The Wall Street Journal’s Greg Ip, reviewing the Trump administration’s first Council of Economic Advisers report, finds credible its claims that President Barack Obama’s policies, particularly in his second term, materially slowed economic growth, even though Ip acknowledges that the CEA’s assertions regarding magnitudes are likely exaggerated.

The CEA’s thesis is that a wave of tax and regulatory policies reduced both workers’ incentives to work and businesses’ incentives to invest, leading to slower economic growth than would otherwise have been achievable.

I am sympathetic to arguments of this type, having often observed that “business confidence is the cheapest form of stimulus.” And I would be the last to argue that every regulatory intervention of the late Obama years was salutary. I would also note that much of what the Obama administration proposed (for example, more infrastructure spending and responsible tax reform) would have triggered even greater economic growth but never came to pass, largely due to congressional roadblocks. There was certainly more that could have been done.

But at least three broad features of the economic landscape make the CEA’s view an unlikely explanation for disappointing economic growth.

First, the dominant reason for slow growth has been what economists label slow “total factor productivity” (TFP) growth. That is, the problem has not primarily been a shortage of capital and labor inputs into production, but rather slow growth in output, given inputs. After growing at about 1 ¾ percent per year between 1996 and 2004, the TFP growth rate has dropped by half since 2005.

While TFP has fallen off rapidly, there is no basis for supposing that levels of labor input or capital are less than one would expect given the magnitude of the Great Financial Crisis. In fact, labor force participation rates in 2016 lined up closely with Federal Reserve researchers’ 2006 predictions. This suggests the lack of importance of the various factors adduced by the CEA’s report.

Second, perhaps the biggest surprise of the last few years has been the remarkably low rate of inflation even as the unemployment rate has reached 4 percent. Year after year, consensus and Federal Reserve Board forecasts of inflation have fallen short of predictions. If, as the CEA believes, our slow economic growth is a result of too little supply of labor and capital, one would expect surprisingly high, rather than surprisingly low, inflation as demand growth collided with constricted supply. This is the opposite of what we observe. On the other hand, the secular stagnation hypothesis that emphasizes issues on the demand side would predict exactly the combination of sluggish growth, low inflation and low capital costs that we observe.

Third, the essential idea behind the CEA’s thesis is that capital has been greatly burdened in recent years by onerous regulation, high taxes and a lack of availability of labor. This idea is belied by the behavior of the stock market and of corporate profits. Over the course of Obama’s second term, corporate profits increased by nearly 20 percent, and the S&P 500 grew by more than 50 percent. This hardly suggests a period of excessively increasing burdens on capital.

The observation that share buybacks appear to be the largest use of the proceeds from the Trump tax cuts points in the same direction. Costs of capital have not been responsible for holding back investment in the United States in recent years.

If the “Obamasclerosis” theory does not fit the facts of slow growth in recent years, what are its likely causes? This will remain a matter for active research. But my guess is that key elements include hysteresis effects from the financial crisis and associated recession, reduced application of innovation in the economy in recent years, and possibly the adverse effects of rising monopoly power and diminishing competition in a range of markets.

McKinsey has a new study out on an important topic—the question of whether corporations systematically take too short a view and do not invest enough for the long term.  If true — as many CEOs believe — this is a serious indictment of current corporate governance arrangements and has important policy implications.  To take one close to my heart, if short termism causes under investment it will be a cause of secular stagnation.

I am not sure what to believe in this area.  On the one hand, there are many anecdotes suggesting that pressures to manage earnings hold back investment.  And the short termism view is very widely believed.

On the other hand, some of what is done in the name of long term may be unmonitored waste.  The observation that many “unicorn” companies with no profits, and sometimes no revenues or even fully developed products, get valued so highly makes me skeptical of the idea that the capital market is systematically myopic.  It is also the case that the companies generating the highest immediate cash flows — which should be overvalued on the myopia theory — historically have had the highest stock market returns, implying undervaluation rather than overvaluation.

I was therefore excited to see that McKinsey had a new empirical study out that provides evidence in favor of the view that corporations should take longer views.  They have a reasonable methodology.  They divide their sample between companies that take a long-term view and those that do not and then compare their performance.  They find that companies that take a long-term view perform better on many metrics like employment growth and shareholder return.

Their findings deserve much discussion, debate and attempts at replication.  At this point though I would give a Scottish verdict of “not proven” to their case.  They may be right but I do not think they have provided evidence that would convince anyone other than a prior believer.

Consider an analogy. It is doubtless the case that golfers with long swings like Phil Mickelson hit the ball further and more accurately than golfers with short swings like myself.  An index of swing length would be highly correlated with almost any measure of golf performance.  Does this mean I should lengthen my swing?  I doubt it.  Those with more flexibility and coordination are able to take and control longer swings and play golf better.  If I were to try to swing like Phil, I would mishit the ball and maybe break my back.

Some companies have great ideas, great management teams, and compelling strategies.  They invest heavily, seek to grow revenue, ignore the management of earnings, and do limited stock buybacks.  These are the criteria McKinsey uses to measure long termism.  Others lack vision and have mediocre management.  They invest less, cut costs more, manage earnings and buy back stock.  McKinsey deems them short term focused.

