasonable to assume that better policy could have avoided the Depression or the huge output losses associated with the financial crisis without having shaved off some previous or subsequent peak.

Third, contrary to the now common view that macroeconomics is best understood by studying the stochastic properties of stationary time series, the most important macroeconomic events are in some sense one off. Think of the Depression or the Great Recession or the high inflation of the 1970s.

The problem has always been that it is difficult to beat something with nothing. This may be changing as topics like hysteresis, secular stagnation, and multiple equilibrium are getting more and more attention.  As well they should. US output is now about 10 percent below a trend estimated through 2007. If one attributes even half of this figure to the effects of recession and assumes no catch up on this component until 2030 the cost of the financial crisis in the USA is about 1 year’s GDP. And matters are worse in the rest of the industrial world.

As macroeconomics was transformed in response to the Depression of the 1930s and the inflation of the 1970s, another 40 years later it should again be transformed in response to stagnation in the industrial world. Maybe we can call it the Keynesian New Economics.

Where Paul Krugman and I differ on secular stagnation and demand


Paul Krugman suggests that I have had some kind of change of heart on secular stagnation and converged towards his point of view, citing the publication of the transcript of a 2011 debate which we both participated in. I certainly appreciate the gravity of the secular stagnation issue more than I did a few years ago, given the continuing decline in global real interest rates. But I think Paul exaggerates the change in my views considerably.

The topic of the debate was: “North America faces a Japan-style era of high unemployment and low growth.” Paul argued in favor. I opposed the motion – not on the grounds that the US economy was in good shape, but on the grounds that our demand deficiency problems should be easier to solve than Japan’s.

Quoting from my response to Paul’s arguments:

You’re right the United States has a serious demand deficiency. You’re right that not enough is being done to contain that demand deficiency. You’re right that we will suffer needless unemployment and stagnation until more is done to address that demand deficiency….

My thesis is that as serious as that problem is, it is dimensionally much less than the problems that Japan faced in four respects. Japan’s problems were different in magnitude, different in the depth of their structural roots, different in the relative perspective they had — relative to the rest of the world — and different in the degree of resilience their system had for adapting to them…

…It will take time. There are steps that need to be taken but we are a society that works. We are a society whose principal problems — we all up here agree — can be addressed by a change in the printing of money and the creation of infrastructure.”

Paul responded in part by saying:

The question is, are we going to be stuck in a state of depressed demand of the kind that Larry has talked about. Larry and I agree that that is what has been happening… I think Larry and I agree almost entirely on the economics, on what needs to be done”.

(Full transcript available here).

I think we have both been focused on demand and the liquidity trap for a long time.

There are, though, two areas where I have had somewhat different views from Paul. I believe that structural issues are often important for demand and growth. I have often asserted that “business confidence is the cheapest form of stimulus”, and quoted to President Obama Keynes’ famous 1938 letter to Roosevelt:

“Businessmen … are … at the same time allured and terrified by the glare of publicity, easily persuaded to be ‘patriots’, perplexed, bemused, indeed terrified, yet only too anxious to take a cheerful view, vain perhaps but very unsure of themselves, pathetically responsive to a kind word. You could do anything you liked with them, if you would treat them (even the big ones), not as wolves or tigers, but as domestic animals by nature, even though they have been badly brought up and not trained as you would wish… If you work them into the surly, obstinate, terrified mood, of which domestic animals, wrongly handled, are so capable, the nation’s burdens will not get carried to market; and in the end public opinion will veer their way.”

Second, I have never related well to Paul’s celebrated liquidity trap analysis. It has always seemed to me be a classic example of economists’ tendency to “assume a can opener”. Paul studies an economy in liquidity trap that will, by deus ex machina, be lifted out at some point in the future. He makes the point that if you assume sufficiently inflationary policy after this point, you can drive ex ante real rates down enough to stimulate the economy even before the deus ex machina moment.

This is true and an important insight. But it seems to elide the main issue. Where is the deus ex machina? Where is the can opener? The essence of the secular stagnation and hysteresis ideas that I have been pushing is that there is no assurance that capitalist economies, when plunged into downturn, will over any interval revert to what had been normal. Understanding this phenomenon and responding to it seems the central challenge for macroeconomics in this era.

Any analysis that assumes restoration of previous equilibrium is, from this perspective, missing the main issue.  I was glad to see Paul recognize this point recently.  I suspect it will lead to more emphasis on fiscal rather than monetary actions in depressed economies.


This critique of the Fed isn’t backed by logic nor evidence


My friends Mike Spence and Kevin Warsh, writing in yesterday’s Wall Street Journal, have produced what seems to me the single most confused analysis of US monetary policy that I have read this year (Brad DeLong has expressed related views).  Unless I am missing something — which is certainly possible — they make a variety of assertions that are usually exposed as fallacy in introductory economics classes.

