Larry Summers’ blog

Two Good Men


Two longtime friends of mine, Chip Case and Michael Elliot, died within the last week after battles with long illnesses.  In different ways, they illustrated something I think is very important—that you can think superbly as an economist and act and live in an extraordinarily humane way.

Chip was a professor at Wellesley for the last forty years.  To the wide world he is best known for his collaboration with Robert Shiller on the Case-Shiller home price indices.  These indices, based on houses that are sold repeatedly, are the best tool economists have for tracking developments in the all-important housing market.

Those who know him well know that the economics profession had no more dedicated and inspiring a teacher.  Chip had time for every student and treated with equal interest the brilliant ones headed for careers as research economists and those who struggled to understand what elasticity meant.  I doubt there is any man anywhere who has done more to encourage women to pursue careers in economics than Chip did while teaching at Wellesley.

Chip’s warm optimism was an inspiration to all who had the opportunity to work with him.  I remember hi saying once that he thought his Parkinson’s had actually improved his golf swing by by weakening his right arm! And because he thought his students could do anything, they did much more than others would have thought possible.

Most economists run with the pack and do what is most rewarded by our profession.  They focus on research using existing data to fill in holes in the literature.  Chip charted his own course of total dedication to students and of doing research that involved developing primary data.  He was as content and happy as any friend I have, and he deserved every bit of the joy that was part of his life.

Michael, for most of the time that I knew him, was a journalists’ journalist.  He served in major editorial roles at The Economist, Time and Newsweek.  He was interested in everything and able to see every point of view.  Unlike so many reporters and editors, he had no axe to grind.  I have never been covered in a more fair-minded way than when Michael was in charge.  You could not predict with confidence where he would come out on any given issue.  But you could always be confident that when he came to an issue he would have something to say that was novel and worthy of serious reflection.

For the last five years Michael served as the CEO of ONE—an enormously effective advocacy group for global development founded by Bono.  As a board member it was my privilege to watch Michael lead.  He never failed to bring intellectual rigor to every question: whether it was how best to raise funds or what priorities with respect to global poverty were most important. But he also never failed to recognize how morally important and practically consequential ONE’s advocacy was.  And he always saw and brought out the best in every one of his colleagues.  Michael was truly a happy warrior as he fought global poverty.

Michael, even after his diagnosis, was always positive.   On those rare instances when he was frustrated, he channeled this energy into his journalism and his advocacy. His smile and his laughter were never forced; they reflected his genuine joy in his work.  He was proud and he should have been.  Millions of desperately poor people around the world who have never heard of Michael or even of Bono will live better lives because of the work Michael did at ONE.

I am deeply saddened by the loss of these two men, but so privileged to have known them and have learned from their great examples.

When the best umps blow a call


CBO is an American national treasure. Without the impartial objectivity it brings to the budget process our country would make much worse policy. Baseball without an umpire would be a very different game, and similarly the making of budget policy without CBO would be a very different and inferior activity. However, even the best umps occasionally blow a call and I am afraid that is what CBO has done in its recent infrastructure report.

An acknowledgment at the outset: I have been a strong advocate of infrastructure investment for years and have even argued that debt financed infrastructure is likely to reduce deb-to- GDP ratios because of the growth bump from infrastructure. This argument has been taken up by the IMF and many others. So I am not neutral on this subject.

My views come in part from a simple calculation. Imagine an infrastructure project that costs $1 and yields a modest 5 cents a year in real return forever, in terms of higher GDP. The project thus has a 5 percent social rate of return. Tax collections will rise by about 1.5 cents a year. With the indexed bond market suggesting federal real borrowing costs that are negative for 10 years and 50 basis points for 30 years, the government will come out ahead on the investment. Now, as Brad DeLong and I pointed out a few years ago, matters are more complex than this particularly because capital depreciates, and because infrastructure projects have other effects, but the basic point continues to hold.

So, I was very surprised to read the June CBO report on the consequences of federal investment. It assumes, from its reading of the literature (also here), as its central base case what it calls a 5 percent rate of return on infrastructure investment but then finds that the payback effect of infrastructure investment on the federal deficit is very small, contradicting my earlier claims and more importantly raising doubts about the desirability of a big infrastructure push.

Why the discrepancy? After carefully reading the report, and speaking at some length with CBO officials, I think I understand at least one aspect of it. CBO uses the term “rate of return” in a way that is very different than what I would regard as standard usage. They take a 5 percent rate of return to mean that one dollar more capital produces five cents more output. This turns out to be quite different from assuming that investments in public capital earn a 5 percent return.

For example, CBO does not subtract depreciation in calculating their rate of return unlike what is standard in the private sector. Nor, contrary to what I would have assumed was natural, do they suppose that rates of return are reduced by the fact that on their (questionable) assumptions it takes many years for dollars invested to turn into capital. (Think of R&D as an example here). Adjusting for these factors, CBO is actually assuming an economic return a little above 2 percent on public investment and then concluding it will not help much.

If one assumes that public investment is basically unproductive, it is no surprise that it does not yield large economic benefits. There is still the question of if the 5 percent rate of return is misdescribed, whether or not CBO has made a reasonable judgement about the productivity of public investment. I’m pretty skeptical. They rely on aggregate econometric estimates of an elasticity of GDP with respect to public capital. Such estimates are plagued by all sorts of problems of heterogeneity, simultaneity, limited variation in the exogenous variables and so forth.

I would prefer to build up from individual projects by looking for example at estimates of the return on fixing potholes, building dams, or repairing water systems. I think anyone taking this kind of ground up approach will conclude that the social return to public investment is far higher than 2 percent. This is, of course, a matter of judgement.

There are other, probably lesser, problems with CBO’s work. Much of the adverse effect of public investment on the budget in their work comes from an assumed increase in interest rates resulting from budget deficits. This assumption would have been natural once, but is much less compelling in the current liquidity trap, possible secular stagnation environment. They also haircut the return to federal investment by assuming that it crowds out state and local investment but do not recognize explicitly the benefits of less state and local borrowing. And they focus on deficit impacts rather than the more appropriate question of impacts on debt-to-GDP ratios.

On balance, I do not think anyone should change her mind about public investment based on CBO’s analysis. Great umpires never change their minds. But they do learn from their mistakes. I hope CBO will do better next time out.


A Remarkable Financial Moment


The US 10 and 30 year interest rates today reached all time low levels of 1.32 percent and 2.10 percent.  Record low 10 year interest rate were also registered in Germany, France, Switzerland and Australia.  Notably Swiss 50 year interest rates are now for the first time negative.  Rates out 15 years are negative in Germany and 9 years in France.

Such rates would have seemed inconceivable a decade ago and very unlikely even a couple of years ago.  I remember my parents paying off their 30 year mortgage on the house I grew up in during 1991 and thinking that the 4.5 percent rate they paid was some kind of antique the likes of which would never be seen again.  At the beginning of this year US 10 year rates were 2.27 percent and there was a general view that they would rise sharply to perhaps 3 as the Fed began to tighten.

As Table 1 makes clear extraordinarily low rates reflect both subtarget expected inflation even over long horizons and very low real interest rates.  Note that the real interest rates exceed reported for TIPS because I have adjusted yields to reflect the 35 basis point average difference between the Consumer Price Index used in calculating TIPS coupons and the Personal Consumption Expenditures deflator targeted by the Fed.Table 1 US Interest Rates & Inflation

The Fed Funds futures market provides a window into market thinking regarding the likely path of monetary policy.  Remarkably the market does not now expect a full Fed tightening until early 2019.  This is despite all the Fed speeches expressing optimism about the economy and a desire to normalize interest rates.

I believe that these developments all reflect a growing awareness of the importance of the secular stagnation risks that I have highlighted over the last several years.  There is a growing sense that the world is demand short—that the real interest rates necessary to equate investment and saving at full employment are very low and may be often unattainable given the bounds on nominal interest rate reductions.  The result is very low long term real rates, sluggish growth expectations, concerns about the ability even over the fairly long term to get inflation to average 2 percent, and a sense that the Fed and the world’s major central banks will not be able to normalize financial conditions in the foreseeable future.

Unfortunately markets have been much more aggressive in responding to events than policymakers.  While there are some signs of recognition such as the Fed’s reduction in its estimated neutral rate from 4.5 percent to 3.0 percent during the last 2 years, the IMF’s explicit use of the term secular stagnation in its World Economic Outlook, ECB president Mario Draghi’s call for global coordination and greater use of fiscal policy, and Japan’s indicated interest in fiscal-monetary cooperation, policymakers still have not made sufficiently radical adjustments in their world view to reflect this new reality of a world where generating adequate nominal GDP growth is likely to be the primary macroeconomic policy challenge for the next decade.

