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December 6, 2015

The unresolved question is how policy can delay and ultimately contain the next recession

While debate about the relevance of the secular stagnation idea to current economic conditions continues to rage, there is now almost universal acceptance of a crucial part of the argument. It is agreed that the “neutral” interest rate, which neither boosts nor constrains growth, has declined substantially and is likely to be lower in the future than in the past throughout the industrial world because of a growing relative abundance of savings relative to investment.

The idea that real interest rates – that is, adjusted for inflation – will be lower than they have been historically is reflected in the pronouncements of policymakers such as Federal Reserve chair Janet Yellen, the medium-term forecasts of official agencies such as the Congressional Budget Office and the International Monetary Fund and the pricing of government bonds whose payments are tied to inflation.

This is important progress and has contributed to more prudent monetary policies than otherwise would have been made and the avoidance of a deflationary psychology taking hold particularly in Europe and Japan. Policymakers, despite having adjusted their views, still overestimate the extent to which neutral real interest rates will rise.

Neutral real interest rates may well rise over the next few years as the American economy creates jobs at a rapid rate and the effects of the financial crisis diminish. This is what many expect, though the fact that an imminent return towards historically normal interest has been widely expected for the past six years should invite scepticism.

A number of considerations make me doubt the US economy’s capacity to absorb significant increases in real rates over the next few years. First, they were trending down for 20 years before the crisis started and have continued that path since. Second, there is at least a significant risk that as the rest of the world struggles there will be substantial inflows of capital into the US leading to downward pressure on rates and upward pressure on the dollar, which in turn reduces demand for traded goods.

Third, the increases in demand achieved through low rates in recent years have come from pulling demand forward, resulting in lower levels of demand for the future. For example, lower rates have accelerated purchases of cars and other consumer durables and created apparent increases in wealth as asset prices inflate. In a sense, monetary easing has a narcotic aspect. To maintain a given level of stimulus requires continuing cuts in rates.

Fourth, profits are starting to turn down and regulatory pressure is inhibiting lending to small and medium sized businesses. Fifth, inflation mismeasurement may be growing as the share in the economy of items such as heathcare, where quality is hard to adjust for, grows. If so, apparent neutral real interest rates will decline even if there is no change in properly measured rates.

All of this leaves me far from confident that there is substantial scope for tightening in the US and there is probably even less scope in other parts of the industrialised world. The fact that central banks in countries, including Europe, Sweden and Israel, where rates were zero found themselves reversing course after raising rates adds to the cause for concern.

But there is a more profound worry. The experience of the US and others suggests that once a recovery is mature the odds of it ending within two years are about half and of it ending in less than three years over two-thirds. As normal growth is below 2 per cent rather than the historical near 3 per cent, the risk may even be greater. While recession risks may seem remote given rapid growth, no postwar recession has been predicted a year ahead by the Fed, the administration or the consensus forecast.

History suggests that when recession comes it is necessary to cut rates more than 300 basis points. I agree with the market that the odds are the Fed will not be able to raise rates 100 basis points a year without threatening to undermine recovery. Even if this were possible, the chances are very high that recession will come before there is room to cut rates enough to offset it. The knowledge that this is the case must surely reduce confidence and inhibit demand.

Central bankers bravely assert that they can always use unconventional tools. But there may be less in the cupboard than they suppose. The efficacy of further quantitative easing in an environment of well-functioning markets and already very low medium-term rates is highly questionable. There are severe limits on how negative rates can become. A central bank forced back to the zero lower bound is not likely to have great credibility if it engages in forward guidance.

The Fed will in all likelihood raise rates this month. Markets will focus on the pace of its tightening. I hope their response will involve no great turbulence. But the unresolved question that will hang over the economy is how policy can delay and ultimately contain the next recession. It demands urgent attention from fiscal as well as monetary policymakers.

This $13 trillion question is more important than ever

November 9th, 2015

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

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

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

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

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

November 3rd, 2015

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

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

Hysteresis Effects

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

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

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

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

Towards a New Macroeconomics

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

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

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

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

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

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

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

The case for expansion

October 7th, 2015

Policymakers must abandon structural reform rhetoric and embrace fiscal stimulus

October 7, 2015

As the world’s financial policymakers convene for their annual meeting on Friday in Peru, the dangers facing the global economy are more severe than at any time since the bankruptcy of Lehman Brothers in 2008.

The problem of secular stagnation – the inability of the industrial world to grow at satisfactory rates even with very loose monetary policies – is growing worse in the wake of problems in most big emerging markets, starting with China.

This raises the spectre of a vicious global cycle in which slow growth in industrial countries hurts emerging markets which export capital, thereby slowing western growth further. Industrialised economies that are barely running above stall speed can ill-afford a negative global shock.

Policymakers badly underestimate the risks of both a return to recession in the west and of a global growth recession. If a recession were to occur, monetary policymakers lack the tools to respond.

There is essentially no room left for easing in the industrial world. Interest rates are expected to remain very low almost permanently in Japan and Europe and to rise only very slowly in the US.

Today’s challenges call for a clear global commitment to the acceleration of growth as the main goal of macroeconomic policy. Action cannot be confined to monetary policy.

There is an old proverb: “You do not want to know the things you can get used to.” It is all too applicable to the global economy in recent years. While the talk has been of recovery from the crisis, forecasts of future gross domestic product have been revised sharply downwards almost everywhere.

Relative to its 2012 forecasts, the International Monetary Fund has revised its estimate for the level of US GDP for 2020 downwards by 6 per cent, Europe by 3 per cent, China by 14 per cent, emerging markets by 10 per cent and 6 per cent for the world as a whole.

These dismal results assume no recessions in the industrial world and the absence of systemic crises in the developing world. Neither can be taken for granted.

We are in a new macroeconomic epoch where the risk of deflation is higher than that of inflation and we cannot rely on the self-restoring features of market economies. The effects of hysteresis – where recessions are not just costly but stunt the growth of future output – appear far stronger than anyone imagined a few years ago.

Western bond markets are sending a strong signal that there is too little, rather than too much, government debt. As always, when things go badly there is a great debate between those who believe in staying the course and those who urge a serious correction. I am convinced of the urgent need for substantial changes in the world’s economic strategy.

History tells us that markets are inefficient and often wrong in their judgments about economic fundamentals. It also teaches us that policymakers who ignore adverse market signals because they are inconsistent with their preconceptions risk serious error.

This is one of the most important lessons of the onset of the financial crisis in 2008. Had policymakers heeded the pricing signal on the US housing market from mortgage securities, or on the health of the financial system from bank stock prices, they would have reacted far more quickly to the gathering storm. There is also a lesson from Europe. Policymakers who dismissed market signals that Greek debt would not be repaid in full delayed necessary adjustments – at great cost.