No surprise the long-term companies outperform the short-term companies.  But this may be due to their vision and execution capacity not their long-term focus.  Mediocre companies seeking to imitate them will be like me trying to imitate Phil—painful failures.  I do not see any basis in the McKinsey results for saying that companies should extend their horizons.

McKinsey tries to address this issue by doing comparisons within industries.  But everything we know suggests that there are substantial differences in company quality within industries as well as across industries.

Again, it may be that the long-termism hypothesis is right and there may be ways of teasing causality out of the very interesting data set that McKinsey has created.  But at this point I think the issue is still unresolved.

On Monday, I gave a speech at Brookings and then had a discussion with my Harvard colleague Ed Glaeser on aspects of infrastructure investment. Here are the links to the video and transcript. While for reasons described below I believe the Trump campaign proposals are wholly ill-conceived, I remain convinced that an increased and improved programme of public infrastructure investment would be very much in the American national interest. The case for public investment today rests largely on grounds of long-run policy and microeconomic efficiency given the sub-5 per cent unemployment rate.

My remarks and conversation with Ed focused on five main issues.

First, improved infrastructure has benefits that go well beyond what is picked up in standard rate of return on investment calculations. Because infrastructure is integrative, we often fail fully to understand the benefits of investment.

Nonquantitative historians are convinced that the Transcontinental railway played a crucial role in American history. They believe it permitted the integration of the west and more broadly drew our nation together. This idea was famously challenged by Nobel Prize economist Robert Fogel in his doctoral dissertation. Fogel pointed out that transport made up only a small per cent of GDP and that the railroad was only a certain per cent cheaper than canals so the contribution to economic growth had to be small. I suspect this calculation, which mirrors those usually done in evaluating infrastructure projects such as high-speed rail, misses the benefits of integrative infrastructure in spurring investment and promoting agglomeration by increasing the range over which the best companies can expand and compete. My bet is that the railway project was in fact very important for the US economy. I suspect something similar can be said on a global basis about the Suez or Panama Canal projects.

There is a broader point as well. Investments in a location can be divided between those that have “spill-out consequences” and those that have “pull-in” effects. Investments in new science, for example, have benefits that spread out widely, as do investments in educating children some of whom inevitably migrate. Investments in infrastructure on the other hand have benefits that are local to where they take place and are likely to attract other investments. For example, Dulles airport and its successive expansion has been a huge spur to the economic development of Northern Virginia. At a time of resurgent interest in the national dimension of economic success, infrastructure projects have the virtue that their benefits are very much concentrated where the investments take place.

Second, there is a particularly compelling case for maintenance investment. Ed and I agreed that there was a presumption that this should be the case since all the incentives facing political decision makers work against adequate maintenance. Deferred maintenance liabilities are largely unmeasured, unnoticed and passed on to subsequent generations of elected officials. No one can name a maintenance project. The desire to come in on budget discourages what might be called “pre-maintenance”, such as when the high-return insulation investments got stripped out at the last moment of Harvard building projects.

The examples are pretty stark. The American Society of Civil Engineers, which is admittedly an interested party, estimates that extra repairs for American automobiles each year have a cost that is the equivalent of a 75 cent a gallon gasoline tax. As I have said many times, look at La Guardia or Kennedy airport. I was struck many years ago by the young teacher who approached me in Oakland after, as secretary of the Treasury, I gave a speech about the importance of education. She said “Secretary Summers — that was a great speech. But the paint is chipping off the walls of this school, not off the walls at McDonald’s or the movie theatre. So why should the kids believe this society thinks their education is the most important thing?” I had no good answer.

As with potentially collapsing bridges, prevention is cheaper than cure and in many cases the return on “un-derferring” maintenance far exceeds government borrowing rates. Borrowing to finance maintenance should not be viewed as incurring a new cost but as shifting from the fast-compounding liability of maintenance to the slowly compounding liability of explicit debt. It should also be noted that inevitably one maintains what has been used, so maintenance investment is much less likely to turn out a white elephant than new infrastructure investment.

My guess is that the US could profitably spend an additional 0.5 per cent of GDP, or about $1.25tn over the next decade, on maintenance of its infrastructure.

Third, there are important new infrastructure investment projects that almost certainly have high rates of return. I have previously used as an example the renewal of the US air traffic control system. While vacuum tubes are no longer in use in our system, radar technology of the kind used during the second world war is pervasive, and there is essentially no role for GPS in our current architecture. The result is greater than necessary threats to safety, substantial unnecessary emission of greenhouse gases as planes circle to maintain greater than necessary distances from each other, pervasive delays during peak travel times, and inefficient usage of airport capacity. Current plans do not involve a satisfactory system being fully implemented until the mid-2030s.

The Treasury department recently released a study identifying 40 projects with a combined cost in the range of $200bn and cost-benefit ratios in the range of 2 to 10. This does not take account of technological progress. For example, autonomous vehicle technology will create new possibilities for very high speed travel lanes. And new developments in energy storage and transmission create potential for infrastructure technologies that will yield large social benefits by facilitating the adoption of renewable energy technologies like solar and wind, where intermittency is an important issue. I suspect also that pervasive fast wireless will create benefits that are currently unimaginable in the same way that the Transcontinental Railroad did.