Having the right world view is essential if there is to be a chance of making the right decisions.  Here are the necessary adjustments.

First, with differences between countries, neutral real interest rates are likely close to zero going forward.  Think about the USA, where growth has been relatively robust by recent standards.  Growth has averaged little more than potential for the last 1, 3 or 5 years while the real Federal Funds rate has been around -1 percent.  There is no good reason to think given sluggish investment expectations that the neutral rate will rise to be significantly positive in the foreseeable future.  The situation is worse in other countries with more structural issues and slower labor force growth.  Substantial continued reductions in Fed estimates of the real neutral rate lie ahead.

Second, as counterintuitive as it is to central bankers who came of age when the inflation of the 1970s defined the central banking challenge, our problem today is insufficient inflation.  In the United States, Europe and Japan markets are now expecting inflation that is below target even with full employment over the next 10 years.  This is despite a 70 percent rise in the price of oil.  Evidence from markets and some surveys suggests that inflation expectations are becoming unhinged to the downside.  The policy challenge with respect to credibility is exactly the opposite of what it has been historically—it is to convince people that prices will rise at target rates in the future.  This is likely to require some combination of very tight markets and mechanisms that give confidence that during the best times inflation will be allowed to exceed target levels so that over the long term they can average target levels.

Third, in a world where interest rates over horizons of more than a generation are far lower than even pessimistic projections of growth, traditional thinking about debt sustainability needs to be discarded.  In the United States, UK, Euro area and Japan the real cost of even 30 year debt will be negative or negligible if inflation targets are achieved.  Indeed, the conditions Brad Delong and I set out in 2012 for expansionary fiscal policy to pay for itself are much more easily satisfied today than they were at that time.

Fourth, the traditional suite of structural policies to promote flexibility are not especially likely to be successful in the current environment, though some structural policy approaches such as removal of restrictions on investment are still desirable.  Indeed in the presence of chronic excess supply structural reform has the risk of spurring disinflation rather than the contributing to a necessary increase in inflation.  There is in fact a case for strengthening entitlement benefits so as to promote current demand.  The key point is that the traditional OECD type recommendations cannot be right as both a response to inflationary pressures and deflationary pressures.  They were more right historically than they are today.

There is much more to be said about policy going forward.  But treatments without accurate diagnosis have little chance success.  We need to begin with a much clearer diagnosis of our current malaise than policymakers have today.  The level of interest rates provides a very strong clue.


Why Brexit is worse for Europe than Britain


Brexit is in train. If journalism is the rough draft of history, instant blog responses are even cruder responses to events.  Nonetheless, here are some thoughts prior to market opening in the United States.


So far given the shock value of what has happened the market response has been on the calm side.  The British pound is only a bit weaker than it was 10 days ago when the outcome looked highly uncertain.  I would not have been surprised to see the pound below 1.30, the yen below 100 and more dramatic moves in credit spreads in the European periphery.  Notably the pound which is a kind of bellwether and many other asset prices have rallied considerably from their lows during the night.

Relatively resilient markets so far probably reflect a combination of confidence that central banks will do whatever is necessary to maintain order as well as some opportunistic buying in response to opportunities created by the falling asset prices.  Notably cool heads seem to be in control for now in London and Brussels.  Fortunately authorities do not seem overly fussed with moral hazard at a time when the preoccupation needs to be maintaining liquidity and orderly markets.  Critically, the market has expressed confidence that the Fed understands the gravity of the situation by taking the probability of a Fed hike by the end of the year down to the 10 percent range.

All of this could easily change when U.S. markets open, when investors ponder the new and more volatile environment they live in, when traders decide they do not want to bear risk over the weekend, or when a weekend of pondering leads to a wave of liquidations on Monday morning.  In 1987 volatile markets with international uncertainties at the end of the preceding week presaged the Monday crash.  It is far too early for any kind of complacency.

The situation of European banks should and will receive extensive policy attention.  Even before the last 24 hours, several were selling at price-book value ratios suggesting alarm about their prospects.  And some, not only British banks are now down more than 20 percent.  Large flight to quality flows into the dollar and yen also risk bringing on alarm about emerging markets and a return to concern about currency wars.


For Britain, the economic effects are two sided.  On the one hand, a major jolt has been delivered to confidence, to future unity and down the road to trade.  On the other, the currency has become more competitive, and liquidity will be in very ample supply.  I would expect that a significant deterioration in growth and a recession beginning in the next 12 months has to be a substantial risk though short of an odds on bet.

As suggested by the fact that stock markets in Italy and Spain are down almost twice as much as in the UK, the prospects for Europe may in some ways be worse than for the UK.  There is the real risk of “populist exit contagion” in a number of countries.  A credit crunch is a serious risk.  Unlike in Britain, the trade weighted exchange rate is unlikely to decline very much.  The central bank has less room for incremental policy measures.

The effects on the rest of the world will depend heavily on psychology.  I continue to be alarmed as I wrote in this space a few days ago that this unexpected outcome in the UK will raise the spectre of “Trump risk”.  If the UK can vote for Brexit perhaps the U.S. can vote for Donald Trump.  I fear this possibility will lead to a freezing up of spending decisions particularly on the part of internationally oriented businesses.  The odds of U.S. recession beginning within the next 12 months are I think now in the 30 percent range.  Also noteworthy is that an environment of increased risk aversion and flight to quality will complicate Japan’s problem of generating inflation, and China’s challenge of attaining currency stability.

To an extent that is underestimated in some quarters and understated in others, the world economy is far more brittle than usual because of the inability almost everywhere to lower interest rates substantially.  Normally in response to incipient downturns central banks lower rates by 400 basis points or more.  Nowhere do they have that kind of room.  Nor is there large scope for reducing term and credit spreads given their very low levels.  This is no time for austerity.  Greater use of fiscal policy should be on the agenda almost everywhere and certainly with the change of government in the UK.

Brexit will rightly be taken as a signal that the political support for global integration is at best waning and at worst collapsing.  Dramatic exchange rate fluctuations tend to portend upswings in protectionist pressure.  And problems in European banks could as in 2009 lead to a drying up of trade finance.  Already global trade has lagged global growth in recent years.  A clear sense of commitment to avoid backsliding towards protection from the G20 will be essential going forward.  Specific efforts with respect to trade finance may be appropriate.

Broader Observations

After Brexit, Trump, Sanders and the misforecast British and Canadian general elections, it should be clear that the term political science is an oxymoron.  Political events cannot be reliably predicted by pollsters, pundits or punters.  All three groups should have humility going forward.  In particular no one should be confident about the outcome of the U.S. presidential election.

The political challenge in many countries going forward is to develop a “responsible nationalism”.  It is clear that there is a hunger on the part of electorates, if not the Davos set within countries, for approaches to policy that privilege local interests and local people over more cosmopolitan concerns.  Channeling this hunger constructively rather than destructively is the challenge for the next decade.  We now know that neither denying the hunger, or explaining that it is based on fallacy is a viable strategy.

Why Brexit would be a history-defining, irreversible mistake


U.K. voters will decide on Thursday whether or not the U.K will withdraw from the European Union.  At one level it is a fundamental political choice.  Does the U.K. want to face the world alone as a limited scale island nation or to remain an influential part of the European Union—the world’s largest economy? Does the U.K. want to stand apart from Europe or try to shape it at this complex hour in global affairs?  These are not questions which an American should presume to answer.

But Thursday’s choices will have immediate financial and economic consequences.  And they can be assessed by outside economists.  My judgements are I believe widely, though not universally, shared by both progressive and conservative global financial and economic analysts.

Put simply, Brexit could well be the worst self-inflicted policy wound by a G7 country since the formation of the G7 forty years ago.  It is a risk no prudent policymaker would take.  And the risk is not confined to the UK.  In the current context, Brexit would unsettle the global economy and possibly tip it into recession.  Four points are crucial.

First, unlike almost all other economic policy choices, Brexit is irreversible. Francois Mitterrand’s lurch towards socialism, Ronald Reagan’s excessive tax cuts, and Japan’s encouragement of bubbles were all egregious errors but all were reversed, albeit not before substantial damage had been done.  Divorce can be reversed by remarriage if regretted.  There is no reversing Brexit if it proves unwise.  Indeed given the EU’s very strong incentive to discourage further dissolution, it is far from clear that there would even be concerted efforts to minimize its cost.

