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.
The case is even more overwhelming when you consider the long-term costs of a slump. It's what economists call hysteresis. For one, the long-term unemployed will eventually become unemployable in the eyes of companies that discriminate against them. For another, putting off investments today means the economy won't be able to grow as much tomorrow. So a slump begets a slump. Or at least a slower-growing economy. But if spending today prevents GDP—and tax revenue—from disappearing tomorrow, it could maybe, just maybe, finance itself. That is, we could create future tax revenue that would cover today's interest payments. That's what Larry Summers and Brad DeLong argued two years ago, and, as you'll see, that's a pretty low hurdle right now.