Larry Summers thinks the economy is broken, and has been for awhile.
It's not just the Great Recession and the not-so-great recovery. It's the 8 years before that too. As Summers points out, even low interest rates, deficit-financed tax cuts, and nonexistent lending standards weren't enough to overheat the economy then. Sure, housing prices boomed, but nothing else did. Inflation was low, and unemployment wasn't that low. In other words, demand wasn't excessive, but it wasn't sustainable either.
Summers worries that this isn't only a story about our economic past, but about our future, too. That we won't be able to create enough jobs without bubbles, now and forever. It's a new old idea called "secular stagnation." Economist Alvin Hansen first proposed it in the late 1930s when it looked like slow population growth might slow investment, and create a permaslump. But, thankfully, the baby boom, and 16 years of pent-up consumer demand proved him wrong.
Goodnight, Sweet Sustainable Growth?
This time, though, might be different. See, there's something called the "natural rate of interest," which is the inflation-adjusted one that gets the economy to its Goldilocks state of low inflation and low unemployment. If the Fed sets rates above it, inflation should fall and unemployment should rise (though, in practice, wages and prices don't tend to fall below zero).
As Summers points out, this natural rate has been negative for most of the last decade. And that's why we've alternated between bust and boom. The Fed's 2 percent inflation target means that even if it sets rates at zero, it might not be able to generate negative enough real rates to hit the natural one. That's the bust. But these kind of persistently low rates might eventually encourage risky behavior that, well, bubbles over. That's the boom. And our economic trap.
There are three ways out: more regulation, more inflation, and more spending. The first is what economists call "macroprudential policy"—which is just another way of saying that we should make it harder to borrow during a boom. Summers, though, thinks it's a "chimera" that this alone can give us the "growth benefits of easy credit ... without cost." He might be right. A recent paper by Kenneth Kuttner and Ilhyock Shim looked at 57 countries, and found that, aside from limits on debt-service-to-income ratios, these kinds of policies don't limit household credit growth all that much.
If we're lucky, all we need is a little more inflation. And maybe a little less of China manipulating its currency. A higher inflation target, say 4 percent, would let the Fed engineer more negative real rates if necessary, and recover faster from a slump. It should also push up nominal rates, and make it less likely that we stuck to begin with. That'd be even more true if China stopped sucking out demand by manipulating down its currency. That last bit would be nice, but maybe isn't necessary. Consider that Australia hasn't had a recession in over 20 years—yes, really—despite running chronic trade deficits. How? Well, it's mining boom is a large part, but even more so is its smart central bank policy that targets 2 to 3 percent inflation averaged over the business cycle. In other words, it makes up for any inflation undershooting with overshooting (and vice versa).
A Free (Fiscal) Lunch?
But we can make the Fed's job easier with some smart spending. The case is overwhelming right now. As I've pointed out before, the Fed's forward guidance is really them telling Congress how much fiscal stimulus they'll allow. See, normally there's not a strong argument for stimulus spending, because the Fed might just negate it by raising rates. But this time the Fed has told us it won't raise rates before unemployment falls to 6.5 percent (and probably not until "well past" that time). That means the "multiplier"—how much total spending a dollar of government spending creates—should be relatively high.