Second, markets are likely to suffer extraordinary volatility in the wake of Brexit. A Black Friday could follow referendum Thursday.  It is likely that foreign investors in British stocks would lose 15 percent off the bat, adding together market declines and currency losses.  This is a judgement supported by the gyrations in markets induced by relatively small fluctuations in the perceived chance of Brexit and by the very high prices commanded by out of the money options.  The truth is that even with all the regulatory changes that have been put in place we do not know for sure how the financial system will respond.  A return of systemic risk as large losses lead to cascading liquidations cannot be ruled out.  At a time when central banks have far less ammunition than they did in 2008, the consequences could be grave.

Third, Brexit will undermine confidence and increase uncertainty.  No one knows what the new structure will be or how soon it will emerge.  Quite likely Brexit would lead to changes not only in Britain’s relationship with Europe but within Europe itself.  While businesses wait to see what happens, they will hold off on new investment.  Some will decide that it is much safer to base European operations outside the U.K.  Others will simply avoid hiring until matters are clear.  There exist contingency plans to move hundreds of thousands of financial sector and other workers out of the UK.  If matters play out slowly, they may be acted on.  Given adverse markets, huge uncertainty, the likely absence of either expansionary fiscal policy (because of government policy commitments) or incrementally expansionary monetary policy (because of lack of room to cut rates), I believe Brexit would likely be followed by a recession in the UK.

Fourth, Brexit would quite likely have large contagion effects.  So irrational and dangerous an act in a traditional bastion of mature democracy would prompt a global reassessment of the likelihood of dangerous populist policy. The result could be large and destabilizing asset price declines and capital flows towards assets like gold and the Swiss franc.  A vicious cycle of falling asset prices, reduced confidence and further declines could ensue.  I am reminded of the Smoot-Hawley tariff and the Depression.  No direct calculation of its impact can explain more than a tiny part of the Depression.  But it may have been a psychological tipping point. Brexit too could have global effects that dwarf its direct impacts.

None of this certain.  But prudence dictates the avoidance of needless risk. Remain is the only rational economic choice.


Groundhog Day at Fed June meeting


As the Fed meets today and tomorrow, I am increasingly convinced that while they have been making reasonable tactical judgements their current strategy is ill adapted to the realities of the moment. Exuding soundness is the task of policymakers. Provoking thought is the task of academics. So here are some not entirely formed reflections.

Japan’s essential macroeconomic problem is no longer lack out output growth. Unemployment is low. Relative to its shrinking labor force, output growth is adequate by contemporary standards. Japan’s problem is that it seems incapable of achieving a 2 percent inflation. This makes it much harder to deal with debt problems and leaves the Japanese with little spare powder if a recession comes.

I am reluctantly coming to the conclusion that the United States may be on a slow-motion trajectory towards a Japanese chronic lowflationary or even deflationary outcome. A corollary of this view is that the current hawkish inclination of the Fed, with its chronic hope and belief that conditions will soon permit interest rate increases, is misguided. The greater danger is of too little rather than too much demand. A new Fed paradigm is therefore in order.

Any consideration of macro policy has to begin with the fact that the economy is now seven years into recovery and the next recession is on at least the far horizon. While recession certainly does not appear imminent, the annual probability of recession for an economy that is not in the early stage of recovery is at least 20 percent. The fact that underlying growth is now only 2 percent, that the rest of the world has serious problems, and that the U.S. has an unusual degree of political uncertainty all tilt toward greater pessimism. With at least some perceived possibility that a demagogue will be elected as President or that policy will lurch left I would guess that from here the annual probability of recession is 25-30 percent.

This seems to me the only way to interpret the yield curve. Markets anticipate only about 65 basis point of increase in short rates over the next 3 years. Whereas the Fed dots suggest that rates will normalize at 3.3 points, the market thinks that even 5 years from now they will be about 1.25 percent.

blog graph a









blog graph b

Markets are thinking that recession will come at some point and when it does rates will go to near zero. As a rough calculation, if it is assumed rates will be raised twice a year with continued growth than the 85 basis point estimate for fed funds in December 2018 implies a 50 percent chance of recession by then.

So both history and markets are telling us that we are in the shadow of possible recession.

What does this mean? First it implies that if the Fed is serious — as it should be – about having a symmetric 2 percent inflation target then its near term target should be in excess of 2 percent. Prior to the next recession — which will presumably be deflationary — the Fed should want inflation to be above its long term target.

The point can be put in one more way. The Fed’s dots forecast refer to a modal scenario of continued recovery. They see inflation rising to 2 percent only in 2018. Why shouldn’t they prefer a path with more demand, inflation at target sooner, more stimulus as recession insurance, and a small margin of extra inflation as a buffer against the next recession? Those who think that raising rates somehow helps prepare to be counter-cyclical are confused. Given lags raising rates now would increase the chances of recession along with the likely severity. Raising inflation and inflation expectations best prevents and alleviates recession.

There is the further point that the logic that led to the adoption of the 2 percent inflation target years ago suggests that it is too low now. As brought out in a famous colloquy between Janet Yellen and Alan Greenspan[1] the case for a positive inflation target balances the benefits of stable money with the output cost of lowering inflation and two ways that positive inflation is helpful—the periodic need to have negative real rates, and inflation’s role in facilitating downward adjustment in real wages given nominal rigidities.

All of the factors pointing towards a higher inflation target have gained force in recent years. Regardless of whether they believe in secular stagnation, almost everyone agrees that neutral real rates have declined 100 basis points or more. This means there will be more frequent need for negative real rates. Slowing underlying wage growth means that there is more pressure for downward adjustments that are facilitated by inflation. Experience has proven that Yellen was correct to be skeptical of the idea very low inflation rates would improve productivity. And it is plausible that the error in price indices has increased with the introduction of new categories of innovative and often free products.

This means that if a two percent inflation target reflected a proper balance when it first came into vogue decades ago, a higher target is probably appropriate today. This is another reason to allow inflation to rise above 2 percent.

Second, the theoretical consideration that the Fed should not raise rates until inflation is clearly above target is reinforced by the current data flow. Long term inflation expectations are depressed and declining, as shown in TIPS (inflation-indexed) government bonds, which I have adjusted to the Fed’s preferred PCE price index. Note that expected inflation is back near record low levels despite oil prices having risen about 70 percent from their February levels.

Starting in 5 years graph








The Fed has in the past counterbalanced declines in market inflation expectation measures by pointing to the relative stability in surveys-based measures. This argument is much harder to make now that consumer expectations of inflation have broken decisively below their all-time lows even as gas prices have been rising.

blog graph d








There is of course the question of a possibly overheating labor market as a source of future inflation. While last month’s highly disappointing employment report was a jolt to most observers, the Fed’s summary employment conditions index has been flashing yellow since the beginning of the year. Declines in this measure have presaged recession half of the time and uniformly been followed by rate reductions rather than rate increases.


Market conditions








Embedded inflation expectations are low and declining. Comprehensive measures of the labor market are deteriorating and growth is at best mediocre. Meanwhile inflation is clearly below where the Fed should want it. The right concern for the Fed now should be to signal its commitment to accelerating growth and avoiding a return to recession, even at some cost in terms of other risks.

This is not the Fed’s policy posture. Watching the Fed over the last year there is a Groundhog Day aspect. One senses they really want to raise rates and achieve a more “normal” stance. But at the same time they do not want to tighten when the economy may be slowing or create financial turmoil. So they keep holding out the prospect of future rate increases and then find themselves unable to deliver. But they always revert to holding out the prospect of rate increases soon, partly for internal comity and partly to preserve optionality.

Blog final image








Over the last 12 months nominal GDP has risen at a rate of only 3.3 percent. We hardly seem in danger of demand running away. Today we learned that Germany has followed Japan into negative 10 year rates. We are only one recession away from joining the club. The Fed should be clear now that its priority is not preventing a small step up in inflation, which in fact should be welcomed, or returning interest rates to what would have been normal to a world gone by. Instead the Fed should focus on assuring adequate growth in both real and nominal incomes going forward.


[1] pp.42-50. Yellen: “As I total things up, it appears to me that a reduction of inflation from 3 percent, which I take as roughly our current level, to 2 percent, very likely, but not surely, yields net benefits. The “grease-the-wheel” argument is of minor importance at that point, and tax effects could be significant. But with further reductions in inflation below 2 percent, nominal rigidity begins to bite so that the marginal payoff declines and then turns negative. To my mind, to go below 2 percent measured inflation as currently calculated requires highly optimistic assumption about tax benefits and sacrifice ratios.”

Why Americans don’t trust goverment


I have an Op-Ed in the Boston Globe today on infrastructure addressing the issue of quality rather than quantity of investment.  Rachel Lipson and I describe the fiasco that has emerged from what should have been a routine maintenance project on the Anderson Memorial Bridge over the Charles River next to my office.  Though the bridge took only 11 months to build in 1912, it will take close to 5 years to repair today at a huge cost in dollars and mass delays.

