April 7, 2014

The post-crisis panic might be subsiding but medium-term prospects are problematic

The world’s finance ministers and central bank governors gather in Washington this week for the biannual International Monetary Fund meetings. While there will not be the sense of alarm that dominated the convocations in the years after the financial crisis, the unfortunate reality is that the medium-term prospects for the global economy have not been so problematic for a long time.

The IMF in its current World Economic Outlook essentially endorses the “secular stagnation” hypothesis, noting that the real interest rate necessary to bring about enough demand for full employment is likely to remain depressed for a substantial period. This is made manifest by the fact that inflation is well below target throughout the developed world and is likely to decline further this year. Without robust growth in, and greater demand from, these markets, growth in emerging economies is likely to subside. That is even without considering the political challenges facing countries as diverse as Brazil, China, South Africa, Russia and Turkey.

In the face of inadequate demand, the world’s primary strategy is easy money. Base interest rates remain at floor levels throughout the developed world and central banks signal that they are unlikely to rise soon. While the US is tapering quantitative easing, Japan continues to ease on a large scale, and the Eurozone seems to be moving closer to this. This is all better than the tight money that in the 1930s made the Depression the Great Depression. But it has problems as a growth strategy.

We do not have a strong basis for supposing that reductions in interest rates from very low levels have a big impact on spending decisions. Any spending they do induce tends to represent a pulling forward rather than an augmentation of demand. We do know they strongly encourage economic actors to take on debt; that they place pressure on return-seeking investors to take increased risk; that they inflate asset values and reward financial activity. And we cannot confidently predict the ultimate impact on markets or the confidence of investors of the unwinding of central bank balance sheets.

While monetary policies lower capital costs and so encourage spending that businesses and households judge unworthwhile even at rock-bottom interest rates, many elements of investment exist that can be increased and that also have high returns but are held back by misguided public policies.

In the US the case for substantial investment promotion is overwhelming. Increased infrastructure spending would reduce burdens on future generations, not just by spurring growth but also by expanding the economy’s capacity and reducing deferred maintenance obligations. For example: can it be rational in the 21st century for the US air traffic control system to rely on paper tracking of flight paths? Equally important, government could do much at no cost to promote private investment including authorizing oil and natural gas exports, bringing clarity to the future of corporate taxes, and moving forward on trade agreements that open up foreign markets.

Japan, with the increase in value added tax on April 1, is engaged in a major fiscal contraction at a time when it is far from clear whether last year’s progress in reversing deflation is durable or a reflection of one-off exchange rate movements. A return to stagnation and deflation could rapidly call its solvency into question. Japan takes a dangerous risk if it waits to observe the consequences before enacting fiscal and structural reform measures to promote spending.

Europe has moved back from the brink, with defaults or devaluations now remote as possibilities. But no strategy for durable growth is yet in place and the slide towards deflation continues. Strong actions to restore the banking system so that it can be a conduit for a robust flow of credit, as well as measures to promote demand in the countries of the periphery where competitiveness challenges remain, are imperative.

If emerging markets’ capital inflows fall off substantially, and so they move further towards being net exporters, it is hard to see where in the developed world can take up the slack by accepting trade balance deterioration. So measures to bolster capital flows and exports to emerging markets are essential. Most important are political steps to reassure about populist threats in a number of countries, such as where authoritarian governments give signs of disregarding contracts and property rights, and provide investor protection and backstop finance. In this regard passage by the US Congress of authorisation for the IMF to enhance its ability to provide backstop finance, is imperative.

Creative consideration should also be given to ways of mobilising the trillions of dollars in public assets held by central banks and sovereign wealth funds largely in the form of safe liquid assets to promote growth.

In a globalised economy, the impact of these steps taken together is likely to be substantially greater than the sum of their individual impacts. And the consequences of national policy failures are likely to cascade. That is why a global growth strategy framed to resist secular stagnation rather than just muddle through with the palliative of easy money should be this week’s agenda.

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

Download the .pdf here.

SUMMERS:  Thank you very much, Michael, for those generous words and for your thoughtful observations about the long-run economic challenges that our country faces.  You do not, however, get to the long run except through the short run, and what happens in the short run has a profound impact on the long run.  To reverse Keynes a bit, if you die in the short run, there is no long run.  So my preoccupation this morning will be with a set of temporary, but I believe ultimately long-term concerns.

Before I turn to those concerns, however, let me just say how grateful I am to be back with the National Association of Business Economists.  It seems to me that the members of this organization make an enormous, ongoing contribution to evaluating, understanding, and responding to the flow of economic events.  I have been coming to these meetings on and off now for more than 30 years, and have always been struck by the sophistication and relevance of the analyses that are discussed herein.

Indeed, I think it is fair to say that some of the themes that are today central to discussions of academic macroeconomics, but had receded from the debate for many years, were always kept alive at the National Association of Business Economists.  I think, for example, of the importance of the financial sector and the flow of credit.  I also think of the issues surrounding confidence and uncertainty.  These have long been staples of the discussions here at the National Association of Business Economists.

Macroeconomics, just six or seven years ago, was a very different subject than it is today.  Leaving aside the set of concerns associated with long-run growth, I think it is fair to say that six years ago, macroeconomics was primarily about the use of monetary policy to reduce the already small amplitude of fluctuations about a given trend, while maintaining price stability.  That was the preoccupation.  It was supported by historical analysis emphasizing that we were in a great moderation.  It was supported by policy and theoretical analysis suggesting the importance of feedback rules.  And it was supported by a vast empirical program directed at optimizing those feedback rules.

Today, we wish for the problem of minimizing fluctuations around a satisfactory trend.  Indeed, I think it is fair to say that today, the amplitude of fluctuations appears large, not small.  As I shall discuss, there is room for doubt about whether the cycle actually cycles.  Today, it is increasingly clear that the trend in growth can be adversely affected over the longer term by what happens in the business cycle.  And today, there are real questions about the totality and sufficiency of the efficacy of monetary policy, given the zero lower bound on interest rates.

In my remarks today, 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.

I shall argue three propositions.  First, as US and industrial economies are currently configured, simultaneous achievement of adequate growth, capacity utilization, and financial stability appears increasingly difficult.  Second, this is likely related to a substantial decline in the equilibrium or natural real rate of interest.  Third, addressing these challenges requires different policy approaches than are represented by the current conventional wisdom.

Let me turn, then, to the first of these propositions.  It has now been nearly five years since the trough of the recession in the early summer of 2009.  It is no small achievement of policy that the economy has grown consistently since then, and that employment has increased on a sustained basis.  Yet, it must be acknowledged that essentially all of the convergence between the economy’s level of output and its potential has been achieved not through the economy’s growth, but through downward revisions in its potential.

In round numbers, the economy is now 10% below what in 2007 we thought its potential would be in 2014.  Of that 10% gap, 5% has already been accommodated into a reduction in the estimate of its potential, and 5% remains as an estimate of its GDP gap.  In other words, through this recovery, we have made no progress in restoring GDP to its potential.

Information on employment is similarly sobering.  This chart depicts the employment/population ratio in aggregate.  Using this relatively crude measure, one observes almost no progress.  It has been pointed out repeatedly and correctly that this chart is somewhat misleading, because it neglects the impact of a range of demographic changes on the employment ratio that would have been expected to carry on even in the absence of a cyclical downturn.