Lessons from the bond market

It is instructive to consider what government bond markets in the industrialised world are implying today. These are the most liquid financial markets in the world and reflect the judgments of a very large group of highly informed traders. Two conclusions stand out.

First, the risks tilt heavily towards inflation rates that are below official targets. Nowhere in the industrial world is there an expectation that central banks will hit their 2 per cent targets in the foreseeable future. Inflation expectations are highest in the US – and even there it expects inflation of barely 1.5 per cent for the five-year period starting in 2020.

This is despite the fact that the market indicates that monetary policy will remain looser than the Federal Reserve expects: the Fed funds futures market predicts a rate around 1 per cent at the end of 2017 compared to the Fed’s most recent median forecast of 2.6 per cent. If the market believed the Fed on monetary policy it would expect even lower inflation and a risk of deflation.

Second, the prevailing expectation is of extraordinarily low real interest rates. Real rates have been on a downward trend for nearly 25 years.

The average real rate in the industrialised world over the next 10 years is expected to be zero. Even this presumably reflects some probability that it will be artificially increased by nominal rates at a zero bound and deflation. In the presence of such low real rates there is no sign that economies would overheat.

Many will argue that bond yields are artificially depressed by quantitative easing and so it is wrong to use them to draw inferences about future inflation and real rates. This cannot be ruled out. But it is noteworthy that rates are now lower in the US than their average during the period ofQE and that forecasters have been confidently – but wrongly – expecting them to rise for years.

The strongest explanation for this combination of slow growth, expected low inflation and zero real rates is the secular stagnation hypothesis.

It holds that a combination of high rates of saving, lower investment and increased risk aversion depresses the real interest rates that accompany full employment. The result is that the zero lower bound on nominal rates becomes constraining.

There are four contributing factors that lead to much lower normal real rates. First, increases in inequality – the share of income going to capital and in corporate retained earnings – raise the propensity to save.

Second, an expectation that growth will slow due to smaller labour force growth and slower increases in productivity reduces investment and boosts the incentives to save.

Third, increased friction in financial intermediation caused by more extensive regulation and increased uncertainty discourages investment.

Fourth, reductions in the price of capital goods and in the quantity of physical capital needed to operate a business – think of Facebook having over five times the market value of GM.

Emerging markets hit reverse

Until recently, a major bright spot has been the strength of emerging markets. They have been substantial recipients of capital from developed countries that could not be invested productively at home.

The result has been higher interest rates than they would otherwise obtain, greater export demand for industrial countries’ products and more competitive exchange rates for developed economies.

Gross flows of capital from industrial countries to developing countries rose from $240bn in 2002 to $1.1tn in 2014. Of particular relevance for the discussion of interest rates is that foreign currency borrowing by the private sector of developing countries rose from $1.7tn in 2008 to $4.3tn in 2015.

Developing country net capital flows fell sharply this year – marking the first such decline in almost 30 years, according to the Institute of International Finance, with the amount of private capital leaving developing countries eclipsing $1tn.

Any discussion has to start with China, which poured more concrete between 2010 and 2013 than the US did in the entire 20th century. A reading of the recent history of investment-driven economies – whether in Japan before the oil shock of the 1970s and 1980s or the Asian tigers in the late 1990s – tells us that growth does not fall off gently.

China faces many other challenges, ranging from the most rapid population ageing in the history of the planet to a slowdown in rural to urban migration. It also faces issues of political legitimacy and how to cope with unproductive investment.

Even taking an optimistic view – where China shifts smoothly to a consumption-led growth model led by services – its production mix will be much lighter, so the days when it could sustain commodity markets are over.

The problems are hardly confined to China. Russia is struggling with low oil prices, a breakdown in the rule of law and harsh sanctions. Brazil has been hit by the decline in commodity prices but even more by political dysfunction. India is a rare exception. But from central Europe to Mexico to Turkey to Southeast Asia, the combination of slowdowns in industrialised countries and dysfunctional politics is hurting growth by discouraging capital inflows and encouraging capital outflows.

Assertive stance

What does all this mean for the world’s policymakers gathered in Lima for the IMF and World Bank meetings? This is no time for complacency. The idea that slow growth is only a temporary consequence of the 2008 financial crisis is absurd. The latest data suggest growth is slowing in the US and it is already slow in Europe and Japan. A global economy near stall speed – and slowing – is one where the primary danger is recession.
The most successful recent assertion of growth policy was Mario Draghi’s famous vow that “the European Central Bank will do whatever it takes to preserve the euro”, uttered at a moment when the single currency appeared to be on the brink.

By making an unconditional commitment to providing liquidity and supporting growth, the ECB president prevented an incipient panic and helped lift European growth rates – albeit not by enough.

What is needed now is something equivalent but on a global scale – a signal that the authorities recognise that secular stagnation and its spread to the world is the dominant risk we face. After last Friday’s dismal US jobs report, the Fed must recognise what should already have been clear: that the risks to the US economy are two-sided. Rates should be increased only if there are clear and direct signs of inflation or of financial euphoria breaking out. The Fed must also state its readiness to help prevent global financial fragility from leading to a global recession.

The central banks of Europe and Japan need to be clear that their biggest risk is a further slowdown. They must indicate a willingness to be creative in the use of the tools at their disposal. With bond yields well below 1 per cent it is very doubtful that traditional QE will have much stimulative effect. They must be prepared to consider support for assets that carry risk premiums that can be meaningfully reduced. They could achieve even more by absorbing bonds to finance fiscal expansion.

Long-term low interest rates radically alter how we should think about fiscal policy. Just as homeowners can afford larger mortgages when rates are low, government can also sustain higher deficits. If the Maastricht criteria of a debt-to-GDP ratio of 60 per cent was appropriate when governments faced real borrowing costs of five percentage points, then a far higher figure is surely appropriate today when real borrowing costs are negative.

The case for more expansionary fiscal policy is especially strong when it is spent on investment or maintenance. Wherever countries print their own currency and interest rates are constrained by the zero bound there is a compelling case for fiscal expansion until demand accelerates. While the problem before 2008 was too much lending, many more of today’s problems have to do with too little lending for productive investment.

Inevitably, there will be discussion of the need for structural reform at the Lima meetings – there always is. But to emphasise it now would be to embrace the status quo. The world’s markets are telling us with increasing force that we are in a very different world now.

Traditional approaches of focusing on sound government finance, increased supply potential and the avoidance of inflation court disaster. Moreover, the world’s principal tool for dealing with contraction – monetary policy – is largely played out. It follows that policies aimed at lifting global demand are imperative.