My problem is not with their policy conclusion, though I do not share their highly negative view of QE.  There are many harshly critical analyses of QE such as those of Martin Feldstein that are entirely coherent and consistent with the macroeconomics of the last 50 years.  My differences are based on judgements about empirical magnitudes and relative risks not questions of basic logic.

Spence and Warsh do not focus on the inflation risks, financial stability risks or distributional risks from overly expansionary monetary policy.  Instead they assert a proposition that I have not encountered in 40 years as a professional economist—that overly easy monetary policy reduces business investment.  Indeed they blame the weakness of business investment during the current recovery on the Fed.

This line of argument is to say the least surprising.  Every major macroeconomics textbook whether Keynesian monetarist or classical in orientation teaches students that investment increases as real interest rates decline.  This is motivated in a variety of quite compelling ways.  It is noted that lower rates raise the present value of the returns from investment and so make them more attractive.  It is observed that lower rates mean lower borrowing costs or lower costs of drawing down liquid asset holding making the purchase of capital goods more attractive.  For these reasons millions of students have been taught that Hicks famous IS curve slopes downward.  Hundreds of empirical studies have found that investment responds to capital cost as theory predicts though the magnitude is open to debate.

What arguments do Spence and Warsh offer for their heterodox conclusion? They note rightly that monetary policy has been easy and investment has been weak in the current recovery.  This is a little like discovering a positive correlation between oncologists and cancer and asserting that this proves oncologists cause cancer.  One would expect in a weak recovery that investment would be weak and monetary policy easy.  Correlation does not prove causation.

They then argue that low rates somehow promote corporate stock buybacks and this is an alternative to real new investment.  I confess that I cannot follow the logic here.  I would have supposed that the choice between real investments and share repurchases would depend on their relative price.  If as Spence and Warsh assert QE has raised stock prices this should tilt the balance towards real investment.

Likewise I would have thought that by making the return to holding cash less attractive, easy money would tend to drive firms into making real investments.  And for the many firms that do not have huge hoards, it would bring down borrowing costs.

Perhaps Spence and Warsh are on to something that I am missing.  I’m curious whether they can point to any peer reviewed economic research or indeed any statistical work that backs up their views.  I am certainly open to any new evidence or new argument after all that has happened in recent years that easy money reduces business investment.  And there is plenty of room for debate over policy.  For now though I would put the Spence-Warsh doctrine that easy money reduces investment in a class of propositions backed by neither logic nor evidence.

Plan for Puerto Rico should be the basis for prompt Congressional action 


Last week, the Treasury announced their recommended approach to the profound economic and financial crisis engulfing  How things play out from here will be an important test of whether or not Washington is, as some allege, controlled by financial interests.

The Puerto Rican economy has declined by more than 10 percent since 2006 and employment has declined by 14 percent.  Nearly 2.5 percent of the population left the island in 2014.

The problems are in part structural, coming from the combination of labor costs close to the US level but productivity more comparable to the richer nations of the Caribbean. They are in part cyclical, as the bursting of a real estate bubble has led to sustained bank deleveraging: the overall balance sheet of Puerto Rican banks has declined more than that of Greece. And they are in part a result of weak Puerto Rican policy going back many years.

This rate of decline is only likely to increase, as Puerto Rico starves basic public functions to service its debts to the greatest extent possible, and eventually defaults in an uncontrolled way that produces financial chaos.

Unfortunately that is what lies ahead for Puerto Rico without Federal government action.  Already Puerto Rico’s debt exceeds its GNP, and debt service takes one third of its tax revenue, compared with the 5 percent average for US states.  Debts are currently being serviced only through emergency measures that cannot be sustained even to the end of the year.  This is well recognized by markets.    The benchmark Puerto Rican bond carries yields of over 11 percent, and in some cases, Puerto Rican bonds trade at only 30 cents on the dollar.

Right now the situation is frozen.  Puerto Rico has little to gain from reforms that increase economic growth if the extra resources will all go to its creditors. In any event it has proven itself incapable of responsible economic management.  On the other hand no individual creditor or group of creditors, even if they bought a claim for 30 cents on the dollar, is motivated to accept less than full payment as long as other creditors are going to be paid in full.  So Puerto Rico’s economy spirals down and the value of its debts declines alongside it.

What needs to be done?  There are two crucial requirements that parallel any situation of financial distress.  First, Puerto Rico needs to adjust its policies so that its economy can compete in the modern world and its government has sustainable finances.  Second, a realistic settlement needs to be reached where Puerto Rico is protected from its creditors and their claims are adjusted to realistic levels.   These two elements are present when a company goes into Chapter 11, a country goes to the IMF or a municipality files for bankruptcy.

Unfortunately, there is no legal provision in the bankruptcy code under which Puerto Rico can file, because it is a territory not a municipality.  This means that there is no overall framework in which debts can be written down in an equitable way that respects their legal status,  and there is no way in which support for Puerto Rico can be officially tied to policy reforms.  Without an extension of the bankruptcy code to cover territories, there is no way of resolving Puerto Rico’s situation.