But that is not the largest part of the story.  Even if one looks at 25 to 54-year old men, a group where there is perhaps the least ambiguity because there is the greatest social expectation of work, one sees that the employment/population ratio  declined sharply during the downturn, and only a small portion of that decrease has been recovered since that time.

The recovery has not represented a return to potential, and, according to the best estimates we have, the downturn has cast a substantial shadow on the economy’s future potential.  Making the best calculations one can from the CBO’s estimates of potential (and I believe quite similar results would come from other estimates of potential), one sees that this is not about technological change.  Slower total factor productivity than we would have expected in 2007 accounts for the smallest part of the downward trend in potential.  The largest part is associated with reduced capital investment, followed closely by reduced labor input.  Let me emphasize this is not a calculation about why we have less output today.  It is a calculation about why it is estimated that the potential of the economy has declined by 5% as a consequence of the downturn that we have suffered.

The record of growth for the last five years is disturbing, but I think that is not the whole of what should concern us.  It is true that prior to the downturn in 2007, through the period from, say, 2002 until 2007, the economy grew at a satisfactory rate.  Mind you, there is no clear evidence of overheating.  Inflation did not accelerate in any substantial way.  But the economy did grow at a satisfactory rate, and did certainly achieve satisfactory levels of capacity utilization and employment.

Did it do so in a sustainable way?  I would suggest not.  It is now clear that an increase in house prices (that can retrospectively be convincingly labeled a bubble) was associated with an unsustainable upward movement in the share of GDP devoted to residential investment.  And this made possible a substantial increase in the debt-to-income ratio for households, which has been reversed only to a limited extent.

It is fair to say that critiques of macroeconomic policy during this period, almost without exception, suggest that prudential policy was insufficiently prudent, that fiscal policy was excessively expansive, and that monetary policy was excessively loose.  One is left to wonder how satisfactory would the recovery have been in terms of growth and in terms of achievement of the economy’s potential with a different policy environment, in the absence of a housing bubble, and with the maintenance of strong credit standards?

As a reminder, prior to this period, the economy suffered the relatively small, but somewhat prolonged, downturn of 2001.  Before that, there was very strong economic performance that in retrospect we now know was associated with the substantial stock market bubble of the late 1990s.  The question arises, then, in the last 15 years, can we identify any sustained stretch during which the economy grew satisfactorily with conditions that were financially sustainable?  Perhaps one can find some such period, but it is very much the minority, rather than the majority, of the historical experience.

What about the rest of the industrialized world?  I remember well when the Clinton administration came into office in 1993.  We carried out a careful review of the situation in the global economy.  We consulted with all the relevant forecasting agencies about the long-term view for the global economy.

At that time, there was some controversy as to whether a reasonable estimate of potential growth for Japan going forward was 3% or 4%.  Since then, Japanese growth has been barely 1%.  So, it is hard to make the case that over the last 20 years, Japan represents a substantial counterexample to the proposition that industrial countries are having difficulty achieving what we traditionally would have regarded as satisfactory growth with sustainable financial conditions.

What about Europe?  Certainly, for some years after the introduction of the Euro in 1999, Europe’s economic performance appeared substantially stronger than many on this side of the Atlantic expected.  Growth appeared satisfactory and impressive.  Fears that were expressed about the potential risks associated with a common currency without common governance appeared to have been overblown.

In retrospect, matters look different.  It is now clear that the strong performance of the Euro in the first decade of this century was unsustainable and reliant on financial flows to the European periphery that in retrospect appear to have had the character of a bubble.  For the last few years, and in prospect, European economic growth appears, if anything, less satisfactory than American economic growth.

In sum, I would suggest to you that the record of industrial countries over the last 15 years is profoundly discouraging as to the prospects of maintaining substantial growth with financial stability.  What does this have to do with?  I would suggest that in understanding this phenomenon, it is useful at the outset to consider the possibility that changes in the structure of the economy have led to a significant shift in the natural balance between savings and investment, causing a decline in the equilibrium or normal real rate of interest that is associated with full employment.

Let us imagine, as a hypothesis, that this has taken place.  What would one expect to see?  One would expect increasing difficulty, particularly in the down phase of the cycle, in achieving full employment and strong growth, because of the constraints associated with the zero lower bound on interest rates.  One would expect that, as a normal matter, real interest rates would be lower.  With very low real interest rates and with low inflation, this also means very low nominal interest rates, so one would expect increasing risk-seeking by investors.  As such, one would expect greater reliance on Ponzi finance and increased financial instability.

So, I think it is reasonable to suggest that if there had been a significant decline in equilibrium real interest rates, one might observe the kinds of disturbing signs that we have observed.  Is it reasonable to suggest that equilibrium real interest rates have declined?  I would suggest it is a reasonable hypothesis for at least six reasons, whose impact probably differs from moment to moment and probably is not readily amenable to precise quantification.

First, reductions in demand for debt-financed investment.  In part, this is a reflection of the legacy of a period of excessive leverage.  In part, it is a consequence of greater restriction on financial intermediation as a result of the experiences of recent years.  Yet, probably to a greater extent, it is a reflection of the changing character of productive economic activity.

Ponder that the leading technological companies of this age – I think, for example, of Apple and Google – find themselves swimming in cash and facing the challenge of what to do with a very large cash horde.  Ponder the fact that WhatsApp has a greater market value than Sony, with next to no capital investment required to achieve it.  Ponder the fact that it used to require tens of millions of dollars to start a significant new venture, and significant new ventures today are seeded with hundreds of thousands of dollars.  All of this means reduced demand for investment, with consequences for equilibrium levels of interest rates.

Second, it is a well known, going back to Alvin Hansen and way before, that a declining rate of population growth means a declining natural rate of interest.  The US labor force will grow at a substantially lower rate over the next two decades than it has over the last two decades, a point that is reinforced if one uses the quality-adjusted labor force for education as one’s measure.  There is the possibility, on which I take no stand, that the rate of technological progress has slowed as well, functioning in a similar direction.

Third, changes in the distribution of income, both between labor income and capital income and between those with more wealth and income and those with less, have operated to raise the propensity to save, as have increases in corporate-retained earnings.  An increase in inequality and the capital income share operate to increase the level of savings.  Reduced investment demand and increased propensity to save operate in the direction of a lower equilibrium real interest rate.

Related to the changes I described before, but I think separate, is a substantial change in the relative price of capital goods.  This graph shows the evolution of the relative price of business equipment.  Something similar, but less dramatic, is present in the data on consumer durables.  To take just one example, during a period in which median wages have been stagnant over the last 30 years, median wages in terms of automobiles have almost doubled according to BLS data.  Cheaper capital goods mean that investment goods can be achieved with less borrowing and spending, reducing the propensity for investment.

Fifth, and I will not dwell on this point, there is a reasonable argument to be made that what matters in the economy is after-tax, rather than pre-tax, real interest rates, and the consequence of disinflation is that for any given after-tax real interest rate, the pre-tax real interest rate now needs to be lower than it was before.