If I am wrong about expansionary fiscal policy, the risks are that inflation will accelerate too rapidly, economies will overheat and too much capital will flow to developing countries. These outcomes seem remote. But even if they materialise, standard approaches can be used to combat them.

If I am right and policy proceeds along the current path, the risk is that the global economy will fall into a trap not unlike the one Japan has been in for 25 years where growth stagnates but little can be done to fix it. It is an irony of today’s secular stagnation that what is conventionally regarded as imprudent offers the only prudent way forward.

The Fed looks set to make a dangerous mistake

August 23rd, 2015

August 23, 2015

Raising rates this year will threaten all of the central bank’s major objectives

Will the Federal Reserve’s September meeting see US interest rates go up for the first time since 2006? Officials have held out the prospect that it might, and have suggested that — barring major unforeseen developments — rates will probably be increased by the end of the year. Conditions could change, and the Fed has been careful to avoid outright commitments. But a reasonable assessment of current conditions suggest that raising rates in the near future would be a serious error that would threaten all three of the Fed’s major objectives — price stability, full employment and financial stability.

Like most major central banks, the Fed has put its price stability objective into practice by adopting a 2 per cent inflation target. The biggest risk is that inflation will be lower than this — a risk that would be exacerbated by tightening policy. More than half the components of the consumer price index have declined in the past six months — the first time this has happened in more than a decade. CPI inflation, which excludes volatile energy and food prices and difficult-to-measure housing, is less than 1 per cent. Market-based measures of expectations suggest that, over the next 10 years, inflation will be well under 2 per cent. If the currencies of China and other emerging markets depreciate further, US inflation will be even more subdued.

Tightening policy will adversely affect employment levels because higher interest rates make holding on to cash more attractive than investing it. Higher interest rates will also increase the value of the dollar, making US producers less competitive and pressuring the economies of our trading partners.

This is especially troubling at a time of rising inequality. Studies of periods of tight labour markets like the late 1990s and 1960s make it clear that the best social programme for disadvantaged workers is an economy where employers are struggling to fill vacancies.

There may have been a financial stability case for raising rates six or nine months ago, as low interest rates were encouraging investors to take more risks and businesses to borrow money and engage in financial engineering. At the time, I believed that the economic costs of a rate increase exceeded the financial stability benefits, but there were grounds for concern. That debate is now moot. With credit becoming more expensive, the outlook for the Chinese economy clouded at best, emerging markets submerging, the US stock market in a correction, widespread concerns about liquidity, and expected volatility having increased at a near-record rate, markets are themselves dampening any euphoria or overconfidence. The Fed does not have to do the job. At this moment of fragility, raising rates risks tipping some part of the financial system into crisis, with unpredictable and dangerous results.

Why, then, do so many believe that a rate increase is necessary? I doubt that, if rates were now 4 per cent, there would be much pressure to raise them. That pressure comes from a sense that the economy has substantially normalised during six years of recovery, and so the extraordinary stimulus of zero interest rates should be withdrawn. There has been much talk of “headwinds” that require low interest rates now but this will abate before long, allowing for normal growth and normal interest rates.

Whatever merit this view had a few years ago, it is much less plausible as we approach the seventh anniversary of the collapse of Lehman Brothers. It is no longer easy to think of economic conditions that can plausibly be seen as temporary headwinds. Fiscal drag is over. Banks are well capitalised. Corporations are flush with cash. Household balance sheets are substantially repaired.

Much more plausible is the view that, for reasons rooted in technological and demographic change and reinforced by greater regulation of the financial sector, the global economy has difficulty generating demand for all that can be produced. This is the “secular stagnation” diagnosis, or the very similar idea that Ben Bernanke, former Fed chairman, has urged of a “savings glut”. Satisfactory growth, if it can be achieved, requires very low interest rates that historically we have only seen during economic crises. This is why long term bond markets are telling us that real interest rates are expected to be close to zero in the industrialised world over the next decade.

New conditions require new policies. There is much that should be done, such as steps to promote public and private investment so as to raise the level of real interest rates consistent with full employment. Unless these new policies are implemented, inflation sharply accelerates, or euphoria in markets breaks out, there is no case for the Fed to adjust policy interest rates.

The writer is the Charles W Eliot university professor at Harvard and a former US Treasury secretary

Comments from ECB Conference

May 22nd, 2015

I commend Mario Draghi and the ECB for their openness in hosting this conference and allowing the presentation of so many perspectives. In the spirit of that openness I shall offer some iconoclastic observations. (more…)

Don’t bet against America.

May 12th, 2015

At the SALT Conference in Las Vegas, NV on Friday, May 8, 2015, Summers told the audience,”This is not a society that is stuck. It is a society that is uniquely able to be resilient through a constant process of savage self-criticism.” (more…)

Concern growth is not going to pick up

May 7th, 2015

On Thursday, May 7, 2015, Summers talked with Bloomberg’s Stephanie Ruhl and Erik Schatzker at the Salt Conference in Las Vegas, NV. They discussed Treasury yields, Europe, China and concerns about growth in the United States. Summers talked of the “dawning and growing awareness in the market of the idea we may have a chronic excess of savings over investment in the economy — a phenomenon known as secular stagnation.” (more…)

Larry Summers: Raise the minimum wage

April 28th, 2015

A ‘maddening’ situation: Larry Summers, the former U.S. Treasury Secretary under President Bill Clinton, had a similar take.

He warned that America’s economy is entering a period of stagnation — he dubs it “secular stagnation” — where it won’t be able to achieve its full growth potential because everyone is saving too much and not spending.

“We are doing less investment in infrastructure than at any time since the Second World War on a net basis,” Summers told Zakaria.

He went as far as calling the situation “madness” since it’s incredibly cheap to borrow money right now when interest rates are at a record low.

“[This] is a moment for us, as a country, to do what a business would do, which is to take advantage of low borrowing costs to invest in our future,” said Summers, who worked as a top adviser to President Obama. “This is not the right moment for a lurch to austerity.”

The U.S. economy grew 2.4% last year. That’s good, but not great. Since the end of World War II, America’s economy has expanded over 3% a year, on average. It has yet to get back to that point after the financial crisis.

Not the Right Moment for Lurch to Austerity

April 21st, 2015

In an interview on April 19. 2015, with CNN’s Fareed Zakaria, Summers said, “This is a moment for us, as a country, to do what a business would do, which is to take advantage of low borrowing costs to invest in our future.” Summers told Zakaria, “This is not the right moment for a lurch to austerity.” (more…)

Establishment Populism Rising

March 5th, 2015

Thomas Edsall
New York Times
March 4, 2015

Larry Summers, who withdrew his candidacy for the chairmanship of the Federal Reserve under pressure from the liberal wing of the Democratic Party in 2013, has emerged as the party’s dominant economic policy strategist. The former Treasury secretary’s evolving message has won over many of his former critics.