An extension of the bankruptcy code to cover Puerto Rico is the centerpiece of Treasury’s proposal.  The proposal makes the judgement that a comprehensive plan is necessary.  The development of the plan it leaves to Puerto Rico, its creditors and the judiciary.  Treasury takes the bold and, I believe, appropriate step of proposing a bankruptcy procedure that can address all of Puerto Rico’s debt and pension issues, rather than excluding some debts from consideration altogether.

It is hard to see why people of good will should oppose such a measure.  Some argue that there has as yet been insufficient forensic accounting.  At one level this is true.  Before an actual restructuring in bankruptcy plan could be agreed, much more financial analysis is surely required.  But enough is known now to leave no doubt: Puerto Rico’s debts cannot be serviced in full and so a bankruptcy procedure is required, even if its precise outcome cannot be predicted.   One of the many virtues of a bankruptcy procedure is that it will provide the financial analysis that is required to move forward.

Others suggest that if Puerto Ricans just tighten their belts all debts can be paid.  This is absurd given the size of the debts, the prices at which they are trading, and the rate of collapse of Puerto Rico’s economy. This is a case like most where insolvency is being acknowledged too late.  If Puerto Rico had acknowledged its insolvency earlier – rather than trying to paper things over by issuing debt with a yield of close to 9 percent to a group of hedge funds – its creditors, its people, and the American economy would all have been better off.

The constituency opposing bankruptcy is largely comprised of those who are hoping for large capital gains on Puerto Rican debt.  If they are able to block the establishment of a framework for dealing with Puerto Rico’s debt, it will be a tragedy for Puerto Rico.  It will also be a profoundly troubling reflection on the power of special interests in Washington.  Let us hope that the Treasury’s prudent approach will prevail.


Canadian elections proof that an anti-austerity message is a winning one


The Canadian liberal party won an overwhelming victory in yesterday’s election.  Voters decisively rejected the ruling Conservative party and placed the Liberal Party far ahead of the left wing New Democratic Party.  This is obviously important for Canada.  But there are also two lessons here for American political observers.

First, polls often get it wrong.  As in Britain, and now the Canadian election, results were much more decisive than had been expected.  A Liberal majority looked extremely unlikely two months ago.  Even three days ago, I suspect Liberals would have been thrilled if they could have counted on a clear plurality of the vote.  An era when less than 10 percent of voters respond to pollsters, and where mass opinion changes rapidly, will be one where Election Day is again a day of drama.

Second in an era of extraordinarily low interest rates and slow growth, it is becoming increasingly clear that progressives do best when they reject austerity and embrace public investment.  The British Labour party and the Canadian NDP sought to demonstrate their soundness by embracing budget balancing as an objective.  Their results were terrible.

The Canadian Liberals on the other hand were rewarded for a very different choice.  As incoming PM Justin Trudeau told the Financial Times “people keep telling me we have made a risky choice in this time when there is this political mantra of balanced budgets as a way to demonstrate responsible leadership.  I am on the side of economists who say: Why put off investing when we have an opportunity now?”

Indeed many Canadian political commentators noted the strategic importance of the Liberals’ infrastructure pledge. Martin Patriquin in Maclean’s called the infrastructure plan “the all-important wedge to isolate the NDP”; Michelle Gagnon in CBC news identified the announcement of deficit-funded infrastructure spending  as “the first turning point”; and, as  noted on Bloomberg, “Trudeau entered the campaign in third place and his numbers began to increase after he broke from his rivals to favor three years of deficit spending, in part to fund an infrastructure blitz aimed at stoking Canada’s sluggish economy”.

More infrastructure investment is not just good economics.  It is good politics.  Let us hope that American presidential candidates get the word!

Pandemic bonds have potential to be win-win-win


During the annual IMF-World Bank meetings last week in Lima, Peru, I was part of a discussion on a proposed pandemic emergency financing facility. The subject brought together two things I am very interested in. First, The Lancet Commission on Global Health 2035, which I recently chaired, argues that under-investment in health-related global public goods is a major problem–and that in particular the world is badly under-investing in epidemic and pandemic protection relative to the risks involved. Second, after all that has gone wrong in recent years, it seems incumbent on all of us involved in finance to think about how financial innovations can address the real problems of real people.

The idea under discussion is a potentially powerful one: some public entity would issue bonds to investors which would be deemed to default in the event of an epidemic, assuring the availability of resources to respond before the epidemic takes on pandemic proportions. The facility would complement the new WHO contingency fund as well as its existing financing mechanisms. Such bonds are routinely issued to mobilize resources that will trigger in the event of hurricanes or earthquakes. So called catastrophe bonds or cat-bonds offer higher yields to investors in return for taking risks that are not correlated with the normal risks of business cycle downturns.

