There has been a lot of talk lately about secular stagnation and the zero lower bound. Larry Summers delivered a talk on the subject at an IMF conference in which he seemed to suggest that asset bubbles might be a possible antidote. Also, Paul Krugman has joined the conversation by describing our current condition as a liquidity trap. Most recently, Larry Summers revisits the subject in a Washington Post column.
Secular stagnation occurs when there is a chronic glut of savings and a shortage of borrowing which prevents the economy from operating at full capacity. Such condition is characterized by persistently high unemployment, uncomfortably low inflation and mediocre GDP growth. Only if interest rates were to fall into negative territory, would savings and borrowing reach an equilibrium. However, since monetary policy is limited by the zero lower bound, meaning that interest rates cannot go below zero, such condition can persist for a long time hence the term secular stagnation. In this post, I will attempt to summarize the tools currently available to policy makers and review some recent proposals to deal with secular stagnation. I will also offer a new solutions, specifically a new approach to tax policy, which provides an enhanced framework for monetary policy without the side effects of asset bubbles or inflation.
As I discuss in my post on stock market bubbles, the 2008 financial collapse prompted a dramatic increase in the demand for money. The Fed averted a second Great Depression with a massive infusion of money dubbed QE. While the demand for money seems to have reached a plateau, the public continues to hold large money balances instead of spending and investing in the real economy. More than 4 years into the recovery, we continue to experience elevated unemployment, low inflation and mediocre growth hence the fear of secular stagnation.
At this point, the options available to policy makers to combat stagnation are limited to three primary tools. Running fiscal deficits is the obvious choice whereby borrowing by the government absorbs excess savings. However, in the current political environment this is unlikely. Rather, the fiscal deficit is declining rapidly which acts to reinforce short and medium-term stagnation pressures. The second option is continuation of QE even after the demand for money has been satisfied, which is exactly what the Fed has been doing and will continue to do in 2014 albeit at a reduced pace. The hope is that QE will continue to inflate asset prices and the associated wealth effect will prompt more spending and investment. The Fed also hopes that continued printing of money will stoke inflation expectations thus increasing the cost of holding money, which is a back-door way of pushing real interest rates below the zero lower bound. Finally, the third and most likely option is that the Federal Reserve will keep the fed funds rate near zero for an extended period of time even past the point when economic conditions justify an increase. In the words of Charles Evans, the governor of the Chicago Fed, this will make up for "the period when it [the Fed] was constrained from taking rates negative". Economists such as Larry Summers and Paul Krugman fear that the Fed will
not sustain such policies long enough as to enable the economy to break-out of stagnation and catch-up for lost ground. More importantly, the Fed suffers a real
political cost due to the perceived side effects of asset bubbles and
inflation associated with extended periods of QE and loose monetary policy.
A group of economists including Miles Kimball and Paul Krugman have suggested a radical solution - elimination of paper money. In today's world, if banks were to charge negative interest rates on deposits, depositors will simply convert into cash which will lead to even more hoarding of money and deflation. Instead, if paper money were to be eliminated, the Fed could be in a position to take rates negative without fear of deposit flight. Politically, I do not see how this will happen - such action will be categorized as grand theft by government. More importantly money balances will flee the US, and new currencies will proliferate (and I do not mean the bitcoin, but currencies issued by credit-worthy non-government parties).
In order to discuss remedies, a basic question has to be asked. What forces the equilibrium rate of interest into negative territory as to suppress the economy into secular stagnation? First, some econ 101. Why do savers demand interest in order to extend credit, and why do borrowers willingly pay interest in order to receive credit? Setting credit risk and inflation expectations aside, savers and borrowers have to consider the marginal utility of consumption today and compare it to the utility of future consumption. If you expect to be richer in the future, the marginal utility of spending $100 today will be higher than if you were to spend it in 10 years when you expect to be twice as rich. Accordingly, you will demand interest to compensate yourself for the loss of utility associated with such delayed consumption. For the same reason borrowers are willing to pay interest. By spending the borrowed money today, they gain higher marginal utility compared to the future utility they forgo when paying back the debt. Now, let's flip things and suppose people expect to be poorer in the future. If you expect that your future wealth will be cut in half, saving $100 today and spending it in the future will give you significantly higher marginal utility. This is the equivalent of saving for a rainy day. Under such scenario, delayed consumptions results in a gain for the saver and a loss to the borrower. In order to induce the borrower to take on more credit, the interest rate has to be negative. And here comes the catch, savers can arbitrage negative equilibrium rates by simply holding cash or bank deposits at 0%. The higher rate forces an excess of savings and shortage of borrowing, which depresses economic activity. Evidence that this is exactly what's been happening in the US economy over the last 4 years is the unprecedented level of excess reserves in the banking system which currently sit at $2.4 trillion.