Summers’s ascendance is a reflection of the abandonment by much of the party establishment of neo-liberal thinking, premised on the belief that unregulated markets and global trade would produce growth beneficial to worker and C.E.O. alike.
Summers’s analysis of current economic conditions suggests that free market capitalism, as now structured, is producing major distortions. These distortions, in his view, have resulted in gains of $1 trillion annually to those at the top of the pyramid, and losses of $1 trillion every year to those in the bottom 80 percent.

At a Feb. 19 panel discussion on the future of work organized by the Hamilton Project, a centrist Democratic think tank, Summers defied economic orthodoxy. He dismissed as “whistling past the graveyard” the widely accepted view that improving education and job training is the most effective way to reduce joblessness.

“The core problem,” according to Summers, is that there aren’t enough jobs, and if you help some people, you can help them get the jobs, but then someone else won’t get the jobs. And unless you’re doing things that are affecting the demand for jobs, you’re helping people win a race to get a finite number of jobs, and there are only so many of them.
He adds that he is “all for” more schooling and job training, but as an answer to the problems of the job marketplace, “it is fundamentally an evasion.”

This line of thought has strong appeal to liberal economists and policy makers who argue that government must intervene to create more demand for workers, primarily by spending more, especially spending that goes to private contractors who would then start hiring.

Summers dismissed as palliative such relatively modest proposals as supplementing the earnings of low-wage workers by increasing the earned-income tax credit and expanding eligibility for the refundable credit.
Even a 50 percent increase in the earned-income tax credit at a cost of $25 billion would barely address current income inequality, Summers said.According to Summers:

If we had the same income distribution in the United States that we did in 1979, the top 1 percent would have $1 trillion less today [in annual income], and the bottom 80 percent would have $1 trillion more. That works out to about $700,000 [a year for] for a family in the top 1 percent, and works out to about $11,000 a year for a family in the bottom 80 percent.
The lion’s share of the income of the top 1 percent is concentrated in the top 0.1 percent and 0.01 percent. The average income of the top 1 percent in 2013, according to data provided by Emmanuel Saez, a Berkeley economist, was $1.2 million, for the top 0.1 percent, $5.3 million, and for the top 0.01 percent, $24.9 million.

In other words, any attempt to correct the contemporary pattern in income distribution would require large and controversial changes in tax policy, regulation of the workplace, and intervention in the economy to expand employment and to raise wages.
To counter the weak employment market, Summers called for major growth in government expenditures to fill needs that the private sector is not addressing:

In our society, whether it is taking care of the young or taking care of the old, or repairing a lot that needs to be repaired, there is a huge amount of very valuable work that needs to be done. It’s much less clear, to use a modern phrase, that there’s a viable business model for getting it done. And I guess the reason why I think there is going to need to be a lot of reflection on the role of government going forward is that, if I’m right, that there’s vitally important work to be done for which there is no standard capital business model that will get it done. That suggests important roles for public policy.

Earlier this year, Summers co-wrote the Report of the Commission on Inclusive Prosperity, a forceful set of economic proposals released on Jan. 15 by the Center for American Progress.

In order to stem the disproportionate share of income flowing to corporate managers and owners of capital, and to address the declining share going to workers, the report calls for tax and regulatory policies to encourageemployee ownership, the strengthening of collective bargaining rights, regulations requiring corporations to provide fringe benefits to employees working for subcontractors, a substantial increase in the minimum wage, sharper overtime pay enforcement, and a huge increase in infrastructure appropriations – for roads, bridges, ports, schools – to spur job creation and tighten the labor market.
Summers also calls for significant increases in the progressivity of the United States tax system. He would eliminate or modify many of the tax breaks that now provide most of their benefits to the affluent, including the conversion of the mortgage interest deduction into a credit. “While deductions deliver a larger benefit to tax payers in higher tax brackets, credits deliver the same benefits to all tax payers, making the tax code more progressive,” the report notes. In addition, the report presses for much tougher rules governing the taxation of corporate overseas income.

I spoke with Summers on the phone last week to get more details about his thinking. One of his central goals, he said, is to make sure that “workers get a larger share of the pie.” He advocates aggressive steps to eliminate “rents” — profits that result from monopoly or other forms of government protection from competition. Summers favors attacking rents in the form of “exclusionary zoning practices” that bid up the price of housing, “excessively long copyright” protections, and financial regulations“providing implicit subsidies to a fortunate minority.”

Signaling that he now finds himself on common ground with stalwarts of the Democratic left like Elizabeth Warren and Joe Stiglitz, Summers adds, “Government needs to try to make sure everyone can get access to financial markets on an equal basis.”

Along with a growing number of Democratic policy advocates, Summers supports looking past income inequality to the distribution of wealth. During our conversation, he pointed out that “a large fraction of capital gains escapes taxation entirely” through “the stepped up basis at death.”Stepped up basis refers to an I.R.S. provision reducing the capital gains tax liability on inherited assets so that the beneficiary’s capital gains tax is minimized. Revenue losses from the stepped up basis amounted, in the 2014 fiscal year, to $36.4 billion according to the Office of Management and Budget.
Summers’s policy proposals have been praised by former critics.

Asked for his assessment of Summers’s views, Lawrence Mishel, president of the liberal, pro-labor Economic Policy Institute, emailed “I very much appreciate that Larry Summers has recently highlighted the need for a ‘high pressure economy’ and the need to ‘expand worker bargaining power.’ ”

Dean Baker, co-director of the Center for Economic and Policy Research, which sponsors the work of liberal economists, replied to my inquiry: “It’s funny you would ask this. I was just writing something praising Summers and others for changing their thinking.”

In his not-yet-published pro-Summers essay, Baker writes:
The idea that an economy could suffer from a persistent shortage of demand is an enormous switch for Summers or anyone who had been adhering to the economic orthodoxy in the three decades prior to the crisis in 2008. Baker goes on to argue that Summers “now recognizes that the financial system needs serious regulation.”

Some economists disagree with Summers. David Autor, a professor of economics at M.I.T., wrote in an email that Summers seems
to presuppose that we have entered an era of secular stagnation with perennially insufficient demand. I don’t share this pessimism, and I think many indicators point in the right direction: employment growth, wage trends, inflation, energy prices, even inequality.