This has the potential to be a win-win-win. The World Bank is using financial innovation to mitigate a major threat to the world, and especially the world’s poor. The vast resources of the global capital market are being tapped to provide vitally important insurance – and bring much-needed financial discipline to pandemic preparedness and response. And investors who, at this time of zero rates, are desperate for return are getting a new vehicle in which to invest. Little wonder that the session brought together health advocates, national aid agencies and leading financial firms, all of whom were very positive.

I hope 2016 will see the advent of epidemic or pandemic bonds. But there are two hurdles that will have to be overcome if this initiative is to succeed. These hurdles, amidst the happy talk of cooperation, were I thought somewhat elided in the conversation.

First, a suitable price has to be found for these bonds: a price that works for both investors and for those who will issue them. Experience with hurricane and earthquake bonds suggests that in order to accept a 1 percent chance of default, investors require about a 3 percent yield premium. The same is likely true of epidemic or pandemic bonds. In an expected value sense the bonds are expensive for issuers and attractive to investors. So the question posed is this: As an aid agency concerned with, say, health in sub-Saharan Africa, is it better to pay $3 million to support the issuance of a bond that will with 1 percent probability pay off $100 million or is it better to give the $3 million to support improvements in local health care systems?

Second, a suitable contract has to be drafted specifying when exactly the bonds will default. Investors will expect something observable that does not involve any discretion so that actuaries can make rigorous models. The health community seems to see these bonds as vehicles for driving all sorts of good things like reform of local systems and very rapid response at the first instant in an epidemic situation. A way of satisfying both constituencies needs to be found.

I think these problems are solvable. But it will take more than rhetoric of cooperation and good will. It will take good ideas and hard negotiation. We can all hope that they will be forthcoming.

Another argument for infrastructure repair


There are many compelling arguments for increasing American infrastructure investment. Capital costs are exceptionally low. Construction labor is highly available. Materials costs are low as commodity prices have fallen. Investment is low by historic standards. Investing today relieves the burden for deferred maintenance from future generations.

Here is another one. Maintaining our infrastructure directly benefits American families and businesses because with fewer potholes they have to spend less maintaining their vehicles. This effect turns out to be surprisingly large. TRIP, a transportation research group, estimates that the cost to motorists of driving on roads in need of repair in 2013 was $109 billion. 1 This includes only extra vehicle repair and operating costs, and not the delays caused by driving on poor roads, so is almost certainly an underestimate. On the other hand, even with proper polices some potholes would remain. To be very conservative assume that proper infrastructure investment policies would save motorists half the total, or $54 billion a year.

How large is this figure? It is comparable to total consumer spending of $49 billion on air transportation or $53 billion on personal computers 2. As another way of seeing its magnitude, it works out to 40 cents per gallon gasoline consumed in the United States 3.

So if we were able to raise the gas tax by 40 cents and repair our highways and roads, we would create no new net burden on consumers: the benefit in reduced vehicle operating costs would at the very least offset their higher gas bills. In fact since our cost estimate is conservative, the net effect on consumers would most likely be positive. And as is fair, those who drive the most would both pay the most and benefit the most from reduced repair costs.

Even after a 40 cent gasoline tax, gas would still be only 82% as expensive as a year ago and 79% as expensive as 2 years ago 4. A gas tax to finance road repair is about as close to a free lunch as we can ever get in economics.

  1. TRIP, Additional Vehicle Operating Cost per Motorist 2013
  2. BEA National Income Table 2.4.5U: Personal Consumption Expenditures by Type of Product, 2013
  3. EIA SEDS Table F3: Motor Gasoline Consumption, Price, and Expenditure Estimates, 2013
  4. EIA Petroleum Data: U.S. All Grades All Formulations Retail Gasoline Prices, Monthly

The Importance of Global Health Investment


One of the things I am proudest of having done in Washington was having the idea as Chief Economist of the World Bank that the Bank should devote its annual World Development Report to making the case for improving both the quantity and quality of global health investment. The 1993 report produced by a team led by Dean Jamison proved more influential than I could have hoped, not least because it drew Bill Gates into the global health arena.

The Report made a strong case that the benefits of the right health investments far exceed the costs.  Indeed, I believe the moral and economic case for investments in health care–both prevention and treatment–is as or more compelling than in any other area in the developing world.  The dramatic declines in child mortality and increases in life expectancy demonstrate that policy can make an immense difference.

Dean and I chaired a commission, timed to coincide with the 20th anniversary of the initial report, under the aegis of the LANCET.   The commission took stock of the remarkable progress made over the last 20 years and emphasized what is possible over the next generation.

The primary conclusion of our commission was that our generation has the opportunity to achieve a “grand convergence” in global health reducing preventable maternal, child, and infectious diseases to universally low levels by 2035.   We further concluded that the necessary investments would have benefits that exceeded their costs by a factor of 10.  But we cautioned that grand convergence would not just happen.  It would require commitments to health system reform and to new domestic and international resources that go well beyond what is in place today.