I would be very surprised if another 0.5 per cent of GDP could not be profitably invested in new infrastructure over the next decade. A $2.5tn programme would still leave public investment at levels that are low by the standards of the post-war period in the US or other countries. Given how much less we are now spending — of the order of 3 per cent of GDP — on national defence compared to the more than 5 per cent we spent for much of the post-war period, it is not plausible to assert that we cannot afford these investments as a nation. Indeed, if over time infrastructure investments yield a return of even 6 per cent and if government can capture even 1/6 of that return in increased tax collection, they will pay for themselves at current low levels of real interest rates.

Fourth, better infrastructure investment is as important as more infrastructure investment. Quality is as important as quantity. Progressives are right to decry the inadequate level of public investment in the US. Conservative complaints about regulatory obstacles, problems in project selection, inefficient procurement and inattention to the use of pricing in assuring the efficient use of infrastructure are equally valid. The short 300-foot bridge outside my office connecting Cambridge and Boston has been under repair with substantial traffic delays for nearly five years. Julius Caesar built from scratch a bridge seven times as long spanning the Rhine in nine days! Famously, it has taken longer to repair the eastern span of the Bay Bridge in San Francisco than took to build the original. Yes, Robert Moses and his contemporaries were too heedless of the environment and the interests of local communities. But we can surely find ways of coming to far more rapid decisions with far less promiscuously distributed veto power than is the case in much of the country today.

There is too much pork barrel and too little cost-benefit analysis in infrastructure decision-making. Projects should be required to pass cost-benefit tests and proposals like a national infrastructure bank that would insulate a larger portion of decision-making from politics should be seriously considered. Ed Glaeser is right that new infrastructure investment in declining areas is often a terrible idea as shrinking populations means that these areas have if anything too much infrastructure. And Field of Dreams — “build it and they will come” approaches do not have a very good track record. Ways should be found to make the costs of procrastination on maintenance more salient and to institutionalise resistance to low-ball cost estimates from advocates of more visionary projects.

The goal of building rapidly at minimum cost should be the primary objective in infrastructure procurement. Deviations from this principle should take place only with compelling justification.

Crucially, modern technology makes possible much more pricing of infrastructure usage than was once the case. In particular, transponder technology means that usage of roads can be priced with sensitivity to exact location and time much as power is priced today. To date, congestion pricing has been very difficult politically. My hope is that in the same way that pricing in the environmental area was once decried as “purchased licences to pollute” but is today quite widely accepted, formulas can be found to introduce congestion pricing. The benefits are potentially very large. And it should be possible to find formulas to compensate losers.

To assert that current public investment decision-making is highly flawed should not be taken as a blanket endorsement of private sector reliance. While there are areas where public-private partnerships are desirable, these should be approached with great caution. The private sector often demands rates of return far greater than public sector borrowing costs, especially in the current low interest rate environment. Insisting on private participation could well substantially raise costs without addressing major problems.

The proposals of Trump advisors Peter Navarro and Wilbur Ross to rely on tax credits to augment infrastructure investment are a textbook case of the dangers of knee-jerk private sector reliance. These benefits would (i) largely go to developers and contractors for infrastructure projects like new pipelines that would happen even without new incentives and so be highly regressive; (ii) raise costs by failing to reach the tax-free pension funds, sovereign wealth funds and international investors that are the most plausible sources of incremental infrastructure finance; (iii) not encourage at all the highest return maintenance projects like fixing potholes that do not yield a pecuniary return for investors; and (iv) by offering credits at an unprecedented 82 per cent rate, invite all kinds of tax-shelter abuse.

Fifth, while the case for expanded infrastructure investment does not depend on Keynesian stimulus or aggregate demand considerations, secular stagnation risks reinforce the argument for increased public investment. As the previous points illustrate, there is a compelling case (wholly apart from any ideas about aggregate demand) for increased infrastructure investment. To the extent that, as I have argued elsewhere, the industrial world is likely to be prone to a chronic excess of saving over private investment in the years ahead, this case is reinforced. Excess saving means that very low real interest costs are likely to persist, reducing the capital cost of infrastructure investment.

While the evidence is far from conclusive, my guess is that low real borrowing costs raise the risk of bubbles and financial instability. This argues for a shift in the policy mix, from monetary policy towards fiscal policy. And to the extent that, because of constraints on how low interest rates can go, recessions become more frequent and protracted in the years ahead, the case for expansionary fiscal policy is reinforced. To be clear, I do not believe that infrastructure investment can be turned on and off in response to cyclical fluctuations without big efficiency losses. And I do not believe there is a case for make-work projects that cannot be justified on microeconomic grounds. There is, however, a case for expanded public investment on a sustained basis with financing from borrowing or taxes that varies with cyclical conditions.

There is also the consideration that infrastructure investment is likely to disproportionately benefit groups such as middle-aged men with limited education who face a major structural employment problem. One way of thinking about this is that it means the real cost of investment is lower because those working on infrastructure would otherwise have been jobless and perhaps collecting unemployment or disability benefits. Another is to simply note that even if the economy does not face a chronic shortage of demand overall, it does face a shortage of demand for certain types of labour and policies that address this shortfall are, other things being equal, desirable.