Finally, there have been substantial global moves to accumulate reserves, disproportionately in safe assets in general, and in US Treasuries in particular.  Each of these factors has operated to reduce natural or equilibrium real interest rates.

What has the consequence been?  Laubach and Williams from the Federal Reserve established a methodology in 2003 for estimating the natural rate of interest.  Essentially, they looked at the size of the output gap, and they looked at where the real interest rate was, and they calculated the real interest rate that went with no output gap over time.  Their methodology was established in 2003.  It has been extended to this point, and it shows a very substantial decline and continuing decline in the real rate of interest.

One looks at a graph of the 10-year TIP and sees the same picture.  Mervyn King, the former governor of the Bank of England, has recently constructed a time series on the long-term real interest rate on a global basis which shows a similar broad pattern of continuing decline.

I would argue first that there is a continuing challenge of how to achieve growth with financial stability.  Second, this might be what you would expect if there had been a substantial decline in natural real rates of interest.  And third, addressing these challenges requires thoughtful consideration about what policy approaches should be taken.

So, what is to be done if this view is accepted?  As a matter of logic, there are three possible responses.  The first is patience.  These things happen.  Policy has limited impact.  Perhaps one is confusing the long aftermath of an excessive debt buildup with a new era.  So there are limits to what can feasibly be done.

I would suggest that this is the strategy that Japan pursued for many years, and it has been the strategy that the US fiscal authorities have been pursuing for the last three or four years.  We are seeing very powerfully a kind of inverse Say’s Law.  Say’s Law was the proposition that supply creates its own demand.  Here, we are observing that lack of demand creates its own lack of supply.

To restate, the potential of the US economy has been revised downwards by 5%, largely due to reduced capital and labor inputs.  This is not, according to those who make these estimates, a temporary decline, but is a sustained, long-term decline.

A second response as a matter of logic is, if the natural real rate of interest has declined, then it is appropriate to reduce the actual real rate of interest, so as to permit adequate economic growth.  This is one interpretation of the Federal Reserve’s policy in the last three to four years.  Not in the immediate aftermath of the panic, when the policy was best thought of as responding to panic, but in recent years.

This is surely, in my judgment, better than no response.  It does, however, raise a number of questions.  Just how much extra economic activity can be stimulated by further actions once the federal funds rate is zero?  What are the risks when interest rates are at zero, promised to remain at zero for a substantial interval, and then further interventions are undertaken to reduce risk premia?  Is there a risk of creating financial bubbles?

At some point, growth in the balance sheet of the Federal Reserve raises profound questions of sustainability, and there are distributional concerns associated with policies that have their proximate impact on increasing the level of asset prices.  There’s also the concern pointed out by Japanese observers that in a period of zero interest rates or very low interest rates, it is very easy to roll over loans, and therefore there is very little pressure to restructure inefficient or even zombie enterprises.  So, the strategy of taking as a given lower equilibrium real rates and relying on monetary and financial policies to bring down rates is, as a broad strategy, preferable to doing nothing, but comes, I would suggest, with significant costs.

The preferable strategy, I would argue, is to raise the level of demand at any given rate of interest, so as to raise the level of output consistent with an increased level of equilibrium rates and mitigate the various risks associated with low interest rates that I have described.

How might that be done?  It seems to me there are a variety of plausible approaches, and economists will differ on their relative efficacy.  Anything that stimulates demand will operate in a positive direction from this perspective.  Austerity, from this perspective, is counterproductive unless it generates so much confidence that it is a net increaser of demand.

There is surely scope in today’s United States for regulatory and tax reforms that would promote private investment.  While it should be clear from what I am saying that I do not regard a prompt reduction in the federal budget deficit as a high order priority for the nation, I would be the first to agree with Michael Peterson and his colleagues that credible long-term commitments would be a contributor to confidence.

Second, policies that are successful in promoting exports, whether through trade agreements, relaxation of export controls, promotion of US exports, or resistance to the mercantilist practices of other nations when they are pursued, offer the prospect of increasing demand and are responses to the dilemmas that I have put forward.

Third, as I’ve emphasized in the past, public investments have a potentially substantial role to play.  The colloquial way to put the point is to ask if anyone is proud of Kennedy Airport, and then to ask how it is possible that a moment when the long-term interest rate in a currency we print is below 3% and the construction unemployment rate approaches double digits is not the right moment to increase public investment in general – and perhaps to repair Kennedy Airport in particular.

But there is a more analytic case to make, as well.  This will represent my final set of observations.  With the help of David Reifschneider, who bears responsibility for anything good you like in what I am about to say, but nothing that you do not like in what I am about to say, we performed several simulations of the standard Federal Reserve macroeconometric model –including the version that he, Wascher, and Wilcox have studied – to address issues associated with hysteresis coming from the labor market.  To be clear, this is the Federal Reserve model as it stands, not modified in any way to reflect any views that I have.

The simulations performed addressed a 1% increase in the budget deficit directed at government spending maintained for five years, tracking carefully the adverse effects on the impacts on investment and labor force withdrawal which in turn affect the economy’s subsequent potential.  The simulations also recognize that until the economy approaches full employment, it is reasonable to expect that the zero interest rate will be maintained, and the standard Fed reaction function is used after that point.

Simulations show what you might expect them to show, that while the fiscal stimulus is in place, there is a substantial response, a greater response when allowance is made for labor force withdrawal effects than when no such allowance is made.  What is perhaps more interesting is that you see some long-run impact of the stimulus on GDP after it has been withdrawn.  That is why the potential multiplier can be quite large.

And my final point – this shows the impact of this fiscal stimulus on the debt-to-GDP ratio.  You will note that with or without taking into account labor force withdrawal, using this standard macroeconometric model, a temporary increase in fiscal stimulus reduces, rather than increases, the long-run debt-to-GDP ratio.

Now, there are plenty of political economy issues, of whether it is possible to achieve a temporary increase in government spending, and so forth.  But I believe that the demonstration that with a standard model, increases in demand actually reduce the long-run debt-to-GDP ratio should contribute to reassessment of the policy issues facing the United States and push us towards placing substantial emphasis on increasing demand for adequate economic growth. This should serve as a prelude to the day when we can return to the concerns that I think almost all of us would prefer to have as dominant: the achievement of adequate supply potential for the US economy.  Thank you very much.

November 19, 2013

ANNOUNCER[1]:

Ladies and gentlemen, please welcome to the stage the former Treasury Secretary Lawrence Summers, and the Economics Editor of The Wall Street Journal, David Wessel.

DAVID WESSEL:

So y’all made it through the magnetometer.  Is anybody still up there waiting to go through?  It’s my great honor and privilege to be here with Larry Summers.  When Larry Summers was two years old, his parents took him to his pediatrician, who happened to be my father.  And, according to Larry’s father, a story he told at my father’s retirement party, Larry’s parents expressed concern that Larry wasn’t talking very much at two years old.  And supposedly my father’s response was, “I wouldn’t worry about it.  Once he starts, he’ll never stop.”  So with that—

LAWRENCE SUMMERS:

Moving right along.