All of this seems immensely relevant as world leaders gather in New York this week to to agree on a bold new global agenda for sustainable development.  The breadth of ambition embodied in the 17 Sustainable Development Goals and the associated 169 targets is truly inspiring and a tribute to the moral energy of many leaders in and out of government.

But there is the risk that with so many priorities, there will be insufficient focus on the most important and achievable objectives.  I was therefore excited when the Rockefeller Foundation asked me to work with them to develop a Declaration that a broad spectrum of economists could issue underscoring the importance of global health efforts.  The 266 economists who have joined our declaration come from 44 countries and at least as many political and ideological perspectives.  But they are united in their belief in the importance of expanding and improving health care globally.

Our Declaration was published in the LANCET last week and is summarized in a full page New York Times ad that is running today.  I hope the world listens.  Millions of lives are at stake.

The relationship between Universities and the Military


I had occasion to address a gathering of Congressional Medal of Honor recipients visiting Harvard last week. It was an opportunity to reflect on the meaning of courage, and also on the relationship between universities and the military. Our freedom, including our academic freedom, depends on the existence of a strong military, and of people who are prepared to serve in it. Universities have a responsibility to support the individuals and the institutions which defend that freedom.

The good news is that ROTC is back at Harvard, and that military recruiters are allowed on campus. The bad news is that our cooperation with the military appears to be contingent.  It reflects less a sense of our obligations of citizenship than our lack of major disagreement at this moment with the country’s military policies. I did not support the Don’t Ask Don’t Tell policy, nor the invasion of Iraq, but I do not believe that support for the military should be contingent on the political decisions of those who exert civilian control over it.

Given that the harmony between universities’ values and the military’s policies is unlikely to endure permanently, I think the issue of universities and the military is profoundly important.

Good news from Ukraine


The Ukrainian parliament today voted to ratify Ukraine’s debt reduction deal by a massive majority embracing all major factions.  This is important positive news in several respects.  First, as I have explained elsewhere it enables Ukraine to get the various benefits of debt reduction.  Second, the unity of support for Finance Minister Natalie Jaresko is encouraging with regards to future economic reform in Ukraine.  Third, today’s action puts Ukraine in the best possible position for coming debt negotiations with Russia and for receiving the further support it requires from the international community.

What to watch on Fed day


Today the Federal Reserve will makes its most consequential announcement in years.  Much attention has rightly focused on whether the fed funds rate is increased.  Ultimately though what matters is the posture of monetary policy, which depends on both the fed funds rate tomorrow and the path of expected rates.  My views are clear; this is not the time for a tightening in monetary policy.

Whether the fed funds target is increased or not is obviously an indicator of monetary policy. A better reflection is the 2 year Treasury rate which is largely determined by expectations of the fed funds rate the fed will set over the next 2 years.  It is this 2 year Treasury rate that I will be watching as the market digests the Fed’s policy announcements and forecasts and Chair Yellen holds her press conference.

I think it likely that the 2 year will move contemporaneously with the fed funds rate.  If rates are not raised I’d expect the two year to fall and if they are raised, I’d expect it to rise.  But this is not certain.  A “hawkish” holding of the rate where the Fed moved towards locking in future increases could raise 2 year rates.  Conceivably but less likely a “one and done” type announcement could on balance lower expected rates and so 2 year yields.

The figure below shows that two year yields and the chance of a rate increase in September have mostly moved together but that very recently markets have started to anticipate policy tightening that is not rooted in a September fed funds hike.  I see a risk that the fed will not move this afternoon but will appease hawks with such firm language on future rate hikes that their overall impact will be contractionary.  This would be very unfortunate.


Monetary policy should seek to avoid major surprises


In recent writings, I have laid out the strategic case against the Federal Reserve tightening this week. There is a compelling tactical case as well.

Monetary policy should seek to avoid major surprises.  Right now the fed funds futures market is assigning only a 28 percent chance to a September tightening. In the last 20 years, the Fed has never tightened without guiding the futures market to at least a 70 percent chance of a tightening.  So a move now, given how expectations have been managed, would be an extraordinary shock at a highly uncertain time.

To find a relevant precedent, one has to go back to 1994, when the Fed raised rates by 25 bps despite the market assigning only about a 30 percent chance (around what is expected now) of a tightening.  What followed was dubbed by Fortune Magazine as the Bond Market Massacre.”  Over the ensuing nine months, the interest rate on the 10-year bond rose by 2.2 percentage points — nearly twice as big an increase as any subsequently — with mortgage rates rising in tandem.   Volatility spiked dramatically across the world, and Orange County had the then-largest municipal bankruptcy in U.S. history.  Mexico and Argentina moved towards financial crisis.

There is a point here quite separate from the issue of what monetary policy should be.  Communication is a key part of the art of monetary policy.  The Fed for a generation has caused its tightening moves to be anticipated because it learned from the 1994 experience.   The same approach should be taken going forward.  Even if it were otherwise a good idea to tighten, no adequate predicate has been laid for a rate increase this week.