While President-elect Trump’s plans for infrastructure stimulus are, I think, misguided and probablyharmful, I agree with the incoming administration on one thing: the case for a substantially increased programme of public infrastructure is undeniable.

On Monday, I gave a speech at Brookings and then had a discussion with my Harvard colleague Ed Glaeser on aspects of infrastructure investment.  Here are the links to the video and transcript.  While for reasons described below I believe the Trump campaign proposals are wholly ill conceived, I remain convinced that an increased and improved program of public infrastructure investment would be very much in the American national interest.  The case for public investment today rests largely on grounds of long run policy and microeconomic efficiency given the sub-5 percent unemployment rate.

My remarks and conversation with Ed focused on five main issues.

First, improved infrastructure has benefits that go well beyond what is picked up in standard rate of return on investment calculations.  Because infrastructure is integrative, we often fail to fully understand the benefits of investment.

Nonquantitative historians are convinced that the Transcontinental railroad played a crucial role in American history.  They believe it permitted the integration of the West and more broadly drew our nation together. This idea was famously challenged by Nobel Prize economist Robert Fogel in his doctoral dissertation.  Fogel pointed out that transport was only a small percent of GDP and that the railroad was only a certain percent cheaper than canals so the contribution to economic growth had to be small.  I suspect this calculation, which mirrors the ones usually done in evaluating infrastructure projects like high-speed rail, misses the benefits of integrative infrastructure in spurring investment and promoting agglomeration by increasing the range over which the best firms can expand and compete.  My bet is that the railroad project in fact was very important for the American economy.  I suspect something similar can be said on a global basis about the Suez or Panama Canal projects.

There is a broader point as well.  Investments in a location can be divided between those that have “spill-out consequences” and those that have “pull-in” effects.  Investments in new science for example has benefits that spread out widely, as do investments in educating children some of whom inevitably migrate.  Investments in infrastructure on the other hand have benefits that are local to where the investment takes place and are likely to attract other investments. For example Dulles airport and its successive expansions has been a huge spur to the economic development of Northern Virginia.  At a time of resurgent interest in the national dimension of economic success, infrastructure projects have the virtue that their benefits are very much concentrated where the investments take place.

Second, there is a particularly compelling case for maintenance investment.  Ed and I agreed that there was a presumption that this should be the case since all of the incentives facing political decision makers work against adequate maintenance.  Deferred maintenance liabilities are largely unmeasured, unnoticed and passed on to subsequent generations of elected officials.  No one can name a maintenance project.  The desire to come in on budget discourages what might be called “pre-maintenance,” such as when the high return insulation investments got stripped out at the last moment of Harvard building projects.

The examples are pretty stark.  The American Society of Civil Engineers, who are admittedly an interested party, estimate that extra repairs costs for American automobiles each year have a cost that is the equivalent of a 75 cent a gallon gasoline tax.  As I have said many times, look at La Guardia or Kennedy airport.  I was struck many years ago by the young teacher who approached me in Oakland after as Secretary of the Treasury I gave a speech about the importance of education. She said “Secretary Summers—that was a great speech.  But the paint is chipping off the walls of this school, not off the walls at McDonald’s or the movie theatre. So why should the kids believe this society thinks their education is the most important thing”  I had no good answer.

As with potentially collapsing bridges, prevention is cheaper than cure and in many cases the return on “un-derferring” maintenance far exceeds government borrowing rates.  Borrowing to finance maintenance should not be viewed as incurring a new cost but as shifting from the fast compounding liability of maintenance to the slowly compounding liability of explicit debt.  It should also be noted that inevitably one maintains what has been used, so maintenance investment is much less likely to turn out a white elephant than new infrastructure investment.

My guess is that the United States could profitably spend an additional 0.5 percent of GDP or about $1.25 trillion over the next decade on maintenance of its infrastructure.

Third, there are important new infrastructure investment projects that almost certainly have high rates of return.  I have previously used as an example the renewal of the US air traffic control system.  While vacuum tubes are no longer in use in our system, radar technology of the kind used during World War II is pervasive, and there is essentially no role for GPS in our current architecture.  The result is greater than necessary threats to safety, substantial unnecessary emission of greenhouse gases as planes circle to maintain greater than necessary distances between themselves, pervasive delays during peak travel times, and inefficient usage of airport capacity.  Current plans do not involve a satisfactory system being fully implemented until the mid 2030s.  The Treasury Department recently released a study identifying 40 projects with a combined cost in the range of $200 billion and cost-benefit ratios in the range of 2 to 10.  This does not take account for projects that take account of new technological progress.  For example, autonomous vehicle technology will create new possibilities for very high speed travel lanes.  And new developments in energy storage and transmission create potential for infrastructure technologies that will yield large social benefits by facilitating the adoption of renewable energy technologies like solar and wind, where intermittency is an important issue.  I suspect also that pervasive fast wireless will create benefits that are currently unimaginable in the same way that the Transcontinental Railroad did.

I would be very surprised if another 0.5 percent of GDP could not be profitably invested in new infrastructure over the next decade.  A $2.5 trillion program would still leave public investment at levels that are low by the standards of the post-World War II period in the United States or other countries.  Given how much less we are now spending–on the order of 3 percent of GDP — on national defense compared to the above 5 percent we spent for much of the post-War period, it is not plausible to assert that we cannot afford these investments as a nation.  Indeed, if over time infrastructure investments yield a return of even 6 percent and if government can capture even 1/6 of that return in increased tax collections, they will pay for themselves at current low levels of real interest rates.