In a follow-up email, Summers took note of Dean Baker’s assertion that Summers had changed his views, replying that John Maynard Keynes
is said to have responded to a similar question by saying ‘when the facts change, I change my mind. What do you do sir?’ Much has changed since the 1990s, including protracted shortfalls in demand, a dramatic decline in labor’s share of income, the pulling away of the top 1 percent, the possible emergence of secular stagnation, and the financial crisis. So of course my policy views have evolved.

Summers has advised Hillary Clinton on economic issues, and a key question looking toward 2016 is how much of the Summers agenda she is prepared to adopt, if she decides to run for president.

Many of the policies outlined by Summers — especially on trade, taxation, financial regulation and worker empowerment — are the very policies that divide the Wall-Street-corporate wing from the working-to-middle-class wing of the Democratic Party. Put another way, these policies divide the money wing from the voting wing.

Summers has forced out in the open a set of choices that Hillary Clinton has so far avoided, choices that even if she attempts to elide them will amount to a signal of where her loyalties lie.

Robots are hurting middle class workers

March 3rd, 2015

In an March 3, 2015 article in The Washington Post’s Wonkblog Summers talked about technology, inequality and education. Summers reaffirmed the idea that more education won’t solve the inequality problem and called technological change an important fuel for the rising economic share captured by the top 1 percent of American earners.
(more…)

USA Today: Summers on Global Threats

February 17th, 2015

On February 16, 2015, in her column for USA TODAY, Maria Bartiromo talks with Summers about Europe, Russia, Ukraine and and the implications for the global economy. Summers also discusses the U.S. economy, oil prices, the Fed and what Summers is learning from his students. (more…)

Focus on growth for the middle class

January 18th, 2015

January 18, 2015

The most challenging economic issue ahead of us involves a group that will barely be represented at this week’s annual Davos summit: the middle classes of the world’s industrial countries. As the Center for American Progress’s Inclusive Prosperity Commission, which I co-chaired with Ed Balls, the top economic official in Britain’s Labor Party, concludes in a new report, nothing is more important to the success of industrial democracies than sustained increases in wages and living standards for working families.

Amid the focus on global finance, geopolitics and the moral imperative to help the world’s poor, no one should lose sight of the fact that without substantial changes in policy, the prospects for the middle class globally are at best highly problematic.

First, the economic growth that is a necessary condition for rising incomes is threatened by the specter of secular stagnation and deflation. In the United States, 2014 was expected to be one of rising interest rates along with acceleration of growth, the end of quantitative easing and the approach of tightened monetary policy. In Japan, prices were to start rising again. In Europe, the year was to bring continued economic reform and normalization.

In fact, 10-year Treasury rates have fallen by more than 1 percentage point in the United States and are only half as high in Germany and Japan as they were a year ago. In a number of major countries, including Germany, France and Japan, short-term interest rates are now negative, with lenders to governments forced to pay for the privilege. Such low interest rates suggest a chronic excess of saving over investment and the likely persistence of conditions that make monetary policy ineffective in Europe and Japan, along with their possible reemergence in the United States. Market indicators almost everywhere suggest that inflation is expected to be well below the target rate for a decade.

The world has largely exhausted the scope for central bank improvisation as a growth strategy. Excess demand, inflation, excessive credit and the need for monetary tightening are the least of our concerns. Central banks still have to do their part, but it is time for concerted and substantial measures to raise both public and private investment.

Second, the capacity of our economies to sustain increasing growth and provide for rising living standards is not assured on the current policy path. The United States is often held out as a model, and indeed its performance has been strong by global standards. The United States has enjoyed growth of about 11 percent over the past five years. Of this, standard economic calculations suggest that about 8 percent can be regarded as cyclical, resulting from the decline in the unemployment rate. That leaves just 3 percent over five years as attributable to growth in the economy’s capacity. Even after our recovery, the share of American men age 25 to 54 who are out of work exceeds that in Japan, France, Germany and Britain.

Demand issues aside, growth prospects are worse in Europe and Japan, where adult populations are shrinking and ageing and economic dynamism is subsiding. A significant part of the sharp downward revisions in the estimated potential of industrial economies is a consequence of the recession conditions of recent years. In many ways, strong growth is itself the best structural policy for promoting growth as investment rises, workers gain experience and so forth. But more must be done.

Third, if it is to benefit the middle class, prosperity must be inclusive, and in the current environment this is far from assured. If the United States had the same income distribution it had in 1979, the bottom 80 percent of the population would have $1 trillion — or $11,000 per family — more. The top 1 percent would have $1 trillion — or $750,000 — less. There is little prospect for maintaining international integration and cooperation if it continues to be seen as leading to local disintegration while benefiting a mobile global elite.

The focus of international cooperative efforts in the economic sphere must shift. Considerable progress has been made in trade and investment. Less has been made in preventing races to the bottom in areas such as taxation and regulation. Only with enhanced international cooperation will the maintenance of progressive taxation and adequate regulatory protection be possible. And only if ordinary citizens see benefit in an ever more open global economy will it come about.

These three concerns — secular stagnation and deflation, slow underlying economic growth and rising inequality — are real. But they are not grounds for fatalism. The experience of many countries, including Canada and Australia in this century, and many eras shows that sustained growth in middle-class living standards is attainable. But it requires elites to recognize its importance and commit themselves to its achievement. That must be the focus of this year’s Davos.

The writer is Charles W Eliot university professor at Harvard and a former US Treasury secretary

Why public investment really is a free lunch

October 7th, 2014

The IMF finds that a dollar of spending increases output by nearly $3

October 7, 2014

It has been joked that the letters IMF stand for “it’s mostly fiscal.” The International Monetary Fund has long been a stalwart advocate of austerity as the route out of financial crisis, and every year it chastises dozens of countries for their fiscal indiscipline. Fiscal consolidation – a euphemism for cuts to government spending – is a staple of the fund’s rescue programmes. A year ago the IMF was suggesting that the US had a fiscal gap of as much as 10 per cent of gross domestic product.

All of this makes the IMF’s recently published World Economic Outlook a remarkable and important document. In its flagship publication, the IMF advocates substantially increased public infrastructure investment, and not just in the US but much of the world. It asserts that when unemployment is high, as it is in much of the industrialised world, the stimulative impact will be greater if investment is paid for by borrowing, rather than cutting other spending or raising taxes. Most notably, the IMF asserts that properly designed infrastructure investment will reduce rather than increase government debt burdens. Public infrastructure investments can pay for themselves.