Why Ukraine’s debt deal is important not just for Ukraine, but for the West


I have spent the last two days in Kiev attending the Yalta European Strategy meeting, where I have had the chance to discuss Ukraine’s economic reform efforts with key officials, including the finance minister and prime minister.  I was encouraged to see a country where, despite huge challenges, including Russia’s war of aggression against Ukraine, economic reforms are being carried out and receiving support from the international community.

The Ukrainian parliament will this week vote on a historic debt reduction agreement that finance minister Natalie Jaresko negotiated with Ukraine’s private-sector creditors. The case for approval is overwhelming, both because Ukraine has made a good deal and because disapproving the deal would be catastrophic for Ukraine’s economy. But approval of the debt deal is only one component of the ambitious economic cooperation among Ukraine, Europe and the United States – cooperation that is essential to the geopolitical moment.

I have been watching debt negotiations closely for more than 30 years, since the Latin American crisis of the 1980s. Ukraine has gotten as good and fast a deal as any I have ever seen.

The deal has many virtues:

  • It reduces the principal value of Ukraine’s debt and eliminates principal payments for the next four years.
  • It unlocks substantial support from the International Monetary Fund and other international financial institutions on a large-scale.
  • It brings forward the day when Ukraine can attract significant private capital flows.
  • It establishes clear principles that will enable Ukraine to defer all principal payments on its obligation coming due to Russia.

Even if Ukraine’s economy does very well, the “value recovery instrument” issued as part of the debt deal, which aligns debt repayment with economic growth, is shrewdly designed so that the vast majority of future growth will still flow to the Ukrainian people, not to its creditors. This is because: (i) the instrument only kicks in at scale in a decade; (ii) it is subject to repurchase on the open market and to subsequent renegotiation; and (iii) it is carefully designed to ensure that only the initial benefit and not the continuing benefit of Ukraine’s growth flows to creditors.

In the unlikely event that Ukraine’s parliament disapproved the deal, all these benefits would be lost. International financial support would dry up as Ukraine would be seen as unable to carry through on commitments. Confidence in the stability of Ukraine’s currency and banking system would be put at risk. And its leverage vis-a-vis its debt to Russia would vanish.

So I hope and expect that the Ukrainian parliament will ratify the debt deal in the very near future. To paraphrase Churchill, this may not be the end, or even the beginning of the end of Ukrainian economic reform, but it may be the end of the beginning.

Make no mistake – the United States and Europe have an immense stake in Ukraine’s economic success. Our leaders rightly assert that military force is often not the right solution to international conflict. Enabling Ukraine to provide greater improvements in living standards for its citizens than Russia does would be a major triumph for the West. In this regard what we do for Ukraine is likely more important than what we do to Russia.

Support for Ukraine should not be seen as foreign assistance to a striving economic reformer, though it is that. Rather, with Ukraine invaded, support should be seen as investment in forward defense of core U.S. and European security interests. If Ukraine succeeds economically, investments will pay for themselves several times over as loans are paid back with interest, and as Russia’s government is both deterred by Ukraine’s stronger economy and pressured by its economic example.

Historians will wonder why the international community has invested more than 10 times as much money in supporting a recalcitrant Greece as in supporting a reforming Ukraine, since the start of their crisis.  Perhaps intra-European Union loans are in some special category, but as of this moment the IMF’s potential exposure to Greece is $41 billion compared to only $22 billion for Ukraine.

Now is the moment for Ukraine at long last to embrace the market and the rule of law.  It has the best, most market-oriented economic team in its history. And it is the time for global community to do whatever it takes—much more than is being done today—to provide support at a critical juncture.


Thoughts on Freeman’s Bargaining for the American Dream


Yesterday, I participated in a Center for American Progress forum where a new study on unions and social mobility was released. The study, by my Harvard colleague Richard Freeman and collaborators, showed a significant correlation across American metropolitan areas between the extent of union membership and social mobility. Freeman, who based his research on data in the famous studies of Raj Chetty and his collaborators, also showed that the children of union members earn higher wages and are healthier than other children.

This is important work. From Ted Cruz to Bernie Sanders, there is agreement across the political spectrum that equality of opportunity is an American ideal — that Thomas Jefferson was right in saying that America should be an aristocracy of talent. Yet equality of opportunity in the U.S., no matter how measured, lags behind other countries and certainly has not progressed over the last several decades.

Chetty’s celebrated “equal opportunity map,” reproduced below, shows that there are no grounds for fatalism. Different parts of the U.S. deliver very different levels of social mobility, while all in the same global economy, with the same technology, and the same increasing proclivity of able men and women to marry each other. There is nothing immutable about the existing inadequate level of equal opportunity.


