Larry Summers’ recent address at the International Monetary Fund has been getting a ton of buzz in the econ blogosphere, thanks in no small part to Paul Krugman’s largely simpatico take.
Summers offered a bleak warning that the U.S. economy likely faces a long spell of “secular stagnation,” akin to Japan’s lost decades. In layman’s terms, this essentially means that the supply of goods and services will exceed the demand for those goods and services—and will likely do so for a long while. In other words, a return to what Americans are accustomed to thinking of as a “normal” economy simply may not be forthcoming anytime soon.
Policymakers should heed this warning: Economic recovery from this depression cannot simply be taken for granted or assumed to be imminent.
Diagnosing the Economy: The Age of Oversupply
Nearly six years after the onset of the Great Recession, the economy is far from recovered. As Summers notes, the share of adults who are working hasn’t really budged from severely depressed levels over the last four years. U.S. output continues to fall below its potential—in fact, it has fallen even further below its potential than it was at the end of the Great Recession in late 2009. Europe is in even worse shape; it is currently underperforming its economic recovery during the Great Depression.
The gist of Summers’ explanation for this economic stagnation is that the market-clearing real (that is, inflation-adjusted) interest rate equilibrating supply and demand is negative. In other words, in order to stimulate the economy enough for demand to meet the existing supply of goods and services, the Federal Reserve would have to set interest rates at a negative number. That would be like trying to charge people to make bank deposits. Because investors would (reasonably enough) respond to such a situation by not making any bank deposits, setting negative interest rates is pretty much a non-starter. In economist speak, this means that the Federal Reserve, which sets short-term interest rates, is constrained by the zero lower bound of nominal interest rates.
Unless we can reach a market-clearing real interest rate, demand will continue to fall well short of supply. Economists often refer to this disequilibrium as a “liquidity trap.” In this situation, the only way real interest rates can fall to market-clearing levels is by markedly increasing inflation, something the Federal Reserve has been unwilling to attempt.
Unfortunately, U.S. short-term interest rates have been stuck around zero since 2008, so there is little more the Federal Reserve can do to stimulate the economy short of simply announcing a higher inflation target. And a host of economic indicators suggest the United States will be stuck in this stagnant disequilibrium—what Krugman calls the “Lesser Depression”—for quite some time.
Summers’ twist is his suggestion that this adverse economic disequilibrium was really reached about a decade ago, well before the Great Recession. He’s essentially suggesting that supply of productive factors eclipsed the demand for their output in the aughts, but the housing bubble masked this fundamental shift. The implication is that the economy was bound to hit a prolonged liquidity trap emerging from the Great Recession. That would mean higher unemployment, lower interest rates, slower growth, lower output, and more subdued inflation than what economists have viewed as “normal” in recent decades. Any of that sound familiar?
The economic experience of the past two decades suggests a fundamental mismatch between global supply and demand. My TCF colleague Daniel Alpert’s new book, The Age of Oversupply, analyzes the inextricably intertwined global and domestic factors giving rise to such an imbalance, arguing that the “central challenge facing the global economy is an oversupply of labor, productive capacity and capital relative to the demand for all three.”
The Bush economy is also an odd benchmark for what “normal” looks like, if not a wholly inappropriate policy target for restoring economic health, for numerous reasons. The housing bubble was unsustainable, the trade deficit rose sharply, income inequality rose sharply, and economic policymaking was fixated with regressive, ineffective tax cuts, among other facets. All told, the Bush economic expansion (2001–2007) was the worst on record since World War II. The degrees to which this weakness was driven by global fundamentals or could be influenced by policy levers is complex but important (to be explored in a follow-up post).
The Way Forward: More Stimulus Spending
While there’s uncertainty about what a fully recovered economy would look like, we know it looks a far cry from the economy of today. And we know the economy isn’t making progress towards that recovery. To this point, Summers’ concluding remarks nail the most important economic policy question of the day (my emphasis):
Four years after the successful combatting of crisis, 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 was before. . . . We may well need, in the years ahead, to think about how we manage an economy in which the zero nominal interest rate is the chronic and systemic inhibitor of economic activity holding our economies back below their potential.
So far, Washington has done almost precisely the opposite of what Summers is suggesting.
Since the financial crisis was arrested in 2009, almost all of the Washington economy and budget policy discourse has assumed that a rapid recovery that would deliver the economy back to full health was just a few years away. For instance, economic forecasts issued by the Congressional Budget Office (CBO) routinely showed the economy returning to full economic health four years after the forecast was issued. Each new forecast pushes the recovery date back a little further.
The Washington establishment’s persistent belief that recovery is just around the corner contributed to its misdiagnosis that deficit reduction should be its top economic priority. Congressional Republicans’ twin mistakes—enacting a sizable austerity program in 2011 and allowing fiscal stimulus programs to expire—moved the economy further away from recovery.
And as my former colleague Josh Bivens of the Economic Policy Institute and I have argued, relying on such forecasts, especially when they have consistently proved overly optimistic, is a deeply risky strategy.
A paper I coauthored with my former colleagues Josh Bivens and Heidi Shierholz of the Economic Policy Institute, From free-fall to stagnation: Five years after the start of the Great Recession, extraordinary policy measures are still needed, but are not forthcoming, argues that monetary policy alone cannot return the economy to full health. Policymakers must instead turn to fiscal policy.
If the private sector is fundamentally incapable of generating adequate demand to support full employment—as a global demand deficit would suggest—the public sector must take a more active role in supporting demand and investment. Summers alluded to this, invoking a “nagging concern that finance is too important to leave entirely to financiers.”
The best candidate for increased public demand would be a massive multi-year overhaul of America’s surface transportation, rail, air, and water infrastructure. These assets are guaranteed to be more productive than empty houses in the sunbelt and will be financed at much lower interest rates. Concerns about shovel-ready projects don’t apply to an outlook of persistently deficient demand.
EPI has advocated major infrastructure investment and public stimulus spending since the onset of the Great Recession, as proposed in their latest budget proposal—an offshoot of Investing in America’s Economy—a 2010 progressive budget blueprint I coauthored on behalf of TCF, EPI, and Demos.
Likewise, a 2011 New America Foundation white paper by Alpert, TCF college Robert Hockett, and Nouriel Roubini, The Way Forward: Moving From the Post-Bubble, Post-Bust Economy to Renewed Growth and Competitiveness, called for a “substantial five-to-seven year public investment program” as one of three prongs to restore economic equilibrium. (Their other recommendations—large-scale debt restructuring and attempting to correct global demand imbalances—should also be heeded.)
Bivens and I estimated that deficit-financed fiscal stimulus on the order of $1.5 trillion to $2.0 trillion (between two-to-three times the size of the Recovery Act) would be needed to close the demand shortfall over the next three years or so. This would be intended as a big push to get the economy into a virtuous cycle with the Federal Reserve raising interest rates, and without complete relapse as fiscal expansion was gradually wound down.
Conventional wisdom says that a stimulus measure of this magnitude is crazy and politically infeasible. But as Summers’ speech suggests, conventional wisdom is turned on its head by the liquidity trap experience and by the prospect of prolonged depression.
The United States is already halfway into a lost decade, growth has been inadequate to propel recovery, and economic policy is pushing away from recovery. At minimum, trying to produce a full economic recovery with any and all policy levers can’t be crazier than complacency about the all-too-real real possibility of recoveryless Japanese-style lost decades for the U.S. economy.
Better to try now than stagnate a decade or two and then try, as Japan is now doing.