Why does the IMF reach these conclusions? Consider a hypothetical investment in a new highway financed entirely with debt. Assume – counterfactually and conservatively – that the process of building the highway provides no stimulative benefit. Further assume that the investment earns only a 6 per cent real return, also a very conservative assumption given widely accepted estimates of the benefits of public investment. Then, annual tax collections adjusted for inflation would increase by 1.5 per cent of the amount invested, since the government claims about 25 cents out of every additional dollar of income. Real interest costs, that is interest costs less inflation, are below 1 per cent in the US and much of the industrialised world over horizons of up to 30 years. So infrastructure investment actually makes it possible to reduce burdens on future generations.

In fact, this calculation understates the positive budgetary impact of well-designed infrastructure investment, as the IMF recognised. It neglects the tax revenue that comes from the stimulative benefit of putting people to work constructing infrastructure, as well as the possible long-run benefits that come from combating recession. It neglects the reality that deferring infrastructure renewal places a burden on future generations just as surely as does government borrowing.

It ignores the fact that by increasing the economy’s capacity, infrastructure investment increases the ability to handle any given level of debt. Critically, it takes no account of the fact that in many cases government can catalyse a dollar of infrastructure investment at a cost of much less than a dollar by providing a tranche of equity financing, a tax subsidy or a loan guarantee.

When it takes these factors into account, the IMF finds that a dollar of investment increases output by nearly $3. The budgetary arithmetic associated with infrastructure investment is especially attractive at a time when there are enough unused resources that greater infrastructure investment need not come at the expense of other spending. If we are entering a period of secular stagnation, unemployed resources could be available in much of the industrial world for quite some time.

While the case for investment applies almost everywhere – possibly excepting China, where infrastructure investment has been used a stimulus tool for some time – the appropriate strategy for doing more differs around the world.

The US needs long-term budgeting for infrastructure that recognises benefits as well as costs. Projects should be approved with reasonable speed. The government can contribute by supporting private investments in areas such as telecommunications and energy.

Europe needs mechanisms for carrying out self-financing infrastructure projects outside existing budget caps. This may be possible through the expansion of the European Investment Bank or more use of capital budget concepts in implementing fiscal reviews.

Emerging markets need to make sure that projects are chosen in a reasonable way based on economic benefit.

What is crucial everywhere is the recognition that in a time of economic shortfall and inadequate public investment, there is for once a free lunch – a way for governments to strengthen both the economy and their own financial positions. The IMF, a bastion of “tough love” austerity, has come to this important realisation. Countries with the wisdom to follow its lead will benefit.

The writer is Charles W Eliot university professor at Harvard and a former US Treasury secretary.

U.S. Economic Prospects

June 23rd, 2014

Secular Stagnation, Hysteresis, and the Zero Lower Bound

In his February 24, 2014 remarks to the National Association of Business Economics, Summers said, “I want to take up these issues -secular stagnation, the idea that the economy re-equilibrates; hysteresis, the shadow cast forward on economic activity by adverse cyclical developments; and the significance of the zero lower bound for the relative efficacy of monetary and fiscal policies.” (more…)

The Inequality Puzzle

May 22nd, 2014

DEMOCRACY: A Journal of Ideas

Issue #32, Spring 2014

Thomas Piketty’s tour de force analysis doesn’t get everything right, but it’s certainly gotten us pondering the right questions. Commentary on Summers’ review

Lawrence H. Summers

Capital in the Twenty-First Century by Thomas Piketty; Translated by Arthur Goldhammer • Belknap/Harvard University Press • 2014 • 696 pages • $39.95

Once in a great while, a heavy academic tome dominates for a time the policy debate and, despite bristling with footnotes, shows up on the best-seller list. Thomas Piketty’s Capital in the Twenty-First Century is such a volume. As with Paul Kennedy’s The Rise and Fall of the Great Powers, which came out at the end of the Reagan Administration and hit a nerve by arguing the case against imperial overreach through an extensive examination of European history, Piketty’s treatment of inequality is perfectly matched to its moment.

Like Kennedy a generation ago, Piketty has emerged as a rock star of the policy-intellectual world. His book was for a time Amazon’s bestseller. Every pundit has expressed a view on his argument, almost always wildly favorable if the pundit is progressive and harshly critical if the pundit is conservative. Piketty’s tome seems to be drawn on a dozen times for every time it is read.

This should not be surprising. At a moment when our politics seem to be defined by a surly middle class and the President has made inequality his central economic issue, how could a book documenting the pervasive and increasing concentration of wealth and income among the top 1, .1, and .01 percent of households not attract great attention? Especially when it exudes erudition from each of its nearly 700 pages, drips with literary references, and goes on to propose easily understood laws of capitalism that suggest that the trend toward greater concentration is inherent in the market system and will persist absent the adoption of radical new tax policies.

Piketty’s timing may be impeccable, and his easily understandable but slightly exotic accent perfectly suited to today’s media; but make no mistake, his work richly deserves all the attention it is receiving. This is not to say, however, that all of its conclusions will stand up to scholarly criticism from his fellow economists in the short run or to the test of history in the long run. Nor is it to suggest that his policy recommendations are either realistic or close to complete as a menu for addressing inequality.

Start with its strengths. In many respects, Capital in the Twenty-First Century embodies the virtues that we all would like to see but find too infrequently in the work of academic economists. It is deeply grounded in painstaking empirical research. Piketty, in collaboration with others, has spent more than a decade mining huge quantities of data spanning centuries and many countries to document, absolutely conclusively, that the share of income and wealth going to those at the very top—the top 1 percent, .1 percent, and .01 percent of the population—has risen sharply over the last generation, marking a return to a pattern that prevailed before World War I. There can now be no doubt that the phenomenon of inequality is not dominantly about the inadequacy of the skills of lagging workers. Even in terms of income ratios, the gaps that have opened up between, say, the top .1 percent and the remainder of the top 10 percent are far larger than those that have opened up between the top 10 percent and average income earners. Even if none of Piketty’s theories stands up, the establishment of this fact has transformed political discourse and is a Nobel Prize-worthy contribution.

Piketty provides an elegant framework for making sense of a complex reality. His theorizing is bold and simple and hugely important if correct. In every area of thought, progress comes from simple abstract paradigms that guide later thinking, such as Darwin’s idea of evolution, Ricardo’s notion of comparative advantage, or Keynes’s conception of aggregate demand. Whether or not his idea ultimately proves out, Piketty makes a major contribution by putting forth a theory of natural economic evolution under capitalism. His argument is that capital or wealth grows at the rate of return to capital, a rate that normally exceeds the economic growth rate. Thus, economies will tend to have ever-increasing ratios of wealth to income, barring huge disturbances like wars and depressions. Since wealth is highly concentrated, it follows that inequality will tend to increase without bound until a policy change is introduced or some kind of catastrophe interferes with wealth accumulation.