The map demonstrates that equality of opportunity is particularly bad in the old confederacy and particularly good in some of the old bastions of abolitionism. It is not therefore surprising that unions, which were concentrated in the North, turn out to be correlated with equal opportunity. More impressive is the research result that looking across families, fathers who are union members have children who earn at least 15 percent more than those who are not in union families, and that this stands up even with various control variables added. The implication is that supporting unions not only helps workers who are members themselves but also helps their children and communities as well.

Few people believe that private unions in the United States had excessive power in the 1970s. Yet the share of private sector workers in unions has fallen from over 24 percent in 1973 to under 7 percent today. Unions are surely too weak today. Their weakness most clearly shows up in workers who have difficulty maintaining a middle class lifestyle. In a more profound way, the weakness of unions leaves a broad swath of the middle class largely unrepresented in the political process, paving the way for the kind of disillusionment that has driven the Trump candidacy. After all, no society is going to remain stable and confident in its central institutions if parents do not believe their kids can lead better lives than they did.

In 2009, at the Brookings Institution, I spoke about the important role of unions in generating broadly shared growth. I said, “If we want to propel this economy forward and we want to have a sound expansion, it has to be an expansion whose benefits are more broadly shared. And that goes to the question of tax policy and progressivity, it goes to the question of education over the longer term, and it goes to the question of having a healthy and well-functioning trade union movement.”

Broadly shared prosperity is even more elusive today, so what is needed going forward? I would suggest three important steps.

First, we need serious enforcement of laws to stop employers from punishing workers seeking to engage in collective action. Enforcement has historically lagged badly as it typically takes at least four and often as many as seven years for cases to be decided. And even if employers are eventually found guilty of violating the rules, the penalty is generally under $10,000 per harmed worker. Anti-union employers can violate the law with near-impunity worrying only about slaps on the wrist years in the future. As Morris Kleiner and David Weill found: “expected costs [for being found guilty of violating labor laws] represent a fraction of the benefits to employers … from thwarting organizing drives. It is therefore not surprising that there has been a sevenfold increase in the percentage of violations of the act”.1

Second, the union movement needs to expand on its efforts to build models of collective action that are not rooted in traditional command and control corporation. This may include increased emphasis on profit sharing, on labor management dialogue, on industry wide bargaining, and many other ideas as well. Organized Labor needs to adapt to the pervasiveness of white collar, pink collar, and no collar work in addition to traditional blue collar work.

Third, there is a compelling case even if it does not appear politically realistic right now for labor law reform to give more scope to those seeking to organize workers. There are detailed agendas of possible reform. What is important now is that a consensus form around the idea of reducing burdens on union organizers.

Thanks to the work of Freeman and his collaborators, we now know that stronger unions are not just good for their members, they are good for our country and our descendants. Strengthening collective worker voice has to be an important component of any realistic American inclusive growth agenda.




Why the Fed must stand still on rates


Two weeks ago I  argued that a Federal Reserve decision to raise rates in September would be a serious mistake.  As I wrote my column, the market was assigning a 50 percent chance to a rate hike. The current chance is 34 percent. Having followed the debate among economists, Fed governors and bank presidents I believe the case against a rate increase has become somewhat more compelling even than it looked two weeks ago.

Five points are salient.

First, markets have already done the work of tightening.  The U.S. stock market is worth $700 billion less than it was 2 weeks ago and credit spreads have widened noticeably.  Financial conditions as measured by Goldman Sachs or the Chicago Fed index have tightened in the last 2 weeks by the impact equivalent of more than a 25 BP tightening.  So even if resisting inflation required a 25 BP tightening as of two weeks ago, this is no longer the case.

The figure below makes a crucial point.  It shows that even though the federal funds rate is very low (negative one and a half percent after adjusting for inflation), financial conditions are helping the economy less than in previous years when interest rates were much higher.


Second, the data flow suggests a slowing in the U.S. and global economies and reduced inflationary pressures.   Employment growth appears to have slowed down, commodity prices have fallen further, and the general data flow has been on the soft side.  Comprehensive measures of data surprises, such as the Bloomberg Economic Surprise Index, bear out this impression and the Atlanta Fed’s GDP Now model is currently predicting only 1.5% growth in Q3.

Third, the case for concern about inflation breaking out is very weak.  Market based expectations suggest that inflation over the next decade on the Fed’s preferred core pce basis is near record lows and well below 2 percent.  The observation that 5 year inflation, 5 years from now is expected to be below target calls into question arguments that current low inflation is somehow transitory.

The recent analysis presented by Fed Vice Chair Stanley Fischer asserting to the contrary relies on assumptions about exchange rates and inflation.  When actual empirical estimates are used his conclusions are substantially weakened.  Indeed as the figure below shows, there is no correlation of late between deceleration in inflation and import share looking across PCE components.InflationAndImportSharePCE.xlsx

Also on inflation, it bears emphasis that (i) we have some room for inflation acceleration (ii) prices are now fully 2 percent below a 2 percent inflation path taking off from 2010, (iii)  the Phillips curve is so unstable that it provides little basis for predicting inflation acceleration.  To take just two examples — first, unemployment among college graduates is 2.5 percent yet there is no evidence that their wages are accelerating. And unemployment in Nebraska has been below 4 percent for the last 3 years and growth in average hourly earnings has been basically constant at the national average level.