DAVID WESSEL:

If we had been able to post questions, I would have asked you this question on the screen.  But I’m going to ask for a show of hands, because it’s relevant to what I want to talk to Larry about.  If you had to pick the top priority, the single top economic priority, for the U.S. government right now, and I gave you a choice between reducing the long-term deficit and doing something to spur growth in the short term and the long term – deficit or growth, you only get one vote.  How many people would choose the deficit over growth?  And how many people would choose growth over the deficit?  Larry, I have been here in Washington for 30 years.  And for much of that time, we have been obsessed with reducing the deficit.  And that has been particularly true in the last few years.  You think that’s a dumb idea, and so do a lot of people here.  Why?

LAWRENCE SUMMERS:

You guys are right.  They’re wrong. You guys are not getting your way.  We’ve had ten bipartisan budget processes.  We’ve had zero bipartisan growth processes.  We’ve had budget summits up the ying yang.  We’ve had no growth summits.  Somehow – and frankly the business community is complicit in it, because they have been substantial financial supporters and encouragers of it – we have gotten the idea that addressing the deficit is the defining challenge facing the country.

There are three relevant realities.  First, on the current forecast, the debt-to-GDP ratio will improve over the next decade.  The debt forecasts look just about right on line with the way they looked in terms of decline after the 1993 budget deal.  For ten years, this problem is in hand.

Second, basing policy on forecasts longer than that is kind of a crazy thing to do.  If you take the confidence interval around the deficit forecast, not 20 years out, not a 95% confidence interval, but five years out, a 90% confidence interval.  That confidence interval is 10% of GDP-wide.  It is plus or minus 5%.  If, with global climate change, people were telling us temperature change would be between -3° to + 6°, we wouldn’t be acting on the problem. And so, we do not know what the long-run deficit is going to be.

And the third thing, and the most important thing, I think, is that if you take the longest-run deficit, and you take the official forecasts of it, if we increase the growth rate by two-tenths of 1%, just two-tenths of 1%, you solve the entire identified fiscal gap problem.

And I’m here to say that in a country that is stifling entrepreneurship in a variety of ways, in a country that is starved for public investment, that lets Kennedy Airport languish in the way we do, in a country that’s missing a huge opportunity on immigration reform, in a country that’s maintaining a regulatory and tax environment that surely doesn’t recognize that confidence is the cheapest form of stimulus, increasing the growth rate by more than two-tenths of a percent is easily attainable.

The truth is that if we get past our current perhaps protracted bout of secular stagnation and get the growth rate up, the debt problem will stay in control.  And if we continue to be a country that doesn’t increase the fraction of adults that are working, that doesn’t catch up with its GDP potential, that grows at 2% or less, we can have all the entitlement summits in the world, and we’re gradually going to accumulate debt and have a serious debt problem.

And so, we just have gotten our focus to the wrong thing.  We should be focusing on growth: because growth creates a virtuous circle, which creates more growth.  In a growing economy, employers work harder to train the next generation of workers.  In a growing economy, there are more ladders for kids to get on, which puts them in a better position to lead ten years down the road.

In a growing economy, there are more profits that can be reinvested in R&D and long-term capacity.  In a growing U.S. economy, there’s a stronger world economy, which is more likely to be a successful world economy.  That is where our priority should be.  And in my view, we have just, I’m sad to say, lost track of it as a country.

DAVID WESSEL:

Why is it wrong to say that, “we know we have an aging society, we know we have some benefit promises that are going to be expensive to keep, and wouldn’t it be prudent to do something about growth and package that with things that we know take a long time to save money for, and do it now rather than bequeathing the problem?”

LAWRENCE SUMMERS:

There were some real problems in the kitchen of the Titanic.  There were.  They just were the wrong problems to be working on given the challenges that the Titanic faced and given that management had only so many issues that it could devote itself to.  And it’s the same thing.  It would be better to be thinking about a range of long-term adjustments about 2035.  It would be.

But we really can’t do very much.  We have a lot of difficulty passing any legislation.  And so, in that context, the right focus is on what is most important.  And what is most important is things that contribute to growth.  And what is surely necessary is things that contribute to growth.  I think that the odds are that we’re going to need to make entitlement adjustments, but given the uncertainties in the forecasts, these forecasts are wrong by 5% of GDP all the time.

They were wrong by 5% of GDP on the high side – the forecasts were too pessimistic in the ’90s.  They were wrong by 5% of GDP on the low side – they were too optimistic in this period.  They’re wrong by 5% of GDP all the time.  And when people are talking about entitlement reform, they’re talking the big numbers.  They’re talking about 1% of GDP. They’re talking about 1.5% of GDP.  So yeah, it’s the right thing to be thinking about.  But it’s not nearly as important as spurring growth.

And one other thing that a group like this should remember.  Again, it’s the right thing to be doing.  But, you know, if you contribute the absolute maximum you’re legally allowed to every year from the time you’re 19 till the time you’re 65, your Social Security benefit is less than $40,000.  And so, yeah, there may be a case that we need to adjust the formula in various ways.

But just how excited can you really be about the central national project being cutting those benefits for the best of the Social Security recipients from $38,000 to $36,000, rather than figuring out a way to grow the economy faster so there can be more benefits for everybody.  The right debate to be having is not a debate about what the best way to contain the budget deficit is.  The debate to be having is about how best to spur growth.

DAVID WESSEL:

You used a rather frightening phrase in your answer about secular stagnation.  Do you mean that we are at substantial risk of having an economy that perks along at 2% growth and has one in six men between 25-54 on the sidelines of the labor market for years to come?

LAWRENCE SUMMERS:

I’m not predicting it.  But I don’t see how you can look at the data and not say that that is a substantial risk.  Here are just two points.  Four years ago, financial repair had happened.  The TARP money had been repaired.  Credit spreads had largely normalized.  There was no panic in the air with respect to banking institutions.

It has been four years.  We have not grown the share of adults who are working in the United States at all since that time.  We have not gained at all on the potential of the economy.  We have predicted a growth machine – the forecasters have been consistent, been absolutely consistent – a return to accelerated rates of growth nine months from now. That has been the forecast for the last four years.  And it has always been wrong.  And it might be right this time.  It really might be.  There are reasons to think it could be right.  But I don’t see how you can be certain that it’s right.  And if you look back, there’s a troubling feature, it seems to me, of the experience before this crisis.  And that’s what’s causes me to become more alarmed.

Think about the 2004-2007 years.  We had what consensus opinion now thinks were excessive budget deficits.  We had what consensus opinion now thinks were substantial excessively easy monetary policies.  We had what universally is regarded as having been a massive, imprudent, and excessive set of credit expansion.  We had what is universally regarded as having been an inordinate credit housing bubble, which created a false impression of wealth and created vast and excessive construction.

You might think that with all of those things going, we’d also have had an economy that would be overheating.  But if you look at the unemployment statistics, if you look at the inflation statistics, if you look at the growth statistics, the economy was bubbling.  There were bubbles all right.  But the underlying real economy, with a huge support to demand from all of that, was not overheating by any stretch of the imagination.

And so, it has now been a decade since we have grown at a rapid rate in a remotely healthy and sustainable way.  And it seems to me that has to be the deep concern as you look to the next decade.  Things happen.  I mean, when I came into the Clinton Administration in 1993, we did a comprehensive exercise.  And Treasury was part of it.  The Fed was part of it.  The IMF was part of it.  We asked all the outside forecasters.