Fourth, better infrastructure investment is as important as more infrastructure investment.  Quality is as important as Quantity.  Progressives are right to decry the inadequate level of public investment in the United States.  Conservative complaints about regulatory obstacles, problems in project selection, inefficient procurement, and inattention to the use of pricing in assuring the efficient use of infrastructure are equally valid.  The short 300 foot bridge outside my office connecting Cambridge and Boston has been under repair with substantial traffic delays for nearly 5 years. Julius Caesar built from scratch a bridge 7x as long spanning the Rhine in 9 days! Famously, it has taken longer to repair the eastern span of the Bay Bridge in San Francisco than took to build the original.  Yes, Robert Moses and his contemporaries were too heedless of the environment and the interests of local communities.  But we can surely find ways of coming to far more rapid decisions with far less promiscuously distributed veto power than is the case in much of the United States today.

There is too much pork barrel and too little cost-benefit analysis in infrastructure decision making.  Projects should be required to pass cost-benefit tests and proposals like a national infrastructure bank that would insulate a larger portion of decision-making from politics should be seriously considered.  Ed Glaeser is right that new infrastructure investment in declining areas is often a terrible idea as declining population means that these areas have if anything too much infrastructure.  And Field of Dreams— “build it and they will come” approaches do not have a very good track record.  Ways should be found to make the costs of procrastination on maintenance more salient and to institutionalize resistance to low-ball cost estimates from advocates of more visionary projects.

The goal of building rapidly at minimum cost should be the primary objective in infrastructure procurement.  Deviations from this principle should take place only with compelling justification.

Crucially, modern technology makes possible much more pricing of infrastructure usage than was once the case.  In particular, transponder technology means that usage of roads can be priced with sensitivity to exact location and time much as power is priced today.  To date, congestion pricing has been very difficult politically.  My hope is that in the same way that pricing in the environmental area was once decried as “purchased licenses to pollute” and is today quite widely accepted,  formulas can be found to introduce congestion pricing.  The benefits are potentially very large.  And it should be possible to find formulas that assure that losers are compensated.

To assert that current public investment decision-making is highly flawed should not be taken as a blanket endorsement of private sector reliance.  While there are areas where public-private partnerships are desirable, these should be approached with great caution.  The private sector often demands rates of return far greater than public sector borrowing costs, especially in the current low interest rate environment.  Insisting on private participation could well substantially raise costs without addressing major problems.

The proposals of Trump advisors Peter Navarro and Wilbur Ross to rely on tax credits to augment infrastructure investment are a textbook case of the dangers of knee-jerk private sector reliance.  These benefits would (i) largely go to developers and contractors for infrastructure projects like new pipelines that would  happen even without new incentives and so be highly regressive; (ii) raise costs by failing to reach the tax-free pension funds, sovereign wealth funds and international investors who are the most plausible sources of incremental infrastructure finance; (iii) not encourage at all the highest return maintenance projects like fixing potholes that do not yield a pecuniary return for investors; and (iv) by offering credits at an unprecedented 82 percent rate, invite all kinds of tax shelter abuse.

Fifth, while the case for expanded infrastructure investment does not depend on Keynesian stimulus or aggregate demand considerations, secular stagnation risks reinforce the argument for increased public investment.  As the previous points illustrate, there is a compelling case (wholly apart from any ideas about aggregate demand) for increased infrastructure investment.  To the extent that, as I have argued elsewhere, the industrial world is likely to be prone to a chronic excess of saving over private investment in the years ahead, this case is reinforced.  Excess saving means that very low real interest costs are likely to persist, reducing the capital cost of infrastructure investment.  While the evidence is far from conclusive, my guess is that low real borrowing costs raise the risk of bubbles and financial instability.  This argues for a shift in the policy mix, from monetary policy towards fiscal policy.  And to the extent that, because of constraints on how low interest rates can go, recessions are more frequent and protracted in the years ahead, the case for expansionary fiscal policy is reinforced.  To be clear, I do not believe that infrastructure investment can be turned on and off in response to cyclical fluctuations without big efficiency losses.  And I do not believe that there is a case for make-work projects that cannot be justified on microeconomic grounds.  There is however a case for expanded public investment on a sustained basis with financing from borrowing or taxes that varies with cyclical conditions.

There is also the consideration that infrastructure investment is likely to disproportionately benefit groups like middle-aged men with limited education who face a major structural employment problem.  One way of thinking about this is that it means the real cost of investment is lower because those working on infrastructure would otherwise have been unemployed and perhaps collecting unemployment or disability benefits. Another is to simply note that even if the economy does not face a chronic shortage of demand overall, it does face a shortage of demand for certain types of labor and policies that address this shortfall are other things equal desirable.

While President-Elect Trump’s plans for infrastructure stimulus are I think misguided and likely harmful, I agree with the incoming Administration on one thing: the case for a substantially increased program of public infrastructure is undeniable.