Fourth, arguments of the “one and done” variety or arguments that the Fed can safely raise rates by 25 BP as long as it’s clear that there is no commitment to a series of hikes are specious. If as some suggest a 25 BP increase won’t affect the economy much at all, what is the case for an increase? And when the same people argue that 25 BP will have little impact and that it is vital to get off the zero rate floor, my head spins a bit.

In a highly uncertain world, the Fed cannot be both data dependent and predictable with respect to its future actions. Much better that it stick with data dependence than that it put its credibility at risk by seeking to mitigate a current rash action by trying to reassure with respect to future steps.

I understand the argument that zero rates are a sign of pathology and the economy is no longer diseased so policymakers have to increase rates.  The problem is that the case for hitting the brakes in an economy with sub-target inflation, employment and output is not there; regardless of whether the brakes are to going to be pressed hard or softly, singly or multiple times.

From the Vietnam War to the Euro crisis, from the Iraq war to the lessons of the Depression we surely should learn that policymakers who elevate credibility over responding to clear realities make grave errors.  The best way the Fed can maintain and enhance its credibility is to support a fully employed American economy achieving its inflation target with stable financial conditions.  The greatest damage it could do to its credibility would be to embrace central banking shibboleth disconnected from current economic reality.

Fifth, I believe that conventional wisdom substantially underestimates the risks in the current moment.  It bears emphasis that not a single post war recession was a predicted a year in advance by the Fed, the Federal government, the IMF or a consensus of forecasters.  Most were not recognized till long after they started.  And if history teaches anything it is that financial interconnections are pervasive and not apparent till it’s too late.   Russia’s 1998 default, problems in subprime lending, and the Asian financial crisis were all moments when financial dislocations had far more pervasive effects than was generally expected.

We know that the world’s largest economy, China, is in its most uncertain state since it began economic reform in 1979 and may well be experiencing a larger volume of capital flight than any economy in history.  We know that the central banks  of Japan and Europe are likely to have to double down in the months ahead on already extraordinary quantitative easing.  We know that American households, firms and markets are processing what appears to a kind of “reverse 1990s” moment of sharply decelerating productivity growth.  We know that liquidity conditions in markets have worsened and there is at least some reason to believe that “positive feedback” trading strategies where investors sell when prices go down may well have become increasingly important.  We know the current U.S. recovery is in its 7th year and that confidence in public institutions is at a low ebb.

More likely than not, these fears are overblown and 2015 and 2016 will not go down in financial history.  If so, and the Fed does not act, inflation will start to accelerate, volatility will subside and policy can step in.  Regret may come in the form of inflation a few tens of basis points too high or a bit of euphoric relief in markets.  If on the other hand, some portion of these fears are warranted and the Fed tips towards tightening, it risks catastrophic error.

Now is the time for the Fed to do what is often hardest for policymakers.  Stand still.

September 9, 2015


Larry’s new blog


Over the summer, I have expanded my website to include a new blog that will enable me to comment on economic policy issues and current events more generally.  I will continue to write my monthly Financial Times/Washington Post column, and their websites will also feature my blog content.  This blog will enable me to address issues immediately, informally, and at varying lengths and to pose questions that I think economists have inadequately considered.   It will also provide an opportunity to disseminate various commentaries and discussions that I present at conferences.

As I have often noted, policymakers in political environments are most constructive when they find approaches that are appealing from a variety of perspectives and command widespread support.  Academics, on the other hand, are most useful when they provoke thought and debate and present new approaches.  In that spirit, I will regard this venture as successful only if it incites disagreement and debate.  My goal will often be to expose fallacy or misguided opinion.  However, I shall never try to impugn the motives of those with whom I disagree.

Comments and questions are welcome, but we will only be able to select a few to post with each blog.  I may, from time to time, respond to questions or comments in a new blog posting, but will not be able to respond to each individual comment received.

I hope you will find some interesting ideas in this new blog and share it with your colleagues and friends.


Thoughts on Ukrainian Debt Restructuring


I was very glad to see Ukraine reach a deal involving reduction in the principal value of its debt with major creditors. This would not have happened without the tenacity and determination of Ukrainian finance minister, Natalie Jaresko, and Ukraine’s political leadership. Congratulations also to the IMF and the U.S. Treasury for their strong efforts. continue

The Astonishing Returns of Investing in Global Health R&D


By Lawrence H. Summers and Gavin Yamey

How to reach a “grand convergence” by 2035

We have a once-in-human-history opportunity to achieve a “grand convergence” in global health—a reduction in infectious, maternal, and child deaths down to universally low levels everywhere on the planet. continue