Looking to the long run, there was a debate.  There were pessimists who thought Japan would grow by 3% a year over the succeeding 20 years.  And there were optimists who thought it would grow by 4% a year over the succeeding 20 years.  It has in fact grown by about .6% a year over the succeeding 23 years.  And so GDP is only slightly more than half today of what we universally believed then.  Because permanent stagnation was kind of inconceivable.

Now, in Japan, what happened was growth was very, very slow and continued to be very, very slow.  And then after awhile, everybody got used to it.  And they stopped calling it a demand gap.  And they started saying it was all that could be done.  And, to some extent, that became true.  Because after all those years, the companies didn’t reinvest, the companies lost their mojo.  They weren’t in a position to compete.

And so, at a certain point, supply came down to demand.  And you just got used to the idea that Japan was a different kind of growing country.  So, I’m not saying we’re going to have a 30% of GDP gap.  But we are already defining our aspirations as measured by potential GDP way down.  So if you ask, “is there a risk of this?”  Absolutely.  Does the risk, does the prospect of this seem as likely or more likely than the high optimism scenario, where we go back to an era of 4% growth?

Yeah, I have to say that as between the pessimistic scenario and the hyper-optimistic scenario, I would choose the pessimistic scenario.  You know, I think things have a way of working out.  And my guess is that it will be better than that.  But the thing that policymakers should be obsessing about is the risk of this secular stagnation.

That’s a much more urgent threat to every American interest than anything about Social Security benefits in 2035.  That is a much greater risk to American interests than anything about the emergence of hyper-inflation coming from monetary policies.  That is where the concern ought to be.

DAVID WESSEL:

The gap between winners and losers in our society is wide by historical measures and has been widening.  A) Should we worry about that?  And B) If so, what should we do about it?

LAWRENCE SUMMERS:

We surely should be worrying about it.  If the only thing that was happening was that, I would argue that we should be worrying about it.  But, I would understand why other people would feel, “well, that’s what the market was doing, and you shouldn’t make that be a preoccupation.”  But here’s what’s really scary.  For 240 years since George Washington, it’s always been true that we became a country with more equal opportunity every generation.

That is no longer true in the United States.  The gap in life prospects between the children of the rich and the children of the poor has widened over the last 40 years.  The gap in the college attendance rates between the children of the rich and the children of the poor has widened over the last 40 years.  It’s not that we don’t know how to make progress.

If you look at the achievement gap between black and white students, that achievement gap in 1970 was twice as large as the gap between the children of the rich and the children of the poor.  If you look today, the achievement gap between the children of the rich and the children of the poor is twice the gap between blacks and whites.  So, we know how to make problems.  With 40 years of effort, we have a long way to go.  But, with 40 years of effort, we have made enormous progress with respect to civil rights.  Still, if s is said the problem with 20th century was the color line, the problem of the 21st century is the class divide and what it means for opportunity.

And so a widening income distribution combined with more and more ways in which the fortunate can advantage their children I think is profoundly corrosive.  What is it that should be done?  We need to find ways to ensure that the educational opportunities open to every kid are like the educational opportunities open to the kids of the people in this room.  And we are not close to that as a country.

We need to make sure that where there are slots to be given, whether it’s the government giving rights to spectrum, or mining right, or whatever it is; that those processes are open and inclusive and are not processes that reward the fortunate.  I have written a lot of papers about the important incentive effects of taxation.  And I believe that.  And we cannot punitively tax; we cannot go back to the kind of tax rates that the country had in the ’50s and ’60s and the ’70s.

But I am here to tell you that there are a substantial set of loopholes, special interest privileges, and the like that distort the allocation of resources, make the economy function less well, and also act to reify and to reinforce inequality, and that serious tax reform that goes after those inequities could both make a fairer economy and make an economy that was more efficient.

DAVID WESSEL:

Well, let me pick up on that last point a minute.  So corporate taxes, obviously something people here care about.  What would you do if you could write the corporate tax rules?  How would you handle the question of overseas earnings?  What’s the right way to do this for the economy and for the social good?

LAWRENCE SUMMERS:

Indulge me for a minute, if you will, in an analogy.  Suppose you had a library and the library’s got a lot of overdue books.  One thing you could do is you could have an amnesty where people got to bring back their books and they didn’t have to pay a fine.  That would make sense.  Another thing you could do is you could is say, “We’re never going to have an amnesty.  You better bring back your books, because no matter how long you keep your books, you’re not going to get an amnesty.”

That would be kind of harsher.  But that would make sense, too.  A really idiotic thing to do would be to put a sign on the door of the library saying, “No amnesty, but stay tuned, there might be one next month.”  That would be the dumbest imaginable thing to do.  What has been the U.S. corporate tax debate for the last five years?  It’s been exactly that.  No break on repatriation now.  But, the constant hope that there may be a break on repatriation in the not too distant future.

And so, why would anyone bring back their money in the face of that?  What should we do?  I think the principle’s clear.  You can call it territorial with a minimum.  There are a lot of different things you can call it.  We should eliminate the distinction between repatriated profits and non-repatriated profits.  And we should establish, in a balanced budget way, a minimum tax on global income.

And so, whether the rate would be in the neighborhood of 15%, you’d pay that if you brought your money back.  You’d pay that if you left your money in Ireland.  And there would no longer be an incentive to keep money offshore.  And if you did it right, there would not be any revenue loss to the government.

But look, there are things we need to fix to stimulate investment in the country.  But, I don’t know that much about multinational business.  But, here’s something I think I do know.  If you measured it right, the places abroad where the American companies make the most profits would be places like China and Japan and Germany and France – places that have big economies.

But, if you look at their tax returns, the places that show up having the highest profits are places like the Netherlands and Ireland and, in case you’re not getting it, the Cayman Islands.  And that really shouldn’t be that way.  It really doesn’t need to be that way.  And it’s not really making the country more competitive or creating jobs to have it be that way.  So the principle is: don’t try to raise more money, but try to raise money in a much better way.  And certainly don’t keep up a set of uncertainties that all but forces everybody to leave their money abroad.

DAVID WESSEL:

I can keep going, but if you have a question?  Okay, I don’t see anything.  Healthcare.gov is a disaster.  How much damage has that done to the trust that Americans have in the ability of the government to do anything?

LAWRENCE SUMMERS:

We’ll see.  It can’t be good.  Look, this is an unhappy tale.  Many of you know from your own experiences that the right general rule on large I.T. projects is take the estimated time to completion, double it, and then move to the next higher unit of time.  So, days become weeks and weeks become months and I could continue the sequence.

And that’s true when it’s done in the private sector.  And there’s no organized constituency for failure.  And when it was done in the public sector, there was a massive organized constituency for failure that organized as best it could to bring about failure by starving the funds and by objecting to the procedures and so forth.

So, it was an extraordinarily difficult task whose difficulty was massively underestimated.  And I don’t think there’s any legitimate excuse for how badly it was underestimated.  And I think you have to say that if you look at the capacity of government to do things, you have to be less optimistic about that than you were before.  And I think it’s a huge imperative to do something that will renew confidence.