Investigating the reasons behind the bridge blunders have helped to illuminate an aspect of American sclerosis—a gaggle of regulators and veto players, each with the power to block or to delay, and each with their own parochial concerns.  Every actor – the  historical commission, the contractor, the environmental agencies, the advocacy groups, the state transportation department — is reasonable in his or her own terms, but the final result is wildly unreasonable.

At one level this explains why, despite the overwhelming case for infrastructure investment, there is so much resistance from those who think it will be carried out ineptly.  The right response is to advocate for reforms in procurement policies, regulatory policies and government procedures to make the investment process more efficient and effective.  This is all clear enough.

At another level, though, our story may illustrate phenomena that go way beyond infrastructure.  I’m a progressive, but it seems plausible to wonder if  government can build a nation abroad, fight social decay, run schools, mandate the design of cars, run health insurance exchanges, or set proper sexual harassment policies on college campuses, if it can’t even fix a 232-foot bridge competently.  Waiting in traffic over the Anderson Bridge, I’ve empathized with the two-thirds of Americans who distrust government.

Years ago as President of Harvard, I did various events with the late Boston Mayor Tom Menino.  I was always struck by his attention to the little things — while we waited at a playground, he would check the fence for holes, or when we visited a school, he would note the missing tiles.  At the time, it seemed odd and micromanaging.  Over time, though, I’ve come to appreciate what he intimately understood:  Faith in government’s ability to do big things depends on its success in executing on routine responsibilities.

We do not want to learn what we can get used to.  I’m sure once the historical commission had delayed the bridge for many months, there was an attitude of “What’s another couple?”  In a broader sense, the Anderson Memorial Bridge tale tees up a bigger question.  Where is the outrage?  Why didn’t the governor or the mayors of Boston and Cambridge act? What about the great free press?  We seem to be caught in a dismal cycle of low expectations, poor results and shared cynicism.

More than questions of personality or even those of high policy, the question of how to escape this trap should be a central issue in this election year.

What you need to know about the next recession


How should we respond to the next recession? That was the topic of an event held by the Brooking’s Hamilton Project where I spoke on Monday in Washington with White House budget director Sean Donovan. I argued a number of points that address issues of current concern.

First, I argued that the possible election of “Demagogue Donald” dwarfs congressional dysfunction as a threat to American prosperity. I argued that beyond lunatic and incoherent budget and trade policies Trump would for the first time make political risk of the kind usually discussed in the context of Argentina, China or Russia relevant to the USA. How else to interpret threats to renegotiate debt, prosecute insubordinate publications, and rip up treaties? Creeping fascism as an issue dwarfs macroeconomic policy!

Second, I cautioned that while 2009 could have seen a repeat of 1929-1933 and that did not happen there are no grounds for complacency. As the picture below illustrates on current forecasts the economy will have performed as badly over the 2007-2018 period as it did over the Depression 1929-1940 period. The single most important issue for containing government debt burdens, increasing us national security, encouraging more generosity towards the poor and raising middle class standards of living is accelerating US economic growth.

Graph 1

Third, I argued — following my secular stagnation thesis — that fiscal policy is now important as a stabilization policy tool in a way that has not been the case since the Depression. Historical evidence suggests a better than even chance of an officially declared recession in the next three years.graph 2


When recessions come, the Federal Reserve normally reduces real rates by four to five percentage points.

graph 3

But there will in all likelihood be nothing like this amount of room when the next recession comes.

Graph 4

I say this with full awareness that the Fed has unconventional tools at its disposal in addition to simply lowering rates. But I think it very unlikely that more than 150bps of Fed funds equivalent additional stimulus is feasible. After all rates below minus 50 or 75 bps are impracticable in a society with cash and might actually hurt financial intermediation. Forward guidance is fine in principle but when the next recession comes expected forward rates will be very low far into the future. And QE is surely already hitting diminishing returns with the yield curve flattening and markets functioning without the illiquidity premia of the early recovery period. “Helicopter money” is basically a form of fiscal policy as I shall argue in a subsequent post and cannot be carried out autonomously by the central bank.

There is an additional case for fiscal policy. The economy as it now stands requires remarkably low interest rates to grow adequately. These rates are an invitation to leverage, to reaching for yield, to financial engineering and to bubbles. Raising rates significantly as many suggest without doing anything else risks recession. So the right strategy is to raise demand so as to make financially sustainable growth. This comes back to fiscal policy along with measures like tax, regulatory and immigration reform to spur private demand.

Fourth. I suggested a number of areas for expansionary fiscal policy both to make recession less likely and to respond when the next one comes. The decline in US infrastructure investment is indefensible in light of recent declines in interest rates, employment opportunities and materials costs.

Graph 5

Other areas in which fiscal support seems desirable include housing — where residential investment still lags badly — and support for social security. I referred to the economists argument going back to Paul Samuelson that pay as you go social security can help all generations in a world where growth rates exceed interest rates. Further it raises demand without enlarging government deficits.

As I expect to discuss in subsequent posts, much of what economists thought they knew about macroeconomic policy needs to be reassessed in light of events. Just as the events of the 1970s and emergence of stagflation throughout the industrial world, led to new policy paradigms, I believe that recent events will force us to develop new approaches to thinking about economic fluctuations and inflation which will, in turn, drive major changes in thinking about fiscal and monetary policy.


Data collection is the ultimate public good.


On Wednesday I spoke at a World Bank conference on price statistics.  While price statistics are not usually thought of as a scintillating subject, I got a great deal of satisfaction out of preparing and presenting my remarks.  In part this was because my late father Robert Summers focused his economic research on International price comparisons.  It was also because I am convinced that data is the ultimate public good and that we will soon have much more data than we do today.

I made four primary observations.

First, scientific progress is driven more by new tools and new observations than by hypothesis construction and testing.  I cited a number of examples: the observation that Jupiter was orbited by several moons clinched the case against the Ptolemaic system, the belief that all celestial objects circle around the Earth.  We learned of cells by seeing them when the microscope was constructed.  Accelerators made the basic structure of atoms obvious.

Second, if mathematics is the queen of the hard sciences then statistics is the queen of the social sciences.  I gave examples of the power of very simple data analysis. We first learned that exercise is good for health from the observation that in 1940s London bus conductors had much lower death rates than bus drivers.  Similarly data demonstrated that smoking was a major killer decades before the biological processes were understood.  At a more trivial level, Moneyball shows how data-based statistics can revolutionize a major sport.

Third, I urged that what “you count counts” and argued that we needed much more timely and complete data. I noted the centrality of timely statistics to meaningful progress towards Sustainable Development Goals.  In comparison to the nearly six year lag in poverty statistics, it only took the USA about three and a half years to win World War II.

Fourth, I envisioned what might be possible in a world where there will soon be as many smart phones as adults.  With the ubiquitous ability to collect data and nearly unlimited ability to process it will come more capacity to discover previously unknown relationships. We will improve our ability to predict disasters like famines, storms and revolutions.  Communication technologies will allow us to better hold policymakers to account with reliable and rapid performance measures.  And if history is any guide we will gain capacities on dimensions we cannot now imagine but will come to regard as indispensable.

This is the work of both governments and the private sector.  It is fantasy to suppose data, the ultimate public good, will come into being without government effort.  Equally, we will sell ourselves short if we stick with traditional collection methods and ignore innovative providers and methods such as the use of smart phones, drones, satellites and supercomputers. That is why something like the Billion Prices Project at MIT, which can provide daily price information, is so important. That is why I am excited to be a Director and involved with Premise – a data company that analyzes information people collect on their smartphones about everyday life, like the price of local foods – in its capacity to mobilize these technologies as widely as possible. That is why Planet Labs, with its capacity to scan and monitor environmental conditions, represents such a profound innovation.

If we really valued excellence, we would single it out.


Catherine Rampell’s column this week reminded me of an issue that has long interested me as an economist and as a president of Harvard.

I remember many years ago listening to some monetarist quote Milton Friedman one too many times with “inflation is always and everywhere a monetary phenomenon.”  I responded “what about grade inflation?”

I could never quite decide whether this was just a wisecrack or it captured something important.  The idea that it might well reflect is that inflation has much to do with different actors seeking to leapfrog each other and in the process setting off a spiral.

In any event, I think that the pervasiveness of top grades in American higher education is shameful. How can a society that inflates the grades of its students and assigns the top standard to average performance be surprised when its corporate leaders inflate their earnings, its generals inflate their body counts, or its political leaders inflate their achievements?

More than ethics classes this is a matter of moral education. And America’s universities are failing when “A” is the most commonly-awarded grade.  If we really valued excellence, we would single it out.