As I argued in the first blog in this series last week, I was disappointed in what came out of Jackson Hole for three reasons.   The first reason, developed in that blog, was that the Fed should have signaled a desire to exceed its two percent inflation target during periods of protracted recovery and low unemployment and in this context to signal that a rate increase was off the table for September and quite likely the rest of the year.  Friday’s employment report further strengthens the case for delay both by adding to the evidence on the absence of inflation pressures and by suggesting a less robust economy than most expected.

Even apart from the desirability of allowing inflation to rise above two percent in a happy economic scenario GDP, labor market and inflation expectations data all make a compelling case against a rate increase.  Private sector GDP growth for the last year has averaged 1.3 percent a level that has since the 1960s always presaged recession.  Total work hours have over the last 6 months grown at nearly their slowest rate since early 2010.   And both market and survey measures of inflation expectations continue to decline.

My second reason for disappointment in Jackson Hole was that Chair Yellen, while very thoughtful and analytic, was too complacent to conclude that “even if average interest rates remain lower than in the past, I believe that monetary policy will, under most conditions, be able to respond effectively”.   This statement may rank with Ben Bernanke’s unfortunate observation that subprime problems would be easily contained.

Rather I believe that countering the next recession is the major monetary policy challenge before the Fed.   I have argued repeatedly that (i) it is more than 50 percent likely that we will have a recession in the next 3 years.  (ii) countering recessions requires 400 or 500 basis points of monetary easing.  (iii) we are very unlikely to have anything like that much room for easing when the next recession comes.

Chair Yellen, relying heavily on research by David Reifschneider using the FRBUS model, comes to the relatively serene conclusion that by using forward guidance and QE policies—or LSAP (Large Scale Asset Purchases) in Fed parlance, the Fed will likely able to respond adequately to the next recession with its existing tool kit.  I think this conclusion is unlikely to be right.

As Paul Krugman points out Reifschneider, working with John Williams and using the same FRBUS model, concluded that the ZLB was only a very small issue less than a decade before the financial crisis led to an 8 year stretch of zero rates.  The market has been consistently wrong for most of the last decade on the ease with which interest rates could be raised by the Fed.  And estimates of the neutral rate have been far lower for far longer than anyone would have predicted a decade ago.  All of this suggests the need for substantial humility about what the Fed’s capacities will be the next time the economy encounters difficult times.

There is an important methodological point here—distrust conclusions reached primarily on the basis of model results.  Models are estimated or parameterized on the basis of historical data.  They can be expected to go wrong whenever the world changes in important ways.  Alan Greenspan was importantly right when he ignored models and maintained easy policy in the mid 1990s because of other more anecdotal evidence that convinced him that productivity growth had accelerated.  I believe a similar skeptical attitude towards model results is appropriate today in the face of the clear evidence that the neutral real rate has fallen.  I pay attention to model results only when the essential conclusion can be justified with some calculation where I can see and follow each step.

Four more specific points deserve emphasis.  First, Reifschneider assumes in is base case that the Fed funds rate reaches 3 percent before the next recession and treats as an extreme case the possibility that rates will reach only 2 percent before the next recession.  As Jared Bernstein points out market expectations are much more pessimistic than this.  According to the OIS market (basically long term fed fund futures) fed funds are expected even in the long run to rise only to 1.5 percent. This may be a bit misleading because the expected fed funds rate in 2020 of 1 percent includes some probability that it is zero because of a recession.  Even so markets, which have been much more right than the Fed so far, are clearly signaling the likelihood that rates will be under 2 percent when the next recession comes.

I appreciate that Reifschneider takes seriously the possibility of secular stagnation by including a section on it.  However, I fear he is overly sanguine in assuming that even under secular stagnation the Fed will start the next recession with an interest rate of 2 percent, as well as a ten year rate of 3 percent.  This seems optimistic given both the market expectations discussed above and the fact that current interest rates are 0.50 percent nearly eight years after the last recession.

Second, though he downplays the significance, Reifschneider finds that the Fed will likely not have as much room to cut rates as it would like under the so-called “optimal control” method that Yellen has extolled in the past.  Under this method the Fed is attempting to minimize the amount which inflation and unemployment differ from target over a series of years.  In his simulations, the Fed is not able to use unconventional policies to fully achieve the equivalent of the nearly 12 percent rate cut it would otherwise desire.  This shortfall is in response to a recession less severe than the recent one and with the questionable assumption that the Fed should view unemployment being too low as being as harmful as being too high.

Third, I suspect that prevailing views at the Fed about the efficacy of QE and forward guidance substantially exaggerate their likely impact.  I don’t think the Fed has taken on board the lesson of the three year period since QE ended.  If longer term rates had risen after QE and forward guidance ended, this would surely have been taken as further evidence of their potency.  It follows that the fact that term spreads have fallen substantially since the end of unconventional policy as shown in Figure 3 should lead to more skepticism about their efficacy.

On the issue of QE Greenwood, Hanson, Rudolph and I show that the contrary to much of the discussion during the QE period the stock of longer term public debt that the market has to absorb went up not down.  The amount of longer term Federal debt that markets have to absorb is now as high as it has been in the last 50 years and long rates are extraordinarily low, as are term spreads.  This calls into question the idea that price pressures caused by changing relative supplies are likely to have large impacts at times like the present when markets are functioning.