Piketty writes in the epic philosophical mode of Keynes, Marx, or Adam Smith rather than in the dry, technocratic prose of most contemporary academic economists. His pages are littered with asides referencing Jane Austen, the works of Balzac, and many other literary figures. For those who don’t like or trust economics and economists, Piketty’s humane and urbane learning makes his analysis that much more compelling. As well it should: The issues of fairness of market outcomes that he deals with are best thought of as part of a broad contemplation of our society rather than in narrow numerical terms.

All of this is more than enough to justify the rapturous reception accorded Piketty in many quarters. But recall that Kennedy seemed to hit the zeitgeist perfectly but turned out later to have missed his mark as the Berlin Wall fell and the United States enjoyed an economic renaissance in the decade after he wrote; similarly, I have serious reservations about Piketty’s theorizing as a guide to understanding the evolution of American inequality. And, as even Piketty himself recognizes, his policy recommendations are unworldly—which could stand in the way of more feasible steps that could make a material difference for the middle class.

Piketty’s argument is straightforward, relying, as he says in his conclusion, on a simple inequality: r>g, in which the rate of return on capital exceeds the growth rate. Its essence is most easily grasped by thinking about population growth. Think first of a world where couples have four children. In that case, an accumulated fortune will dissipate, as the third generation of descendants has 64 members and the fourth has 256 members. On the other hand, if couples have only two children, a fortune has to be split only 16 ways even after four generations. So slow growth is especially conducive to rising levels of wealth inequality, as is a high rate of return on capital that accelerates wealth accumulation. Piketty argues that as long as the return to wealth exceeds an economy’s growth rate, wealth-to-income ratios will tend to rise, leading to increased inequality. According to Piketty, this is the normal state of capitalism. The middle of the twentieth century, a period of unprecedented equality, was also marked by wrenching changes associated with the Great Depression, World War II, and the rise of government, making the period from 1914 to 1970 highly atypical.

This rather fatalistic and certainly dismal view of capitalism can be challenged on two levels. It presumes, first, that the return to capital diminishes slowly, if at all, as wealth is accumulated and, second, that the returns to wealth are all reinvested. Whatever may have been the case historically, neither of these premises is likely correct as a guide to thinking about the American economy today.

Economists universally believe in the law of diminishing returns. As capital accumulates, the incremental return on an additional unit of capital declines. The crucial question goes to what is technically referred to as the elasticity of substitution. With 1 percent more capital and the same amount of everything else, does the return to a unit of capital relative to a unit of labor decline by more or less than 1 percent? If, as Piketty assumes, it declines by less than 1 percent, the share of income going to capital rises. If, on the other hand, it declines by more than 1 percent, the share of capital falls.

Economists have tried forever to estimate elasticities of substitution with many types of data, but there are many statistical problems. Piketty argues that the economic literature supports his assumption that returns diminish slowly (in technical parlance, that the elasticity of substitution is greater than 1), and so capital’s share rises with capital accumulation. But I think he misreads the literature by conflating gross and net returns to capital. It is plausible that as the capital stock grows, the increment of output produced declines slowly, but there can be no question that depreciation increases proportionally. And it is the return net of depreciation that is relevant for capital accumulation. I know of no study suggesting that measuring output in net terms, the elasticity of substitution is greater than 1, and I know of quite a few suggesting the contrary.

There are other fragmentary bits of evidence supporting this conclusion that come from looking at particular types of capital. Consider the case of land. In countries where land is scarce, like Japan or the United Kingdom, land rents represent a larger share of income than in countries like the United States or Canada, where it is abundant. Or consider the case of housing. Economists are quite confident that the demand for housing is inelastic, so that as more housing is created, prices fall more than proportionally—a proposition painfully illustrated in 2007 and 2008.

Does not the rising share of profits in national income in most industrial countries over the last several decades prove out Piketty’s argument? Only if one assumes that the only factors at work are the ones he emphasizes. Rather than attributing the rising share of profits to the inexorable process of wealth accumulation, most economists would attribute both it and rising inequality to the working out of various forces associated with globalization and technological change. For example, mechanization of what was previously manual work quite obviously will raise the share of income that comes in the form of profits. So does the greater ability to draw on low-cost foreign labor.

There is also the question of whether the returns to wealth are largely reinvested. A central claim by Piketty is that a country’s wealth-income ratio tends toward s/g, the ratio of its savings rate to its growth rate. Hence, as he argues, a declining growth rate leads to a higher wealth ratio. But this presumes a constant or rising saving ratio. Since he imagines returns to capital as largely reinvested, he finds this a plausible assumption.

I am much less sure. At the simplest level, consider a family with current income of 100 and wealth of 100 as opposed to a family with current income of 100 and wealth of 500. One would expect the former family to have a considerably higher saving ratio. In other words, there is a self-correcting tendency Piketty abstracts from whereby rising wealth leads to declining saving.

The largest single component of capital in the United States is owner-occupied housing. Its return comes in the form of the services enjoyed by the owners—what economists call “imputed rent”—which are all consumed rather than reinvested since they do not take a financial form. The phenomenon is broader. The determinants of levels of consumer spending have been much studied by macroeconomists. The general conclusion of the research is that an increase of $1 in wealth leads to an additional $.05 in spending. This is just enough to offset the accumulation of returns that is central to Piketty’s analysis.

A brief look at the Forbes 400 list also provides only limited support for Piketty’s ideas that fortunes are patiently accumulated through reinvestment. When Forbes compared its list of the wealthiest Americans in 1982 and 2012, it found that less than one tenth of the 1982 list was still on the list in 2012, despite the fact that a significant majority of members of the 1982 list would have qualified for the 2012 list if they had accumulated wealth at a real rate of even 4 percent a year. They did not, given pressures to spend, donate, or misinvest their wealth. In a similar vein, the data also indicate, contra Piketty, that the share of the Forbes 400 who inherited their wealth is in sharp decline.

But if it is not at all clear that there is any kind of iron law of capitalism that leads to rising wealth and income inequality, the question of how to account for rising inequality remains. After Piketty and his colleagues’ work, there can never again be a question about the phenomenon or its pervasiveness. The share of the top 1 percent of American income recipients has risen from below 10 percent to above 20 percent in some recent years. More than half of the income gains enjoyed by Americans in the twenty-first century have gone to the top 1 percent. The only groups that have outpaced the top 1 percent have been the top .1 and .01 percent.

Piketty, being a meticulous scholar, recognizes that at this point the gains in income of the top 1 percent substantially represent labor rather than capital income, so they are really a separate issue from processes of wealth accumulation. The official data probably underestimate this aspect—for example, some large part of Bill Gates’s reported capital income is really best thought of as a return to his entrepreneurial labor.