I did succeed in a small way as Harvard president in reducing the fraction of students graduating with honors from a ludicrous 90 percent to an excessive 55 percent.  I wish I had been able to do more. Even more I wish that today’s academic leaders would take up this issue.

Vast double standard on American college campuses


It has seemed to me that a vast double standard regarding what constitutes prejudice exists on American college campuses.  There is hypersensitivity regarding prejudice against most minority groups but what might be called hyper-insensitivity with respect to anti-Semitism.

At Bowdoin College, holding parties with sombreros and tequila is deemed to be an act of prejudice against Mexicans.  At Emory, the chalking of an endorsement of the likely Republican Presidential candidate on a sidewalk is deemed to require a review of security tapes.  The existence of a college named after widely admired former US President has under the duress of a student occupation been condemned at Princeton.  At Yale,  Halloween costumes are the subject of administrative edict.  The dean of Harvard Law School has acknowledged that hers is a racist institution, while the Freshman Dean at Harvard College has used dinner placemats to propagandize the student body on aspects of diversity.   Professors acquiesce as students insist that they not be exposed to views on issues like abortion that make them uncomfortable.

All I have discussed in the past, this is in my view inconsistent with basic American values of free speech and open debate.  It fails to recognize that the a proper liberal education should cause moments of acute discomfort as cherished beliefs are challenged.

But, if comfort is elevated to be a preeminent value, the standard should be applied universally.  Unfortunately, there is a clear exception made on most university campuses for anti-Semitic speech and acts.

The State Department has made clear that it regards demonizing Israel or  “applying double standards by requiring of it a behavior not expected or demanded  of any other democratic nation” as anti-Semitism.   This makes obvious good sense.  Does anyone doubt that applying standards to African countries that were not applied to other countries or singling them out for sanction when other non-African countries were guilty of much greater sins would be deemed racism?

Instances of anti-Semitism by this standard are ubiquitous in American academic life.  Nearly a dozen academic associations have enacted formal boycotts of Israeli institutions and in some cases Israeli scholars.  Student governments at dozens of universities have demanded the divestiture of companies that do business in Israel or the West Bank.   Guest speakers and even some faculty in their classrooms compare Israel with Nazi Germany and question its right to continued existence as a Jewish state.

Yet, with very few exceptions, university leaders who are so quick to stand up against microagressions against other groups remain silent in the face of anti-Semitism.  Indeed, many major American universities including Harvard remain institutional members of associations that are engaged in boycotts of Israel.  The idea of divesting Israel is opposed only in the same way that divesting apartheid South Africa was opposed—as an inappropriate intrusion into politics, not as immoral or anti-Semitic.

That is why the recent statement of the University of California Regents is so welcome.  It is forceful and clear on anti-Semitism, while at the same time recognizing the importance of free speech.  It holds that “Anti-Semitism, anti-semitic forms of anti-Zionism and other forms of discrimination have no place at the University of California”.  Let us hope that similar statements will be made by the leaders of private and public universities across the country.

Corporate profits are near record highs. Here’s why that’s a problem.


As the cover story in this week’s Economist highlights, the rate of profitability in the United States is at a near-record high level, as is the share of corporate revenue going to capital.   The stock market is valued very high by historical standards, as measured by Tobin’s q ratio of the market value of the nonfinancial corporations to the value of their tangible capital.  And the ratio of the market value of equities in the corporate sector to its GDP is also unusually high.

All of this might be taken as evidence that this is a time when the return on new capital investment is unusually high.  The rate of profit under standard assumptions reflects the marginal productivity of capital.  A high market value of corporations implies that “old capital” is highly valued and suggests a high payoff to investment in new capital.

This is an apparent problem for the secular stagnation hypothesis I have been advocating for some time, the idea that the U.S. economy is stuck in a period of lethargic economic growth.  Secular stagnation has as a central element a decline in the propensity to invest leading to chronic shortfalls of aggregate demand and difficulties in attaining real interest rates consistent with full employment.

Yet matters are more complex.  For some years now, real interest rates on safe financial instruments have been low and, for the most part, declining.  And business investment is either in line with cyclical conditions or a little weaker than would be predicted by cyclical conditions.  This is anomalous, as in the most straightforward economic models the real interest rate is the risk adjusted rate of return on capital.  And an unusually high rate of investment would be expected to go along with a high rate of return on existing capital.

How can this anomaly be resolved?  There are a number of logical possibilities.  First, the riskiness associated with capital investment might have gone up and so higher rates of return could be simply compensating for higher risk rather than implying attractive investments.  There are two major problems with this story.  One is that available proxies for risk are not especially high in recent years.  The chart below depicts realized stock market volatility and the VIX measure of expected volatility as implied by options.  Another problem is that if capital returns have become far more uncertain, then the stocks should have become less attractive in recent years rather than more.  In the last 7 years, the stock market has risen to 250 percent of its spring 2009 levels.

VIX and Realized Stock Mkt Volatility







A second explanation could be that a heightened demand for liquidity and a shortage of Treasury instruments, perhaps created by quantitative easing programs, has driven down bond yields, widening the spread between the rate of profit and these yields.  This story does not provide a natural explanation for the relatively weak behavior of business investment.  Further as Sam Hanson, Robin Greenwood, Joshua Rudolph and I pointed out in earlier work, the market is today being asked to absorb an abnormally high rather than an abnormally low level of long term Federal debt.

Long Term Treasury







On top of that, if Treasuries were in short supply, one would expect that they would have their yield bid down relative to market synthesized safe instruments.  Yet the so-called swap spread is actually negative and Treasury yields (vs swaps) are unusually high relative to history.

Ten Year Swaps






Third, it could be that higher profits do not reflect increased productivity of capital but instead reflect an increase in monopoly power.  If monopoly power increased one would expect to see higher profits, lower investment as firms restricted output, and lower interest rates as the demand for capital was reduced.  This is exactly what we have seen in recent years!

Is the increased monopoly power theory plausible?  The Economist makes the best case I have seen for it noting that (i) many industries have become more concentrated (ii) we are coming off a major merger wave (iii) there is some evidence of greater profit persistence among major companies (iv) new business formation has declined (v) overlapping ownership of companies that compete has become more common with the rise of institutional investors, (vi) leading technology companies like Google and Apple may be benefiting from increasing returns to scale and network effects.

The combination of the fact that only the monopoly power story can convincingly account for the divergence between the profit rate and the behavior of real interest rates and investment, along with the suggestive evidence of increases in monopoly power makes me think that the issue of growing market power deserves increased attention from economists and especially from macroeconomists.


Trump’s rise illustrates how democratic processes can lose their way


While comparisons between Donald Trump and Mussolini or Hitler are overwrought, Trump’s rise does illustrate how democratic processes can lose their way and turn dangerously toxic when there is intense economic frustration and widespread apprehension about the future. This is especially the case when some previously respected leaders scurry to make peace in a new order — yes Chris Christie, I mean you.

The possible election of Donald Trump as President is the greatest present threat to the prosperity and security of the United States.  I have had a strong point of view on each of the last ten presidential elections, but never before had I feared that what I regarded as the wrong outcome would in the long sweep of history risk grave damage to the American project.

The problem is not with Trump’s policies, though they are wacky in the few areas where they are not indecipherable. It is that he is running as modern day man on a horseback—demagogically offering the power of his personality as a magic solution to all problems—and making clear that he is prepared to run roughshod over anything or anyone who stands in his way.

Trump has already flirted with the Ku Klux Klan and disparaged and demeaned the female half of our population.  He vowed to kill the families of terrorists, use extreme forms of torture, and forbid Muslims from coming into our country.  Time and again, he has claimed he will crush those who stand in his way; his promised rewrite of libel laws, permitting the punishment of The New York Times and Washington Post for articles he does not like, will allow him to make good on this threat.

Lyndon Johnson’s celebrated biographer, Robert Caro, has written that while “power doesn’t always corrupt…[it] always reveals.” What will a demagogue with a platform like Trump’s who ascends to the presidency do with control over the NSA, FBI and IRS?  What commitment will he manifest to the rule of law? Already Trump has proposed that protesters at his rallies “should have been roughed up.”

Nothing in the way he campaigned gave Richard Nixon a mandate for keeping an enemies list or engaging in dirty tricks.  If he is elected, Donald Trump may think he has such a mandate.  What is the basis for doubting that it will be used?

To be sure there are precedents in American politics for Trump. Precedents like Joe McCarthy, George Wallace, and Huey Long.  Just as Trump does, each mined the all too rich veins of prejudice, paranoia and excess populism that lie beneath American soil.  Yet even at their highest points of popularity, none of these figures looked like plausible future Presidents.  One shudders to think what President Huey Long would have done during the Depression, what President Joe McCarthy would have done at the height of the Cold War, or what President George Wallace would have done at the end of the turbulent 1960s.