I wonder what credibility Fed forward guidance is likely to have given the utter disconnect over many years between Fed and market views regarding future rate and the track record so far of the Fed being wrong and the market being right.

Fourth, even if unconventional policy could be highly efficacious in moving long term rates and even if QE induced moves in long rates were potent, there is the question of how much room there is to bring down long rates.   Reifschneider in his very careful paper shows that with a big recession rates would likely approach -6 percent, or even -9 percent, but for the zero lower bound.  I find the idea that forward guidance and QE could do the anything like the work of 600, let alone 900, basis points of rate cutting close to absurd.  Both QE and forward guidance are said to work by bringing down longer term rates.  The 10 year Treasury is now in the 1.6 percent range.  If the Fed returned Fed Funds to its lower bound level in the context of a recession, I would expect to see 10 year rates fall substantially perhaps to 1 percent without any QE or forward guidance.   How much room is there for unconventional policy to bring them down further?  Reifschneider ‘s assumption that there will be room for unconventional policy to bring down 10 year rates by hundreds of basis points seems to me very doubtful.

To put the point differently, typically in recessions the 10 year Treasury has declined from peak to trough by around 1.8 percentage points.  Even if the rate got to European or Japanese levels, surely an unappealing prospect, there may not be enough room to bring down long rates to assure prompt recovery.

On balance, I think the Fed’s complacency about its current toolbox is unwarranted.  If I am wrong in either exaggerating the risks of recession or understating the efficacy of policy, the costs of taking out insurance against a recession that cannot be met with monetary policy are relatively low.  If I my fears are justified, the costs of complacency could be very high.  The right policy in the near term should be tilting as hard as possible against recession as argued in the first blog in this series. For the longer term the Fed will have to reconsider its broad policy approach.  This will be subject of my next entry.

I had high hopes for the Federal Reserve’s annual Jackson Hole conference.  The conference was billed as a forum that would look at new approaches to the conduct of monetary policy—something that I have been urging as necessary given secular stagnation risks and the sharp decline in the apparent neutral rate of interest.  And Chair Yellen’s speech in a relatively academic setting provided an opportunity to signal that the Fed recognized that new realities required new approaches.

The Federal Reserve system and its Chair are to be applauded for welcoming challengers and critics into their midst.  The willingness of many senior officials to meet with the Fed Up group is also encouraging.  And its important for critics like me to remember that the policy explorations of today often become the conventional wisdom of tomorrow.   In this regard the fact that the Fed has now recognized that the decline in the neutral rate is something that is much more than a temporary reflection of the financial crisis is a very positive sign.

On balance though, I am disappointed by what came out of Jackson Hole judging by press reports since I was not there.  First, the near term policy signals were on the tightening side which I think will end up hurting both the Fed’s credibility and the economy.  Second, the longer term discussion revealed what I regard as dangerous complacency about the efficacy of the existing tool box.  Third, there was failure to seriously consider major changes in the current monetary policy framework.

I shall argue each of these points in a blog series this week.  At the outset however, it is important to recognize that the Fed has not earned the right to be intellectually complacent or to expect that others will have faith in its current policy framework.  Given the Great Recession and its forecasting record, it is not surprising that Gallup has found that public confidence in the Fed has sharply declined in recent years, though it has increased recently.

For nearly a decade, since the mid 2008 FOMC meetings where many believed that the worst had past, the Fed been too serene about the economic outlook and a return to past regularities.  When the Fed predicted last December that it would raise rates four times in 2016, market participants saw a disconnect from reality.  It has been that way for a long time.  Figure 1 shows the Fed’s forecasts of its future monetary policies since they began releasing them.  The Fed has always believed that rate increases and normalization were around the corner but never been able to deliver.  Figure 2 looks at the current situation showing the “dots” reflecting Fed forecasts and the market’s prediction of future interest rates.  The divergence between the market and even the dovish end of Fed forecasts is clear.

Near Term Policy

Chair Yellen in Jackson Hole basically repeated the existing Fed position that rates would be raised at some point when the data were clear that the economy was strong and inflation reaching two percent.  Markets took the remarks as mildly dovish until Vice Chair Fischer was seen on CNBC as interpreting the Chair as implying that two rates increases by the end of the year were possible at which point interest rates across the spectrum rose fairly sharply and stock prices fell.

The right signal to have sent in my view was very dovish.  The Fed has emphasized that its two percent inflation target is a symmetric one.  Its current forecast is for a strong economy  that will next Spring enter its 9^th year of recovery.  If inflation should not be allowed to rise a bit above two percent in such circumstances, how can it be expected to average two percent over time given that recessions and downturns at some point are inevitable? I hoped that the Fed would make clear that it would tighten only when there appeared a real risk of inflation expectations rising above two percent.  At a time when market forecasts of inflation on Fed’s preferred price index are in the range of 1.2 percent, this is very likely some time off.   Some are skeptical of market measures of inflation expectations.  Note that survey measures of long term inflation expectations for both professionals and consumers are near historical lows and if anything have declined over the last year.

