IMF Fourteenth Annual Research Conference in Honor of Stanley Fischer

November 25th, 2013

Washington, DC

November 8, 2013

I am very glad for the opportunity to be here.  I had an occasion to speak some years ago about Stan’s remarkable accomplishments at the IMF when he left the IMF, and I had an occasion some months ago to speak about his remarkable accomplishments at the Israeli Central Bank when he left the Israeli Central Bank.  So, I will not speak about either of those accomplishments this afternoon.

Instead, the number that is on my mind is a number that I would guess is entirely unfamiliar to most of the people in this room, but is familiar to all of the people on this stage, and that is 14.462.  That was the course number for Stan Fischer’s class on monetary economics at MIT for graduate students.  It was an important part of why I chose to spend my life as I have, as a macroeconomist, and I strongly suspect that the same is true for Olivier [Blanchard], and for Ben [Bernanke], and for Ken [Rogoff].

It was a remarkable intellectual experience, and it was remarkable also because Stan never lost sight of the fact that this was not just an intellectual game.  He emphasized that getting these questions right made a profound difference in the lives of nations and their peoples.  So, I will leave it to others to talk about the IMF and Israel, and I will say to you, Stan, thank you on behalf of all of us for 14.462, and for all you have taught us ever since.

I agree with the vast majority of what has just been said [by Ben Bernanke, Stan Fischer and Ken Rogoff]  – the importance of moving rapidly; the importance of providing liquidity decisively; the importance of not allowing financial problems to languish; the importance of erecting sound and comprehensive frameworks to prevent future crises.  Were I a member of the official sector, I would discourse at some length on each of those themes in a sound way, or in what I would hope would be a sound way.  But, I’m not part of the official sector, so I’m not going to talk about any of that.

I’m going to talk about something else that seems to me to be profoundly connected, and that is the nagging concern that finance is all too important to leave entirely to financiers or even to financial officials.  Financial stability is indeed a necessary condition for satisfactory economic performance but it is, as those focused on finance sometimes fail to recognize, far from sufficient.

We have all agreed, and I think our agreement is warranted, that a remarkable job was done in containing the 2007-2008 crisis.  That an event that in the fall of 2008 and winter of 2009 that appeared, by most of the statistics – GDP, industrial production, employment, world trade, the stock market – worse than the fall of 1929 and the winter of 1930, ended up in a way that bears very little resemblance to the Great Depression.  That is a huge achievement which we rightly celebrate.

But there is, I think, another aspect of the situation that warrants our close attention and tends to receive insufficient reflection, and it is this:  four years ago, in the fall of 2009, the financial panic had been arrested.  The TARP money had been paid back, credit spreads had substantially normalized; there was no panic in the air. To have normalized financial conditions so rapidly so soon after a panic was no small achievement.

Yet, in the four years since financial normalization, the share of adults who are working has not increased at all and GDP has fallen further and further behind potential, as we would have defined it in the fall of 2009.  And the American experience of dismal economic performance in the wake of financial crisis is not unique, as Ken Rogoff and Carmen Reinhart’s work has documented.  Japan provides a particularly clear example.   I remember at the beginning of the Clinton administration, we engaged in a set of long run global economic projections.  Japan’s real GDP today in 2013 is little more than half of what we at the Treasury or the Fed or the World Bank or the IMF predicted in 1993.

It is a central pillar of both classical models and Keynesian models that stabilization policy is all about fluctuations – fluctuations around a given mean – and that the achievable goal and therefore the proper objective of macroeconomic policy is to have less volatility.  I wonder if a set of older and much more radical ideas that I have to say were pretty firmly rejected in 14.462, Stan, a set of older ideas that went under the phrase secular stagnation, are not profoundly important in understanding Japan’s experience in the 1990s, and may not be without relevance to America’s experience today.