My Harvard colleague, Niall Ferguson, suggests that William Jennings Bryan is the right precursor for Trump. This comparison seems unfair to Bryan who was a progressive populist but not a thug, as evidenced by the fact that he ended up as Secretary of State in the Wilson Administration.  Trump’s election would threaten our democracy.  I doubt that democracy would have been threatened if Bryan had beaten McKinley.

Robert Kagan and others have suggested that Trump is the culmination of trends under way for decades in the Republican Party.  I am no friend of the Tea Party or of the way in which Congress has obstructed President Obama.  But the suggestion that Trump is on the same continuum as George W. Bush or even the Republican congressional leadership seems to me to be quite unfair.

Even the possibility of Trump becoming President is dangerous.  The economy is already growing at a sub-two percent rate in substantial part because of a lack of confidence in a weak world economy.  A growing sense that a protectionist demagogue could soon become President of the United States would surely introduce great uncertainty at home and abroad. The resulting increase in risk premiums might well be enough to tip a fragile US economy into recession.  And a concern that the US was becoming protectionists and isolationist could easily undermine confidence in many emerging markets and set off a financial crisis.

The geopolitical consequences of Donald Trump’s rise may be even more serious. The rest of the world is incredulous and appalled by the possibility of a Trump presidency and has started quietly rethinking its approach to the United States accordingly.  The US and China are struggling over influence in Asia.  It is hard to imagine something better for China than the US moving to adopt a policy of ‘truculent isolationism.’  The Trans-Pacific Partnership, a central element in our rebalancing toward Asia, could collapse.  Japan would have to take self-defense, rather than reliance on American security guarantees more seriously.  And others in Asia would inevitably tilt from a more erratic America towards a relatively steady China.

Donald Trump’s rise goes beyond his demagogic appeal. It is a reflection of the political psychology of frustration – people see him as responding to their fears about the modern world order, an outsider fighting for those who have been left behind. If we are to move past Trumpism, it will be essential to develop convincing responses to economic slowdown.

The United States has always been governed by the authority of ideas, rather than the idea of authority.  Nothing is more important than to be clear to all Americans that the tradition of vigorous political debate and compromise will continue.  The sooner Donald Trump is relegated to the margins of our national life, the better off we and the world will be.


In defense of killing the $100 bill


By Peter Sands and Lawrence Summers

Our advocacy for ending the printing of high denomination notes — first in a working paper by Peter and colleagues and, later in a post by Larry — have been attacked on the ground that this proposal represents an infringement on liberty (for example, see here and here).  Most prominently, the Wall Street Journal  concludes an editorial with the remarkable assertion “Beware politicians trying to limit the way you can conduct private economic business.  It never turns out well.”

There are two levels of illogic here.  First, even the most ardent libertarian recognizes the need for antifraud statues, limits on what can be contracted, and requirements of tax withholding, so the general principle that government should not affect the conduct of private business is absurd.

Second, it is surely a stretch to assert that ceasing government’s active effort to circulate and print 500 euro notes or $100 bills constitutes a government infringement on the conduct of private economic business.  Do the Journal editors believe that liberty was constrained by the US decision in the 1960s to stop printing $1000 dollar bills or to stop issuing bearer bonds?  Surely it is not a government’s obligation to provide every means of payment or store of value that someone might choose to use.   Nor, it should be emphasized, did the abolition of the $1000 put us on any kind of slippery slope to monetary perdition.

Our advocacy for the elimination of high denomination notes is based on a judgment that any losses in commercial convenience are dwarfed by the gains in combatting criminal activity, not any desire to alter monetary policy or to create a cashless society.  We take no position on the desirability of negative interest rates but are convinced by the arguments of JPMorgan,  Miles Kimball and others that significantly negative rates can, if desired, be maintained without any limitation on currency through bank withdrawal fees.  And we believe that for the foreseeable future there will be a role for cash in modern economies though we would not be surprised if in many contexts its transactions costs come to exceed those of various electronic payment schemes.

No ATMs in Europe offer 500 euro notes and very rarely do American ATMs offer $100 bills, so we are highly skeptical that legitimate commerce for the vast majority of law abiding citizens will be impacted.  Only the affluent will be affected at all and we do not think that giving a grandchild five $20 dollar bills rather than a single $100 or tipping a caddy with three $50 bills is too great an inconvenience relative to the benefit of inhibiting criminal activity.

There are 30 US $100 bills in circulation for every man woman and child, and more than 300 billion euro in 500 euro notes.  As Peter’s paper documents, the vast majority of this currency is involved with activity that is at a minimum problematic, and often criminal. This inference for Europe is supported by the observation that high denomination note issuance relative to GDP is nearly 20 times as high in Luxembourg, a traditional haven for illicit activity, relative to the rest of Europe.

We agree with the philosophical position of the Wall Street Journal that governments should do only what is necessary and that excessive government activity is dangerous.   That is why we favor an end to the further printing of high denomination notes.

Peter Sands is a Senior Fellow at the Mossavar-Rahmani Center for Business and Government at the Harvard Kennedy School and the former Chief Executive Officer at Standard Chartered Bank.

Lawrence Summers is a professor at and past president of Harvard University. He was treasury secretary from 1999 to 2001 and an economic adviser to President Obama from 2009 through 2010. He serves as an advisor or board member to a number of financial technology and payments companies.




Increasingly Convinced of the Secular Stagnation Hypothesis


Foreign Affairs has just published my latest on the secular stagnation hypothesis.  I am increasingly convinced that it captures what is going on in the industrialized world and that the risks of long term weakness on the current policy path are growing.

Unfortunately since I put forward the argument in late 2013, the data have been all too supportive.  Despite monetary policy being much more expansionary than was expected and medium term interest rates falling rapidly, growth and inflation throughout the industrial world have been much lower than anticipated.  This is exactly what one would expect if structural factors were increasing saving propensities relative to investment propensities.

Bond markets are now saying that neither inflation rates approaching 2 percent targets or real interest rates substantially above zero are on the horizon anytime in the foreseeable future.  Growth forecasts are being revised downwards in most places and there is growing evidence in the United States that inflation expectations are becoming unanchored to the downside.

I would put the odds of a US recession at about 1/3 over the next year and at over ½ over the next 2 years.   There is a substantial chance that widening credit spreads, a strengthening dollar as Europe and Japan plunge more deeply into the world of negative rates, and lower inflation expectations will be tightening financial conditions even as recession looms.  And while there is certainly scope for QE, for forward guidance and possibly for negative rates it is very unlikely that the Fed can take steps that are nearly the functional equivalent of 400 basis point cut in Fed funds that is normally necessary to respond to an incipient recession.

If I am right in these judgements, monetary policy should now be focused on avoiding an economic slowdown and preparations should be starting with respect to the rapid application of fiscal policy.  The focus of global coordination should shift from clichés about structural reform and budget consolidation to assuring an adequate level of global demand.   And policymakers should be considering the radical steps that may be necessary if the US or global economy goes into recession.

Of course, real time economic theorizing is problematic and I cannot be certain that I am reading the current situation accurately.  If the Fed succeeds in significantly raising rates over the next two years without a growth slowdown and if inflation accelerates to 2 percent, I will conclude that the secular stagnation hypothesis was overly alarmist in confusing cyclical elements with long term problems.  If on the other hand, the economy turns down even at current interest rates, secular stagnation will have to be taken more seriously by policymakers than is currently the case.



It’s Time To Go After Big Money


The Mossavar-Rahmani Center for Business and Government at Harvard that I am privileged to direct has just issued an important paper by Senior Fellow Peter Sands and a group of student collaborators.  Sands’ paper makes a compelling case for stopping the issuance of high denomination notes like the 500 euro note and 100 dollar bill or even withdrawing them from circulation.

I remember that when the euro was being designed in the late 1990s, I argued with my European G7 colleagues that skirmishing over seigniorage by issuing a 500 euro note was highly irresponsible and mostly would be a boon to corruption and crime.  Since the crime and corruption in significant part would happen outside European borders, I suggested that to paraphrase John Connally it was their currency, but would be everyone’s problem.  And I made clear that in the context of an international agreement, the US would consider policy regarding the $100 bill.  But because the Germans were committed to having a high denomination note, the issue was never seriously debated in international fora.

The fact that – as Sands points out — in certain circles the €500 is known as the “Bin Laden” confirms the arguments against it.  Sands’ extensive analysis is totally convincing on the linkage between high denomination notes and crime. He is surely right that illicit activities are facilitated when a million dollars weighs 2.2 pounds as with the €500 note rather than more than 50 pounds as would be the case if the $20 was the high denomination note. And he is equally correct in arguing that technology is obviating whatever need there may ever have been for high denomination notes in legal commerce.