So why has the labor income of the top 1 percent risen so sharply relative to the income of everyone else? No one really knows. Certainly there have been changes in prevailing mores regarding executive compensation, particularly in the English-speaking world. It is conceivable, as Piketty argues, that as tax rates have fallen, executives have gone to more trouble to bargain for super high salaries, effort that would not have been worthwhile when tax rates were high (though I think it is equally plausible that higher tax rates would pressure executives to extract more, so as to maintain their post-tax income levels).

There is plenty to criticize in existing corporate-governance arrangements and their lack of resistance to executive self-dealing. There are certainly abuses. I think, however, that those like Piketty who dismiss the idea that productivity has anything to do with compensation should be given a little pause by the choices made in firms where a single hard-nosed owner is in control. The executives who make the most money are not for most part the ones running public companies who can pack their boards with friends. Rather, they are the executives chosen by private equity firms to run the companies they control. This is not in any way to ethically justify inordinate compensation—only to raise a question about the economic forces that generate it.

The rise of incomes of the top 1 percent also reflects the extraordinary levels of compensation in the financial sector. While anyone looking at the substantial resources invested in trading faster by nanoseconds has to worry about the over-financialization of the economy, much of the income earned in finance does reflect some form of pay for performance; investment managers are, for example, compensated with a share of the returns they generate.

And there is the basic truth that technology and globalization give greater scope to those with extraordinary entrepreneurial ability, luck, or managerial skill. Think about the contrast between George Eastman, who pioneered fundamental innovations in photography, and Steve Jobs. Jobs had an immediate global market, and the immediate capacity to implement his innovations at very low cost, so he was able to capture a far larger share of their value than Eastman. Correspondingly, while Eastman’s innovations and their dissemination through the Eastman Kodak Co. provided a foundation for a prosperous middle class in Rochester for generations, no comparable impact has been created by Jobs’s innovations.

This type of scenario is pervasive. Most obviously, the best athletes and entertainers benefit from a worldwide market for their celebrity. But something similar is true for those with extraordinary gifts of any kind. For example, I suspect we will soon see the rise of educator superstars who command audiences of hundreds of thousands for their Internet courses and earn sums way above the traditional dreams of academics.

Even where capital accumulation is concerned, I am not sure that Piketty’s theory emphasizes the right aspects. Looking to the future, my guess is that the main story connecting capital accumulation and inequality will not be Piketty’s tale of amassing fortunes. It will be the devastating consequences of robots, 3-D printing, artificial intelligence, and the like for those who perform routine tasks. Already there are more American men on disability insurance than doing production work in manufacturing. And the trends are all in the wrong direction, particularly for the less skilled, as the capacity of capital embodying artificial intelligence to replace white-collar as well as blue-collar work will increase rapidly in the years ahead.

Where does this leave policy?

Piketty’s argument is that a tendency toward wealth accumulation and concentration is an inevitable byproduct of the workings of the capitalist system. From his perspective, differences between capitalism as practiced in the English-speaking world and in continental Europe are of second order relative to the underlying forces at work. So he is led to far-reaching policy proposals as the principal redress for rising inequality.

In particular, Piketty argues for an internationally enforced progressive wealth tax, where the rate of tax rises with the level of wealth. This idea has many problems, starting with the fact that it is unimaginable that it will be implemented any time soon. Even with political will, there are many problems of enforcement. How does one value a closely held business? Even if a closely held business could be accurately valued, will its owners be able to generate the liquidity necessary to pay the tax? Won’t each jurisdiction have a tendency to undervalue assets within it as a way of attracting investment? Will a wealth tax encourage unseemly consumption by the wealthy?

Perhaps the best way of thinking about Piketty’s wealth tax is less as a serious proposal than as a device for pointing up two truths. First, success in combating inequality will require addressing the myriad devices that enable those with great wealth to avoid paying income and estate taxes. It is sobering to contemplate that in the United States, annual estate and gift tax revenues come to less than 1 percent of the wealth of just the 400 wealthiest Americans. With respect to taxation, as so much else in life, the real scandal is not the illegal things people do—it is the things that are legal. And second, such efforts are likely to require international cooperation if they are to be effective in a world where capital is ever more mobile. The G-20 nations working through the OECD have begun to address these issues, but there is much more that can be done. Whatever one’s views on capital mobility generally, there should be a consensus on much more vigorous cooperative efforts to go after its dark side—tax havens, bank secrecy, money laundering, and regulatory arbitrage.

Beyond taxation, however, there is, one would hope, more than Piketty acknowledges that can be done to make it easier to raise middle-class incomes and to make it more difficult to accumulate great fortunes without requiring great social contributions in return. Examples include more vigorous enforcement of antimonopoly laws, reductions in excessive protection for intellectual property in cases where incentive effects are small and monopoly rents are high, greater encouragement of profit-sharing schemes that benefit workers and give them a stake in wealth accumulation, increased investment of government pension resources in riskier high-return assets, strengthening of collective bargaining arrangements, and improvements in corporate governance. Probably the two most important steps that public policy can take with respect to wealth inequality are the strengthening of financial regulation to more fully eliminate implicit and explicit subsidies to financial activity, and an easing of land-use restrictions that cause the real estate of the rich in major metropolitan areas to keep rising in value.

Hanging over this subject is a last issue. Why is inequality so great a concern? Is it because of the adverse consequences of great fortunes or because of the hope that middle-class incomes could grow again? If, as I believe, envy is a much less important reason for concern than lost opportunity, great emphasis should shift to policies that promote bottom-up growth. At a moment when secular stagnation is a real risk, such policies may include substantially increased public investment and better training for young people and retraining for displaced workers, as well as measures to reduce barriers to private investment in spheres like energy production, where substantial job creation is possible.

Look at Kennedy airport. It is an embarrassment as an entry point to the leading city in the leading country in the world. The wealthiest, by flying privately, largely escape its depredations. Fixing it would employ substantial numbers of people who work with their hands and provide a significant stimulus to employment and growth. As I’ve written previously, if a moment when the United States can borrow at lower than 3 percent in a currency we print ourselves, and when the unemployment rate for construction workers hovers above 10 percent, is not the right moment to do it, when will that moment come?

Books that represent the last word on a topic are important. Books that represent one of the first words are even more important. By focusing attention on what has happened to a fortunate few among us, and by opening up for debate issues around the long-run functioning of our market system, Capital in the Twenty-First Century has made a profoundly important contribution.

http://www.democracyjournal.org/32/the-inequality-puzzle.php?page=1

Larry Summers

Charles W. Eliot University Professor and President Emeritus at Harvard University

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