Let me say a little bit more about why I’m led to think in those terms.  If you go back and you study the economy prior to the crisis, there is something a little bit odd.  Many people believe that monetary policy was too easy.  Everybody agrees that there was a vast amount of imprudent lending going on.  Almost everybody believes that wealth, as it was experienced by households, was in excess of its reality:  too much easy money, too much borrowing, too much wealth.  Was there a great boom?  Capacity utilization wasn’t under any great pressure.  Unemployment wasn’t at any remarkably low level.  Inflation was entirely quiescent.  So, somehow, even a great bubble wasn’t enough to produce any excess in aggregate demand.

Now, think about the period after the financial crisis.  I always like to think of these crises as analogous to a power failure or analogous to what would happen if all the telephones were shut off for some time.  Consider such an event.  The network would collapse.  The connections would go away.  And output would, of course, drop very rapidly.  There would be a set of economists who would sit around explaining that electricity was only 4% of the economy, and so if you lost 80% of electricity, you couldn’t possibly have lost more than 3% of the economy. Perhaps in Minnesota or Chicago there would be people writing such a paper, but most others would recognize this as a case where the evidence of the eyes trumped the logic of straightforward microeconomic theory.

And we would understand that somehow, even if we didn’t exactly understand it in the model, that when there wasn’t any electricity, there wasn’t really going to be much economy.  Something similar was true with respect to financial flows and financial interconnection.  And that’s why it is so important to get the lights back on, and that’s why it’s so important to contain the financial system.

But imagine my experiment where say for a few months, 80% of the electricity went off.  GDP would collapse.  Then ask yourself, what do you think would happen to GDP afterwards?  You would kind of expect that there would be a lot of catch up, that all the stuff where inventories got run down would get produced much faster.  So, you’d actually expect that once things normalized, you’d get more GDP than you otherwise would have had, not that four years later, you’d still be having substantially less than you had before.  So, there’s something odd about financial normalization, if panic was our whole problem, to have continued slow growth.

So, what’s an explanation that would fit both of these observations?  Suppose that the short-term real interest rate that was consistent with full employment had fallen to -2% or -3% sometime in the middle of the last decade.  Then, what would happen?  Then, even with artificial stimulus to demand coming from all this financial imprudence, you wouldn’t see any excess demand.  And even with a relative resumption of normal credit conditions, you’d have a lot of difficulty getting back to full employment.

Yes, it has been demonstrated absolutely conclusively that panics are terrible and that monetary policy can contain them when the interest rate is zero.  It has been demonstrated less conclusively, but presumptively, that when short-term interest rates are zero, monetary policy can affect a constellation of other asset prices in ways that support demand even when the short-term interest rate can’t be lowered.  Just how large that impact is on demand is less clear, but it is there.

But imagine a situation where natural and equilibrium interest rates have fallen significantly below zero.  Then, conventional macroeconomic thinking leaves us in a very serious problem, because we all seem to agree that whereas you can keep the federal funds rate at a low level forever, it’s much harder to do extraordinary measures beyond that forever; but, the underlying problem may be there forever.  It’s much more difficult to say, well, we only needed deficits during the short interval of the crisis if equilibrium interest rates cannot be achieved given the prevailing rate of inflation.

If this view is correct, most of what might be done under the aegis of preventing a future crisis would be counterproductive, because it would, in one way or another, raise the cost of financial inter-mediation, and therefore operate to lower the equilibrium interest rate on safe liquid securities.

Now, this may all be madness, and I may not have this right at all.  But it does seem to me that four years after the successful combating of crisis, since there’s really no evidence of growth that is restoring equilibrium, one has to be concerned about a policy agenda that is doing less with monetary policy than has been done before, doing less with fiscal policy than has been done before, and taking steps whose basic purpose is to cause there to be less lending, borrowing, and inflated asset prices than there were before.

So, my lesson from this crisis, and my overarching lesson, which I have to say I think the world has under-internalized, is that it is not over until it is over, and that time is surely not right now, and cannot be judged relative to the extent of financial panic. And that we may well need, in the years ahead, to think about how we manage an economy in which the zero nominal interest rate is a chronic and systemic inhibitor of economic activity holding our economies back below their potential.  Thank you very much.


Transcript lightly edited for grammar and clarity of presentation.