What should happen next?  I’d guess the idea of removing existing notes is a step too far.  But a moratorium on printing new high denomination notes would make the world a better place.  In terms of unilateral steps, the most important actor by far is the European Union.  The €500 is almost six times as valuable as the $100.  Some actors in Europe, notably the European Commission, have shown sympathy for the idea and ECB chief Mario Draghi has shown interest as well.  If Europe moved, pressure could likely be brought on others, notably Switzerland.

I confess to not being surprised that resistance within the ECB is coming out of Luxembourg (see also), with its long and unsavory tradition of giving comfort to tax evaders, money launderers, and other proponents of bank secrecy and where 20x as much cash is printed relative to GDP compared to other European countries.

These are difficult times in Europe with the refugee crisis, economic weakness, security issues and the rise of populist movements.  There are real limits on what it can do to address global problems.  But here is a step that will represent a global contribution with only the tiniest impact on legitimate commerce or on government budgets.  It may not be a free lunch, but it is a very cheap lunch.

Even better than unilateral measures in Europe would be a global agreement to stop issuing notes worth more than say $50 or $100.  Such an agreement would be as significant as anything else the G7 or G20 has done in years.  China, which is hosting the next G-20 in September, has made attacking corruption a central part of its economic and political strategy. More generally, at a time when such a demonstration is very much needed, a global agreement to stop issuing high denomination notes would also show that the global financial groupings can stand up against “big money” and for the interests of ordinary citizens.

Global security and pandemic risk


I was privileged this morning to deliver keynote remarks at the release event for the Global Health Risk Framework Commission report on “The Neglected Dimension of Global Security: A Framework to Counter Infectious Disease Crises”.  The commission, convened by the National Academy of Medicine and chaired by Peter Sands, has delivered a very important report on what I think is the issue with the highest ratio of seriousness to policy preparation in the global system.  Indeed, for reasons I sketched in my remarks, I believe the threat to global well-being from pandemics over the next century is comparable to the threat from global climate change.

I began by expanding on why I think pandemics are such an important issue.  The global mortality rate from the flu pandemic of 1918 was 7000 times as large as from the recent Ebola outbreak.  AIDS profoundly changed the human experience in Africa.  No one knows the probability of a recurrence of these kinds of disasters.  History is too short to permit reliable estimates and in any event conditions are rapidly changing because of scientific improvements on the one hand, and huge increases in global interconnection on the other.

In the context of the Global Health 2035 report that Dean Jamison and I developed, we considered the economic benefit of mortality reduction using approaches derived from economic theory.  We noted that the well established fact that people demand higher pay to accept riskier jobs demonstrates that reduced mortality risk has economic value.  And we further showed that these benefits are very large relative to standard estimates of the economic impact of health interventions.

In related work, Dean and I with Victoria Fan calculate the potential cost of a 1918 flu recurrence, discounted by its chance of happening.  We expect to publish this work soon. On plausible assumptions we find an expected flu cost approaching $1 trillion a year going forward into the 21st century. This underscores the urgency of doing all that can be done to counter pandemic risks.

Eisenhower famously said that “in preparing for battle, I have always found that plans are useless but planning is indispensable”. So also with the pandemic threat, which is what makes the GHRF report so important.  I have three main takeaways from its consideration of the Ebola experience and its stock-taking of the current global architecture.

First, this is an area where the urgent has crowded out the profoundly important.  In too many countries, pressing near term needs and budgetary pressures have prevented the establishment of necessary infrastructures for public health. Such resilient health systems would be a high payoff investment even if catastrophe never comes and would be transformative if and when catastrophe comes.

Second, the international system needs to do more to clarify responsibilities and authorities when the next emergency comes and to put in place financial mechanisms for rapid action.  Given the nonlinear exponential character of pandemic processes this is of the highest urgency.

Third, there is a need for more and better science both ex-ante and ex-post after a pathogen is identified.  I will never forget my friend Barry Bloom, former Dean of Harvard’s School of Public Health, asking me how I would prefer to have spent money in the 1950s: on scholarships for iron lungs or on supporting Salk and Sabin.  There is much here that science could be doing but currently is not.  Given that profiting hugely in time of pandemic is unacceptable, markets provide insufficient incentives for gaps to be filled. As such, pre-emptive research is fundamentally important.


A postscript to Delong and Krugman





Brad is unpersuaded by my response.  He is broadly right in my view that models function both as discovery tools and as ways of organizing and codifying thought. The danger comes when too primitive a model is regarded as too powerful a discovery. Thus Krugman was right to recognize that first generation models of currency crises were an inadequate basis for making policy in response to many actual currency crises.

On the issue at hand my judgement is that excessive spending and fear of a sudden stop can push the IS curve back leading to contractionary capital outflows. I cite the work of Blanchard et al in support of this proposition. With a bit of political economy, the argument can be extended. Suppose countries in danger of high inflation are more likely to turn populist.  It was Keynes after all who introduced animal spirits and warned Roosevelt about business confidence.

Again, I don’t think any of this is of concern for the US right now and I think my track record in favor of fiscal expansion notably in my work with Brad is clear enough.

The point though is that responsible policy makers like Janet Yellen and Stan Fischer may sometimes come to judgements different from mine. I find it unhelpful and likely wrong to attribute this to a failure to understand and appreciate basic macroeconomics.


Paul now offers some observations. He is right that we are not all very far apart. I agree with him that one needs more than attitude, one needs a logically consistent view of how the world works. As my response to Mike Spence and Kevin Warsh illustrates I too am impatient with fear mongering attitude as an approach to analysis.

We have I think two remaining disagreements. First, I am more willing than Paul to credit the possibility that people with substantial experience and even a track record of making money by predicting markets, have important insights even if they cannot speak the language of “models” in the way I teach in economics. Hyman Minsky is an example of a scholar whose warnings were ignored in part because they were not formalized not because they were incoherent or illogical.

Second, on the issue of confidence crises I think Paul is way too serene for reasons Blanchard’s work makes clear. If loss of confidence in their government or economy makes people less wealthy, they will spend less and that is contractionary. This objection may for some reason be wrong but I do not see why it should be dismissed apriori. This is a case where I think reliance on formalism may lead people astray.

Thoughts on Delong and Krugman blogs


Brad Delong and Paul Krugman accept my criticisms of Fed thought regarding their monetary policy strategy but disagree with my assertion that it reflects an excessive attachment to existing models and modes of thought.

Their argument is that standard IS-LM leads to the conclusion you should not raise rates in the present environment so no move away from orthodoxy is necessary to reach this conclusion.  I think the issue is more on the supply side than the demand side.  If I believed strongly in the vertical long run Phillips curve with a NAIRU around five percent and in inflation expectations responsiveness to a heated up labor market, I would see a reasonable case for the monetary tightening that has taken place.

Since I am not sure of anything about the Phillips curve and inflation is well below target I come down against tightening.  The disagreement does it seems to me come down to the Fed’s attachment to the standard Phillips curve mode of thought.  My disagreement is reinforced by other judgmental aspects that are outside of the standard model used within the Fed.  These include hysteresis effects, the possibility of secular stagnation, and the asymmetric consequences of policy errors.

I am sure Paul and Brad are right that a desire to be “sound” also influences policy.  I am not nearly as hostile to this as Paul.  I think maintaining confidence is an important part of the art of policy.  A good example of where market thought is I think right and simple model based thought is I think dangerously wrong is Paul’s own Mundell-Fleming lecture on confidence crises in countries that have their own currencies.  Paul asserts that a damaging confidence crisis in a liquidity trap country without large foreign debts is impossible because if one developed the currency would depreciate generating an export surge.

Paul is certainly correct in his model but I doubt that he is in fact. Once account is taken of the impact of a currency collapse on consumers’ real incomes, on their expectations, and especially on the risk premium associated with domestic asset values, it is easy to understand how monetary and fiscal policymakers who lose confidence and trust see their real economies deteriorate as Olivier Blanchard and his colleagues have recently demonstrated.  Paul may be right that we have few examples of crises of this kind but if so this is perhaps because central banks do not in general follow his precepts.

I do not think this is a pressing issue for the US right now.   But the idea that policymakers should in general follow the model and not worry about considerations of market confidence seems to me as misguided as the view that they should be governed by market confidence to the exclusion of models.