And, as I wrote a few days ago, the great danger at a moment like this – the great danger for a football team that’s down by two touchdowns early in the 4th quarter is that they will abandon their playbook and start throwing Hail Marys in every direction.  And usually, that’s a good way to end up down by three touchdowns.  And the great danger at a moment like this is that you’ll promise days when you’ll have results.  You’ll make confident claims about what’s going to happen next.  You’ll try to jerry-rig something rather than recognizing that given the depth of the hole you’re in, it’s going to be very difficult.

So, I think this it is going to take, as difficult as it was to do this right in the first place, it is going to be more difficult to fix.  But I think it is hugely important that it be fixed.  At the same time, I do think that we do need a kind of compact in this country, where we debate things and we debate things and we debate things; and then, when we come to a conclusion, for a while everybody tries to make them work.

And if they don’t work, then at a certain point, we draw the lessons from that.  But those who try to bring about failure and then say, “Look, we saw failure; therefore, we can’t rely on government,” I don’t think they are performing in a way that they should be proud of either.  So, I don’t think there’s anybody in Washington who is emerging as a winner from how this appears.

And I do, if I may say so, think that those of you who (which I suspect is a majority of people in this room) are of a more conservative bend than I, do need to recognize that of the several strategies that could have been pursued that would have resulted in universal health care, the one that was in fact pursued was the one that was most-respecting of the traditional market, was the one that went the most with the grain of the current system, was the one that was closest to what had been proposed by Republican think tanks like The Heritage Foundation and implemented by conservative state administrations.

And so, if this kind of combination of government operating at the edge rather than taking over the whole system is too difficult to make work, there are conclusions from that that could be drawn in both directions.  But, my hope and my expectation would be that this will over time be fixed and be made right.  And I think it is worth remembering, just as a general matter, having now kind of lived around Washington things for quite some time, you know.  It was only two months ago, less than two months ago, that the budget deal and the failures around the budget and the fact that the Republicans were face down on debt issues meant that they could have been seen as being in deep and terminal difficulties.

And that now is completely out of everyone’s mind.  And no one remembers that as an important event all of six weeks later.  And so it’s a great mistake to think that whatever the mood is right now that that’s what the mood will be three months from now, let alone three years from now.  There’s a large universe of possibility.

DAVID WESSEL:

So Larry, you mentioned Japan, slow growth over more than a decade now, two decades.  Abe comes in, a new economic approach is three arrows – monetary, fiscal, and restructuring.  We’ve seen one of the arrows fired.  Maybe the second one is kind of in the quiver.  The third really isn’t that of the talking shop yet.  Wonder what your evaluation of that economic policy is and the likelihood of success.

LAWRENCE SUMMERS:

You know, it’s a little bit like pulling your goalie in a hockey game.  It’s not that when you got a minute and a half to play, pulling your goalie out is that great a strategy.  It’s just that if you don’t pull your goalie out and the clock runs out, then you lose for sure.  And so you have to try something new.  So, I think the basic thrust of a substantial commitment to expansion was the right one.

I think there have been some encouraging signs so far in the increasing growth expectations, in the reduction in deflation expectations.  And so I think the prospects for Japan look considerably better than they did a year ago.  And that is a tribute to the policies.  But I don’t think we’ll know until nine months from now.  I think nine months from now they will put the value added tax in.  And either the economy will have weathered that and continue to be growing in a reasonable way or, as has happened in the past, there will be a run-up of growth until they do that.  And then, there’ll be an air pocket in spending afterwards and they’ll be back in the soup.  And I can’t confidently predict between those two possibilities.  Both, I think are real possibilities.

DAVID WESSEL:

Question from one of the CEOs here.  Can you raise your hand?

RICH SCHLECTER:

Rich Schlecter.  You talked about the secular challenges to long-term growth.  Could you talk about the role of labor in society?  It feels like the combination of globalization, automation – we heard a wonderful discussion at lunch, which says even at the university level, there’ll be increasing pressures on traditional jobs.  Not maybe at the very top universities, but at many, many others.

And it just seems that, if you’re at the very top, today’s world offers more opportunity than ever to contribute globally.  And if you’re not at the very top, the pressures for middle-class jobs and other things are just enormous.  Do you see an underlying trend here?  And what do you think it means in terms of long-term growth and the inequities in society that you described?

LAWRENCE SUMMERS:

If the issues that I called “secular stagnation” around lack of demand and all of that are the issue for the next decade, the issue for the next half-century is the issue that you raised.  You know, there were some guys who wrote, very distinguished economists who wrote a book nine years ago about technology and its impact on employment.

And one of the most striking passages was they said, you know, computers can do some things.  But computers really aren’t going to be able to do other things.  And their example of something that computers were not going to be able to do was make a left turn against ongoing traffic.  Well, Google nailed that one within less than a decade.

And one of the things I’ve done since leaving government is spend a bunch of time out in Silicon Valley.  And the set of things for which they are developing capacities to do is mind-boggling.  Now, it’s always been true before that jobs were eliminated in one sector by productivity increase and they went to somewhere else.  And that people thought it couldn’t happen.  That’s true with respect to agriculture.  That’s true with respect to the Luddites in England.  It’s always been true before.  It was always true before that, you know, house prices in America went up.  And so “it’s always been true before” is not a conclusive argument.  I think our chances are maximized if our education system is preparing as many people as possible to be as creative and flexible as possible.

I think we’re going to have to recognize that in a world where the potential rewards and leverage to the most creative are larger, that we’re going to have to find ways of having some redistribution from the most creative to everyone else.  You know, the example I like to give is George Eastman had some fantastic ideas about photography.  And he was very successful.  And along with his success, the City of Rochester supported a thriving middle-class for two generations.

Steve Jobs equally fundamental innovations or more fundamental innovations produced even greater success for him and for his shareholders.  But there was no comparable large-scale middle-class job creation.  And that’s what we’re going to have to work through.  It’s going to require us to be much more imaginative in thinking about various kinds of service work and thinking about the quality of jobs and the dignity of jobs associated with the service sector.

I’m all for doing everything we can.  And there’s a lot that we can do that is still undone to bring about a renaissance of American manufacturing.  But, China has gained competitiveness, gained share, innovated and raised its efficiency, as much as any country ever will.  And there are fewer workers in Chinese manufacturing today than there were 20 years ago.  Let me say that again.  There are fewer workers in Chinese manufacturing today than there were 20 years ago.  And so success, if and when it comes, is going to come from various kinds of service work, various kinds of greater customization.

Look, it’s a tragedy that on the one hand you’re saying (and you’re right and I understand why you’re saying it), that there may not be enough work to do.  On the other hand, there are several million kids in this country who profoundly need individual attention and mentoring of a kind they are not close to getting.  And we don’t have a way of bringing the people who want to work together with those kids.  And I don’t think it’s traditional government that’s going to do it.  But I also don’t think it’s going to be turning the country into some kind of Libertarian paradise.

DAVID WESSEL:

With that, join me in thanking Larry Summers.

LAWRENCE SUMMERS:

It seems that my father was right.