Additional points that I would have thought appropriate in commenting on near term policy include: (i) With current estimates of the real neutral rate running near zero and there being a downward trend it is far from clear that current policy is highly expansionary.  (ii) It is plausible that hysteresis effects account for some of the decline in productivity growth and that if so allowing for rapid demand growth might have lasting supply side benefits.  (iii) If a two percent inflation target was appropriate when the neutral real rate was thought to be two percent and stable, surely a higher target is appropriate when the neutral real rate is zero and unstable.  (iv) In contrast to the risks of inflation exceeding two percent ,which are likely very small, the risks of a downturn are very serious. (v) The apparent rigidity of inflation expectations and insensitivity of inflation to measures of slack create extra uncertainties about the conventional idea that unemployment rates in the 4.5 percent range risk accelerating inflation.

I agree with Chair Yellen’s observation that the case for a rate increase now is stronger than it was a few months ago.  The economy certainly does appear to be gaining strength in the second half of the year,  the Brexit shock has been easily absorbed, and markets are unusually calm.  But to say that the case for a rate increase has strengthened is not to say that it has reached the point of being persuasive.

Even if the September employment report is strong, I do not see a case for a September rate increase.  There is no imminent danger of repeating the 1970s experience where inflation expectations ratcheted up leading to stagflation.  If a greater than 1/3 chance of a rate increase in September was not in markets, the cost of credit for small business would be lower and mortgage rates would decline.  Employers would be more confident about hiring.  And pressures would be removed from emerging markets.  The world economy would be more robust.

John Williams has written the most thoughtful piece on monetary policy that has come out of the Fed in a long time.  He recognizes more explicitly than others that r* (r-star), the neutral interest rate, is now very low and quite likely will remain very low for a long time to come.  As he recognizes, this the essence of the secular stagnation concern that I and others have been expressing for the last 3 years.

I now believe that it just as reasonable to suppose that neutral rates will fall further as it is to suppose they will revert towards historically normal levels.  First, there is a kind of hysteresis in rates in which a lower interest rate today tends to lower the neutral rate in the future.  To the extent that low rates stimulate spending by pulling forward investment, low rates today reduce neutral rates tomorrow by moving investment forward.  Second, major structural factors like rising inequality, slowing labor force  growth, lower capital goods prices, slowing productivity growth  and more capital outflows from developing countries appear to represent continuing trends.  Third, there is the prospect that the growing expectation that rates will be low for a long time decreases the spending of target savers and interferes with financial intermediation.

Wlliams rightly if rather tentatively draws the conclusions that a chronically very low neutral rate has important policy implications.  He stresses the desirability of raising r* by pursuing structural policies to raise growth and affirms the importance of fiscal policy.  I yield to no one in my enthusiasm for improved education and educational opportunity but I do not think it is plausible that it will change the neutral rate appreciably in the next decade given that the vast majority of the 2030 labor force will be unaffected.

If Williams is overenthusiastic on education, he is under enthusiastic on fiscal stimulus.  He fails to emphasize the supply side benefits of infrastructure investment that likely enable debt financed infrastructure investments to pay for themselves as suggested by DeLong and Summers and the IMF.  Nor does he note at current interest rates an increase in pay as you go social security could provide households with higher safe returns than private investments.  More generous Social Security would likely reduce the saving rate, thereby raising the neutral interest rate with no change in budget deficits.  Nor does Williams address the possibility of tax measures such as incremental investment credits or expansions in the EITC financed by tax increases on those with a high propensity to save.  The case for fiscal policy changes in the current low r*’environment seems to me overwhelming and much can be accomplished without any increase in deficits.

Williams comments on monetary policy have generated more interest.  He makes the now familiar point that if negative real rates are sometimes desirable on counter cyclical grounds there is a strong argument for an inflation target high enough that the ZLB does not bind or binds only very infrequently.  If the Fed believed that a 2 percent inflation target was appropriate at the beginning of 2012 when it believed the neutral real rate was above 2 percent, I cannot see any argument for not adjusting the target or altering the framework when the neutral real rate is very plausibly close to zero.  The benefits of a higher target have increased and so far as I can see nothing has happened to change the cost of a higher target,

I am disappointed therefore that Williams is so tentative in his recommendations on monetary policy.  I do understand the pressures on those in office to adhere to norms of prudence in what they say.  But it has been years since the Fed and the markets have been aligned on the future path of rates or since the Fed’s forecasts of future rates have been even close to right. I cannot see how policy could go badly wrong by setting a level target of 4 to 5 percent growth in nominal GDP and think that there could be substantial benefits. (I expect to return to this topic in the not too distant future)

Moreover even accepting the current framework, I find the current policy framework hard to comprehend.  If as it asserts, the Fed is serious about the 2 percent inflation target being symmetric there is an anomaly in its forecasts.   Surely if, as the Fed forecasts, the economy enters a 10th year of recovery with unemployment below five percent inflation should be expected to be above 2 percent at that point.  How else could inflation average 2 percent over time given the likelihood of downturns and recessions?

Finally there is this:  Everything we know about business cycle history suggests an overwhelming likelihood that there will be downturns in the industrial world sometime in the next several years.  Nowhere is there room to cut rates by anything like the normal 400 basis points in response to potential recession.  This is the primary monetary and indeed macroeconomic policy challenge of our generation.  I hope it will be very much in focus at Jackson Hole.

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.

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.

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.

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.

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.

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

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

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.

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.

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.

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.

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.

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.