There could be a number of reason why people fear their economic prospects and expect to be poorer in the future - the collapse of home values, the loss of good paying jobs, the national debt, uncertainty about the long-term viability of medicare and social security. Investors, having been burned twice in the last 15 years, may fear another boom-and-bust cycle. The wealthy my expect higher levels of future taxation. Corporations may continue to hold large cash balances after having looked into the economic abyss when Lehman Brothers collapsed. Baby-boom retirees may fear that productivity will not keep up with the aging population and declining workforce.
Is this doom-and-gloom a permanent feature of US economic landscape? David Rosenberg, the chief economist and strategist at Gluskin Sheff, doesn't buy stagnation fears because US households and the Federal government have de-levered while increased energy production has helped cut the trade deficit in half. Also, the Fed continues to pump money in the economy which should continue to inflate asset prices and increase the risk of another bubble. I don't know whether Larry Summers and Paul Krugman are justified to worry about stagnation, but what I do know is that policy makers lack the political will and the right tools to deal with an extended economic slump, should the economy continue to face anemic growth and high unemployment.
Aside from continued monetary stimulus as discussed above, there are three policies that can provide a significant boost in the fight against secular stagnation. Despite wide-spread public support, the first two proposals are stymied in Congress due to political gridlock and ideological intransigence. The third proposal requires a new framework for monetary and fiscal policy and as such requires more deliberation and public debate.
The first proposal is a grand bargain that sets the federal budget on a sustainable path and preserves Social Security and Medicare. In the current state of limbo, when pundits profess unsustainable fiscal deficits and the impending collapse of these programs, the wealthy fear higher levels of future taxation while the middle class is concerned with their prospects for retirement. Such a grand bargain, even if it involves small reduction in benefits and marginally higher taxes, will have an immediate effect on current sentiment. For the rich, paying higher taxes today will remove the uncertainty of paying even higher taxes in the future. For the middle class such a deal will provide certainty that these crucial retirement programs will be preserved. Counter to conventional thinking, a grand bargain which raises taxes could initiate a strong bull market and a sustained period of growth simply by restoring optimistic expectations and raising equilibrium interest rates back into positive territory.
Progressive immigration policies can also have a positive effect especially as the baby-boom generation begins to retire. Aging population and declining workforce is probably the greatest long-term force behind secular stagnation. There is no better recipe for long-term growth than bringing in the smartest, the most entrepreneurial, the hardest-working people from around the world. Passing immigration reform and encouraging immigration can be the second-leg of a pro-growth policy that will significantly reduce the risk of secular stagnation in the coming decades.
The third proposal has to do with fiscal policy and specifically, granting taxing authority to the Fed. As I've observed in prior posts, the Fed has a limited tool set. It can only influence the supply of money but not what people do with that money (a.k.a. the demand for money). The Fed cannot directly compel people to spend and invest. However, should the Fed gain control over fiscal deficits and surpluses, it will have the ability to expand and contract the money supply through monetary flows in the real economy. Suppose Congress establishes a new Federal sales tax and gives the Fed authority to set the respective tax level. In a normal economy, the Fed will set the tax at 0%. If the Fed wants to spur the economy, it could lower the tax to -5%, turning into a sales credit. If the Fed wants to slow down an overheating economy, it could raise the tax to +5%. Investment credits could work in a similar fashion giving the Fed a powerful tool for managing investment activity on a macro-level. Another tax that should be controlled by the Fed is the capital gains tax. Currently, there is a lot of uncertainty as to future tax levels which hampers investment. However, should the tax percentage payable on capital gains be fixed at the time the investment is originally made regardless of when it is sold, such tax uncertainty will be removed. More importantly, during a recession the Fed can lower the capital gains tax which will immediately raise returns and spur investment when the economy needs it the most.
Granting such fiscal authority to the Fed will give rise to powerful new tools for dealing with the economic cycle. New money supplies provided by the Fed will be spent and invested directly in the economy rather than being stuffed in mattresses or bank deposits as is the case today. An added benefit is that the Fed can fight off stagnation and deflation by lowering taxes to the point where the marginal utility of current spending once again rises above the perceived utility of future expenditures. Such tools can be just as effective in an inflationary environment. The Fed can simply raise taxes on current spending and investment, which will immediately act to cool off the economy. This can be especially useful in the aftermath of QE. The public holds unprecedented amounts of money, and if inflation expectations were to change, traditional monetary tools may prove futile.
Is such proposal politically feasible? As I mentioned earlier QE has not come without a political price - the Fed is deeply unpopular in conservative circles, and the likelihood that Congress will delegate some of its taxing authority is practically non-existent at the moment. A possible political framework for a compromise is a constitutional amendment which requires Treasury to run a balanced budget while giving the power to run budget deficits and surpluses to the Fed within parameters pre-approved by Congress. Such compromise is based on the simple idea that there is no free lunch and everything the government does should be paid for. The decision whether to issue more debt to pay for current deficits or to reduce the national debt by running fiscal surpluses is strictly a monetary one and as such should reside with the Fed.