___________________________________

Washington, DC

November 8, 2013

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

__________________________________________

January 8, 2012

It would have been almost unimaginable five years ago that the Financial Times would convene a series of articles on “Capitalism in Crisis”. That it has done so is a reflection both of sour public opinion and distressing results on the ground in much of the industrial world.

Americans have traditionally been the most enthusiastic champions of capitalism. Yet, a recent public opinion survey found that among the US population as a whole 50 per cent had a positive opinion of capitalism while 40 per cent did not. The disillusionment was particularly marked among young people aged 18-29, African Americans and Hispanics, those with incomes under $30,000 and self-described Democrats.

Three elections in a row in the US have been, by recent standards, bloodbaths for incumbents. In 2006 and 2008 the left did well; in 2010 the right won comprehensively. With the rise of the Tea Party on the right and the Occupy movement on the left, this suggests that far more is up for grabs than usual in this election year.

So how justified is disillusionment with market capitalism? This depends on the answer to two critical questions. Do today’s problems inhere in the present form of market capitalism or are they subject to more direct solution? Are there imaginable better alternatives?

The spread of stagnation and abnormal unemployment from Japan to the rest of the industrialised world does raise doubts about capitalism’s efficacy as a promoter of employment and rising living standards for a broad middle class. The problem is genuine. Few would confidently bet that the US or Europe will see a return to full employment, as previously defined, within the next five years. The economies of both are likely to be demand constrained for a long time.

But does this reflect an inherent flaw in capitalism or, as Keynes suggested, a “magneto” problem – like the failure of a car alternator – that can be addressed with proper fiscal and monetary policies and which will not benefit from large scale structural measures. I believe the evidence overwhelmingly supports the latter. Efforts to reform capitalism are more likely to divert from the steps needed to promote demand, than to contribute to putting people back to work. I suspect that if and when macro-economic policies are appropriately adjusted, much of the contemporary concern will fade away.

That said, serious questions about the fairness of capitalism are being raised. These are driven by sharp increases in unemployment beyond the business cycle – one in six of American men between 25 and 54 is likely to be out of work even after the economy recovers – combined with dramatic rises in the share of income going to the top 1 per cent (and even the top 0.01 per cent) of the population and declining social mobility. The problem is real and profound and seems very unlikely to correct itself untended. Unlike cyclical concerns there is no obvious solution at hand. Indeed, since even Chinese manufacturing employment appears well below the level of 15 years ago it suggests that the roots of the problem lie deep within the evolution of technology.

The agricultural economy gave way to the industrial one because progress enabled demands for food to be met by only a small fraction of the population freeing large numbers of people to work elsewhere. The same process is now under way with respect to manufacturing and a range of services, reducing employment prospects for most citizens. At the same time, just as in the early days of the industrial era the combination of substantial dislocations and greater ability to produce at scale is enabling a lucky few to acquire great fortunes.

The nature of the transformation is highlighted by the 50 fold change in the relative price of a television set of a constant quality and a day in a hospital over the last generation. While it is often observed that wages for median workers have stagnated, this obscures an important aspect of what is occurring. Measured via items such as appliances or clothing or telephone services, where productivity growth has been rapid, wages have actually risen rapidly over the last generation. The problem is that they have stagnated or fallen measured relative to the price of food, housing, healthcare, energy and education.

As fewer people are needed to meet the population’s demand for goods like appliances and clothing it is natural that more people work in producing goods like healthcare and education where outcomes are manifestly unsatisfactory. Indeed as the economist Michael Spence has documented, a process of this kind is under way: essentially all US employment growth over the last generation has come in non-traded goods.

The difficulty is that in many of these areas the traditional case for market capitalism is weaker. It is surely not an accident that in almost every society the production of healthcare and education is much more involved with the public sector than is the case with the production of manufactured goods. There is an imperative to move workers from activities like steelmaking to activities like taking care of the aged. At the same time there is the imperative of shrinking or least slowing the growth of the public sector.

This brings us to the charge that the governments of industrial market capitalist societies are bankrupt. Even as market outcomes seem increasingly unsatisfactory, budget pressures have constrained the ability of the public sector to respond. How and when – not whether – basic programmes of social protection will be cut back is now back on the table. The basic solvency of too many capitalist states seems in question.

Again the problems are very real. While I believe more than most that the US government will be able to borrow on very attractive terms for a long time, if – as I fear – private borrowing remains depressed, there is no denying that the current path of planned spending and planned revenue collection are inconsistent. And Europe is teaching us that markets can take significant fiscal problems and make them catastrophic by becoming too alarmed too rapidly.

At one level the answer here is simply to insist on more political will and courage. But at a deeper level, citizens of the industrial world who believe that they live in progressive societies are right to wonder why increasingly affluent societies need to roll back levels of social protection. Paradoxically, the answer lies in the very success of capitalism which has made the opportunity-cost of an individual teaching or nursing or administering that much more expensive.

When outcomes are unsatisfactory, as they surely are at present, there is always a debate between those who believe that the current course needs to be pursued with increased vigour and those who argue for a radical change in direction. That debate is somewhat beside the point in the case of market capitalism.

Where it has been applied it has been an enormous success. The challenge for the next generation is that success will increasingly be taken for granted and indeed will become an increasing source of frustration, for in these pinched times, its success cannot be matched outside the market’s natural domain. It is not so much the most capitalist parts of the contemporary economy but the least – those concerned with health education and social protection that are in most need of reinvention.

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

Copyright The Financial Times Limited 2012.

June 18, 2012

Once again good news has had a half-life in the markets of less than 24 hours. Just as news of Spain’s bank bailout rallied markets and sentiment for only a few hours, a Greek election outcome as good as could have been hoped did not buoy markets for even a day. There could be no clearer evidence that the strategy of vowing that the European system will hold together, doing the minimum to address each crisis as it comes and promising to build a system that is sound in the long run has run its course.

Nor is the Group of 20 leading economies, whose leaders conclude their meeting today, likely to change anything soon. Europe’s troubled economies will demand more emphasis on growth, lower interest rates on their official debts and more transfers. The Germans will show sympathy with the aim of reform but will insist that financial integration coincide with political integration. The rest of the world will express exasperation with Europe’s failures and demand more be done. Officials blessed with more diplomatic than economic insight or courage will produce a communiqué expressing a measure of satisfaction with the steps under way, recognising the need to do more and looking forward to continued dialogue. The only good thing is that expectations are so low this will barely disappoint markets.

The truth is that Europe’s debtors and creditors are both right. The borrowers are right that austerity and internal devaluation have never been a successful growth strategy, certainly not when major trading partners are stagnating. In the few cases where fiscal consolidations have preceded growth, they have either involved stagnation relative to previous levels of income (as in Ireland and the Baltics) or buoyant demand associated with surging exports, increasing competitiveness and low borrowing costs (many euro members in the early years). The borrowers are also right to claim that even a previously healthy economy will quickly become very sick if forced to operate for several years with interest rates far above growth rates, as is the case across southern Europe. And experience clearly shows that structural reform is always harder when an economy is contracting and there is no sector to absorb those displaced by reform.

Those wary of institutionalising financial integration without serious political integration are right as well. In a sound system, those with deep pockets who act either as borrowers or as guarantors must have control over borrowing decisions. A system where I borrow and you repay is a prescription for profligacy. This is why there is now so much discussion of eurozone bonds and Europe-wide deposit insurance being linked with much deeper political integration.