The Fed and Financial Reform – Reflections on Sen. Sanders op-Ed


Bernie Sanders had an op Ed in the New York Times on Fed reform last week that provides an opportunity to reflect on the Fed and financial reform more generally. I think that Sanders is right in his central point that financial policy is overly influenced by financial interests to its detriment and that it is essential that this be repaired. At the same time, reform requires careful reflection if it is not to be counterproductive. And it is important in approaching issues of reform not to give ammunition to right wing critics of the Fed who would deny it the capacity to engage in the kind of crisis responses that have judged in their totality been successful in responding to the financial crisis.  The most important policy priority with respect to the Fed is protecting it from stone age monetary ideas like a return to the gold standard, or turning policymaking over to a formula, or removing the dual mandate commanding the Fed to worry about unemployment as well as inflation.

Sanders is right that Fed governance has been and is overly tied up with the financial sector. Each of the 12 regional Fed s has a board of directors that is made up of 9 people—three banking representatives, three private sector non-banking representatives and three public interest representatives. The fact that a member of Goldman Sachs’ board at the time of the 2008 crisis was the “public interest” Chairman of the New York Fed board is to put it mildly indefensible.

More generally, it is not clear why a government institution with vital policy responsibilities should have a role in governance for the private sector. Yes, advice on market conditions and the like is needed but this can be sought from advisory committees. Yes, Dodd Frank did clean things up some by removing bankers from the selection process for regional bank presidents and orienting regulatory responsibility towards the Washington. But it is hard to imagine an appropriate governance activity for business figures with respect to the Federal Reserve System. Nor is it clear why banks should in any sense be “shareholders” in the Federal Reserve System.

I am less certain as to whether Sanders particular reform of making regional presidents senate confirmed is wise given the dysfunctionalities of the Senate process. Also, I suspect that this reform would strengthen the NY Fed with its close ties to Wall Street and hawkish regional presidents in ways that Sanders would not like.

A separate issue from Sanders concern with governance is his concern with who holds the full time senior positions within the Fed.  He asks rhetorically whether the CEO of Exxon should be head of the EPA or FCC should be stuffed with former Verizon executives. This is a difficult issue.  There is a tension between acquiring expertise and avoiding cooptation or cognitive capture. In fact many FCC chairs have had industry backgrounds including both Obama FCC chairs who pushed net neutrality approaches that industry loathed. It would be a valuable study but it is not my impression that as a general matter officials who come from industry have been systematically softer on industry than those who have come from other backgrounds.   It is worth pondering that figures much respected for their commitment to aggressive financial regulation like Arthur Levitt came into their positions from full time roles in industry whereas the principal regulators in place before the 2008 crisis—Bernanke, Geithner, Cox– came from public sector backgrounds. Franklin Roosevelt was hardly a pushover to the financial industry. He famously made former stock-operator Joseph Kennedy the inaugural leader of the SEC on the theory that it takes a thief to catch a thief.

Sanders proposes to make the Fed more transparent and accountable by releasing not just minutes but transcripts six months after meetings rather than the current five years. I am not sure I understand the logic here. Monetary policy accountability is essential but so is accountability for decisions of war and peace or protection of the environment. No one expects transcripts from the Pentagon’s war room or the EPA senior staff meetings. The Supreme Court Justices meet alone, without clerks or stenographers, because the best decisions tend to come when policymakers can deliberate privately before reaching conclusions. This encourages out of the box thinking and forceful dissent while minimizing grandstanding. Why should monetary policy be different? It seems to me that Janet Yellen has done great work over the years in pushing the Fed to be more open and that if further steps are to be taken, they should be in the directions she has pioneered such as more frequent press conferences.

With respect to proposals to audit the Fed, I think the issues are really of truth in labeling. There is no question that the Fed like every other part of government should be subject to independent audit. My understanding is that this is currently the case. If there are lacunae in current procedures, these should be pointed up and repaired. This is not the focus of current proposals like those of Ron and Rand Paul who would prefer to abolish the central bank and whose ideas are not so much about auditing the Fed as subjecting it to political control and straitjacketing it.  Surely Senator Sanders should not wish to curtail the Fed’s ability to act with discretion to insure a continued flow of credit to businesses and households in the event of an economic downturn or financial crisis.

On the substance of monetary policy, I have been clearly on the dovish side of the Fed for quite sometime and think the risks of the last rate increase exceeded the benefits so I agree with Sanders general thrust. I prefer the “do not raise rates until you see the whites of inflation’s eyes” to Sanders rather arbitrary 4 percent unemployment target.

I did not feel strongly but am inclined to agree with Sanders that the Fed should not have paid interest in excess reserves while it was setting the Fed funds rate in the zero range.  However, when rates are raised it is a matter of necessity that the Fed either pay interest on reserves or what is essentially equivalent offer Treasury bills to banks which soak up their excess cash. In a positive interest rate environment, there is no way that banks will or should hold on to zero interest rate cash. I do not think there would be any expert support for Sanders views here.

On regulatory policy, no one is for gambling with insured deposits. But Sanders fails to recognize some of the tensions that make regulatory policy so difficult. Loans to small businesses which he likes are far riskier than holdings of securities that are marked to market on a daily basis so if banks focused on traditional lending they would be riskier than they are today. Indeed the majority of the world’s banking crises over the last three centuries and over the last quarter century have come from traditional lending especially against real estate.  Making banks safer means reducing their dependence on traditional lending activities so balances must be struck.

Sanders asserts as many do that Glass Stegall’s repeal contributed to the crisis. I may not be objective as I supported this measure as Treasury Secretary but I do not see a basis for this assertion. Virtually everything that contributed to the crisis was not affected by Glass Steagall even in its purest form. Think of pure investment banks Bear and Lehman, or the GSEs Fannie and Freddie, or the banks Washington Mutual and Wachovia or AIG or the growth of the shadow banking system. Nor were the principle lending activities that got Citi and Bank of America in trouble implicated by Glass Stegall.

Moreover preventing financial institutions from diversifying into multiple activities can actually make them more likely to fail. Imagine how much better the outcome would have been if Lehman had sold itself to a large bank during 2008. There is the also the further point that without the repeal of Glass Stegall it would have been much more difficult to aggressively use the discount window to contain panic following Lehman s fall.

We currently have a system in which institutions have higher capital requirements if they are larger, more complex or more interconnected. I think there is a good case to be made that capital requirements should be further increased and further graduated with size and complexity. This would tend to encourage deconsolidation and is I think the right 21st century response to the concerns about concentration in banking.

Finally, stepping back from Sanders specifics, I agree with his core claim that the excessive power of financial interests shapes financial policy to an unhealthy extent. I saw this during the debate on Dodd Frank when there were nearly five registered lobbyists for every member of Congress. It’s worth pondering how policy would be different if special interests were kept in check. Here are my top five:

First, the financial regulatory agencies would be adequately resourced and would not be under pressure to kowtow to legislators pushing their contributors interest. CFTC head Tim Massad had it right when he condemned the recent budget agreement as undercutting the ability to regulate derivatives in a serious way.

Second, the Balkanized character of US banking regulation is indefensible and would be ended. The worst regulatory idea of the 20th century—the dual banking system—persists into the 21st. The idea is that we have two systems one regulated by the States and the Fed and the other regulated by the OCC so banks have choice. With ambitious regulators eager to expand their reach, the inevitable result is a race to the bottom.

Third, the current SEC and CFTC would be combined and charged with regulating in a coherent way all financial markets with respect to market integrity, manipulation issues, insider trading, transparency, fairness of execution, and systemic risk. When there were securities markets and commodity markets it may have made sense. It no longer is defensible when the vast majority of “commodity trading” is in financial derivatives. The current system persists only so that multiple congressional committees can maintain jurisdiction over financial regulation and reap the benefits in terms of campaign contributions.  Quite possibly, it would be a good idea to give the new agency if it was strong jurisdiction over fiduciary rules for investment and pension advisors.

Fourth, either the new agency formed out of the SEC and CFTC or the existing FSOC would take on systemic risks associated with asset management in a serious way. While the asset managers have the better side of the argument when they claim not to be systemic in the sense of JP Morgan or Goldman Sachs, their activities are systemic and egregiously under regulated. It took far far too long to reach a still unsatisfactory solution with respect to money market funds. And ETFs are as likely as anything else to be the source of the next major bit of financial drama.

Fifth, there would be appropriate taxation of financial activities and the financial sector. Among the obvious reforms held back only by special interests are the highly preferential treatment of carried interest, the privileged treatment of dividends and capital gains, the ability of financial institutions to reduce their tax liabilities by using off shore tax havens and the tax deductibility of huge fines paid to resolve allegations of wrongdoing.

Senator Sanders is right that there is more to be done to respond to the long standing problems pointed up by the financial crisis and he is right in his concern about the way in which special interests distort the process. These notes will have served their purpose if they help to channel legitimate energy in the most constructive directions.