But there are two problems lying behind the soft references to greater integration. The first is the question of who really has control. If decisions are genuinely to be made at eurozone level, it is far from clear that there is any majority or even plurality support for responsible policies. If the idea is that the eurozone will be modelled on the European Central Bank – a European facade behind which Teutonic policies are pushed – it is far from clear that this will or should be acceptable across the continent.

The second problem is the scale of the transfers that could be involved. A good guess would be that during the US savings and loans crisis, the American south-west received a transfer from the rest of the country equal to at least 20 per cent of its gross domestic product. Is there a real will to commit to potential transfers of this scale in Europe? Maybe all of this can be resolved but it will surely not happen quickly.

Not all problems can be solved. It is not certain that the full repayment of all currently contracted sovereign debts, sustainable growth for all, and the eurozone retaining all its current members will prove feasible. The private sector is making clear that it recognises this painful reality. Official sector planning needs to recognise it as well. Outside Europe, even as leaders hope for the best they need to plan for the worst, ensuring adequate liquidity and demand in their economies even if Europe’s situation deteriorates rapidly. The fortification of the International Monetary Fund is a start but policy makers need also to consider national policies, trade, finance and social safety nets.

But a eurozone collapse would be a disaster that might define our era. Its prospect must focus the minds of all at the G20 summit on action. Non-Europeans must persuade Europeans that the rules change when the stakes rise. The ECB’s credibility will mean little if there is no longer a common currency.

Setting the right precedent seemed far more important 24 hours before Lehman’s collapse than 24 hours after it. Now is the time for radical cuts in the rates charged by official creditors to European sovereigns; for a willingness to subordinate official debts; and for expansionary monetary policies in Europe that prevent deflation and encourage the growth that can create jobs and reduce debts. Only if the system is preserved can its future be debated.

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

Copyright The Financial Times Limited 2012.

September 16, 2012

It is the mark of science and perhaps rational thought to operate with a falsifiable understanding of how the world works. So it is fair to ask economists a fundamental question: what could happen that would cause you to revise your views of how the economy operates and acknowledge that the model you had been using was flawed? As a vigorous advocate of fiscal expansion as an appropriate response to a major economic slump in an economy with zero or near-zero interest rates, I have for the past several years suggested that if the British economy – with its major attempts at fiscal consolidation – were to enjoy a rapid recovery, it would force me to substantially revise my views about fiscal policy and the macroeconomy.

Unfortunately for the British economy, nothing in the past several years compels me revise my views. British economic growth post-crisis has lagged substantially behind the US and the gap is growing. British gross domestic product has not yet returned to its pre-crisis level and is more than 10 per cent below what would have been forecast from the pre-crisis trend. The cumulative output loss from this British downturn in its first five years exceeds even that experienced during the 1930s. Forecasts continue to be revised downwards, with a decade or more of Japan-style stagnation emerging as a real risk.

Whenever policy is failing to achieve its objectives, as in Britain today, there is a debate as to whether the right response is doubling down – perseverance and intensification of the existing path – or recognition of error or changed circumstances and a change in course. In Britain today such a debate rages on the aggressive fiscal consolidation that the government has made its economic centrepiece. Until and unless there is a substantial reversal on near-term fiscal consolidation, Britain’s short and long-run economic performance is likely to deteriorate.

An effective policy approach to Britain’s economic problems must start with the recognition that the principal factor holding back the British economy over both the short and medium term is the lack of demand. It is true that Britain also faces important structural issues ranging from difficulties in promoting innovation to deficiencies in the system of worker training. Still, it is apparent from the relatively low level of vacancies, the reluctance of workers to leave jobs and the pervasiveness across industries of increased unemployment that it is lack of demand that is holding the economy back. Testimony from companies on their investment plans also supports this view.

During the depression, John Maynard Keynes compared Britain’s economic woes to a “magneto” problem, referring to the fact that a car might have many infirmities but if its electrical system did not work the car would not go. If that was fixed, the car would run, even with other problems. So it is today. Moreover, to a greatly under-appreciated extent in the policy debate, short-run increases in demand and output would have medium to long-term benefits as the economy reaps the rewards of what economists call hysteresis effects. A stronger economy means more capital investment and fewer cuts to corporate research and development. It means fewer people lose their connection to good jobs and become addicted to living without work. It means that more young people get first jobs and it means more businesses choose leaders oriented to expansion rather than cost-cutting. The most important structural programme for raising Britain’s potential output in the future is raising its output today.

The objection to this view comes in many forms but it is in essence that reversing course on fiscal expansion now would undermine credibility, backfire with respect to growth by risking a spike in capital costs and risk catastrophe down the road as debts became unsustainable. This line of argument is profoundly flawed. First, the behaviour of financial markets suggests that economic weakness rather than profligacy is the main source of concern about future credit problems. Why else would the tendency be for the costs of buying credit insurance on the UK to rise when overall interest rates fall? In a similar vein, a tendency has emerged in both the UK and US for interest rates to rise and fall with stock prices, implying that it is evolving optimism and pessimism about the future, not changing views about fiscal policy driving markets. Second, the reality is that the primary determinant of fiscal health in both the US and UK over the medium term will be the rate of growth. An extra percentage point of growth maintained for five years would reduce Britain’s debt-to-GDP ratio by close to 10 percentage points whereas austerity policies that slowed growth could even backfire in the narrow sense of raising debt-to-GDP ratios and turning debt unsustainability into a self-fulfilling prophecy.

Britain must change the pace of fiscal consolidation to stand a chance of avoiding a lost decade. Rather than starving public investment, now is the time to add to confidence by making plans for structural reforms to contain the growth of public consumption spending over time. It is also time to take overdue measures to promote exports and, after years of appropriately low investment, to restart housing investment. But when demand is needed for growth and the private sector is hanging back, the first priority must be for the public sector to stop exacerbating the contraction.

The writer is Charles W. Eliot university professor at Harvard.

Copyright The Financial Times Limited 2012.

GENED 1120 – The Political Economy of Globalization

This course analyzes how a globalizing world of differing countries – rich and poor, democratic and authoritarian – can best promote inclusive growth and human security by meeting the challenges of inequality, climate change, rising populism, war, and global disease. Why is populism becoming pervasive – and is there a revolt against global integration? What is the right balance between national sovereignty and international integration? Is the US equipped to sustain its role as a global leader? How does international trade affect prosperity and inequality? Should we regulate multi-national companies who move their factories to countries with lower labor standards? How should the IMF respond to financial crises in Europe and the developing world? How will the rise of China change the world system? This course uses basic economic logic to illuminate the choices – and trade-offs – faced by governments, international institutions, businesses, and citizens as the global economy evolves. Our course is based on the premise that passion without careful reason is dangerous and that reliance on solid analytics and rigorous empirical evidence will lead to a better world. Policy issues are debated in class by the professors and guest speakers, and students will participate in simulated negotiations on US climate policy and the US-China economic relationship, experiencing the issues firsthand, as well as illustrating the importance of decisions made by individual actors for the evolution of the global system.