Secular Stagnation Part II - On Bubble Business Bound

"I now suspect that the kind of moderate economic policy regime...... that by and large lets markets work, but in which the government is ready both to rein in excesses and fight slumps – is inherently unstable."
Paul Krugman - The Instability of Moderation

"Conventional macreconomic theory 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 that go 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 period of the crisis if equilibrium interest rates can't be achieved given the prevailing rate of inflation."
Larry Summers - IMF 14th Annual Research Conference In Honor Of Stanley Fisher,

Discussion surrounding the Larry Summers speech to the autumn 2013 IMF research conference (text here) - where he suggested that what we might be observing in developed economies is a phenomenon similar to that which Alvin Hansen (writing in the 1930s) termed secular stagnation (see eg here) - has been intense, raising a plethora of issues, among them whether or not modern developed economies NEED to continually generate bubbles to sustain growth.

Naturally one part of the debate currently taking place revolves around whether or not secular stagnation exists at all. Here I think we can safely leave the heavy lifting part of the argument to Messrs Krugman, Summers et al who will through their ongoing work continue to defend the "aye" corner. The issue, at the end of the day is going to be an empirically testable one, even if - in a discursive space where rival world views are constantly in play - things are never, ever, quite that simple.

Permanent Fiscal Stimulus?

But there is another, equally important, part to this problem.  Suppose for a moment that the secular stagnation thesis is a valid one, and suppose - as I argue in the introduction to this series - that the phenomenon is the result of a slowdown in the rate of growth (turning eventually into contraction) in working age populations in one country after another. Then add to this the further supposition that the process is ongoing (ie not the product of a "baby boom" generation or any such similar "one off") and effectively irreversible.

If these three suppositions jointly and severely satisfy the minimum conditions necessary to warrant their being explored, then we have to face the possibility - as Larry Summers does (and as Eggertsson and Mehrotra attempt to do via the elavoration of  a  model) -  that the conditions might be given whereby what is called the "natural" (or equilibrium) rate of interest gets stuck in permanently negative territory and and thus become - to all intent and purpose - permanently out of reach. So, asks Larry, how can we justify the fiscal deficits we run as being purely counter-cyclical? Or, as Paul Krugman puts it after reading the Eggertsson and Mehrotra  paper, "I’m wondering in particular whether there is a possibility of sustaining the economy with permanent fiscal expansion".

Larry Summers doesn't go quite so far. In an article in the Financial Times - Why stagnation might prove to be the new normal - he recognizes there is a risk of producing bubbles when there is a continuous and unending  application of non-conventional measures, but then, somehow, he seems to duck the bigger question: namely what can realistically be achieved and at what cost. Rather than the issue being -  as presented by Keynes (see my intro to this series)  - how we manage the consequences of inevitable population decline, Summers asks us 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".

Naturally, there are assumptions here - large ones - that need to be thought about. Do developed economies really have a growth potential, above and  beyond that which is already being manifested. How do we know that? How can we confirm or deny the hypothesis? How can we be sure that long term growth potential is not simply being systematically negatively reduced by the decline in working age populations?

At the very minimum we are in need of one positive counter example, one which shows that there is an underlying potential waiting to be unleashed.

Today's Situation Very Different From 1930s

The current situation is very different from the one John Maynard Keynes contemplated in the 1930s in his General Theory. At that point in the evolution of our economies and our societies the more advanced economies were stuck in a long lasting depression, a depression whose general dynamics are still far from being adequately understood, but one which was at least partly being perpetuated by the ineffectiveness of monetary policy due to the presence of a liquidity trap. The problem at that time was not simply cyclical, and certainly attempts to address it offer pointers to how we can handle our present day one. But the 1930s problem was not not in-principle self perpetuating. Economies really were being held back, as subsequent history has shown.  

Today many economies are suffering the effects of a liquidity trap, but this time what we have is not simply a transient phenomenon since that trap is being generated by the impact of long term demographic changes in a way which was not the case in the 1930s - indeed you could speculate that in some countries the liquidity trap is a by-product of being stuck in a low fertility one. So the temporary application of exceptional fiscal and liquidity measures isn't going to resolve the "problem" (if problem - as opposed to inevitable and natural evolution in our economic and demographic regimes -  there be) since once the effects of these wear off the economy may simply return to its old lethargy. This outcome I fear is one we will see in Japan if the Abenomics stimulus is ever removed.

Thus we are not simply talking about what Keynes referred to in his Essays in Persuasion as "magneto trouble" (despite this being one of PK's favourite analogies), wherein "the economic engine was as powerful as ever — but one crucial part [the magneto]was malfunctioning, and needed to be fixed". Which, we may ask, is the component which needs to be "fixed" here - I reiterate - could it possibly be fertility?

That's why people are talking about permanent fiscal stimulus, assuming "stimulus" is the appropriate word here. If it is then the definition of  "austerity" transits into "failure to apply permanent fiscal  stimulus".  It's a new and different world, one where there is no "back" to head for, or as the American writer Thomas Wolf put it, "you can look homeward, angel", but "you can't go home again".

And Permanently Rising Sovereign Debt?

So to take the standard case, Japan, we might like to ask ourselves what the risks involved in carrying out such permanent stimulus actually are. Curiously the worry here isn't the standard one, hyperinflation. The Bank of Japan and the Ministry of Finance are pumping large amounts of "juice" into the economy, but trend growth is only being sustained at something just over 1% per annum, and outside periods of rapid yen devaluation or consumption tax hikes there is little to be seen in the way of demand led inflation.

The BoJ is currently buying virtually all new issue Japan Government Bonds (holding in doing so the interest rate on 10yr debt at around 0.6%) and the MoF is funding something like 10% of GDP in annual deficit spending by selling bonds to the central bank.

Despite such strong policy measures, the  only incontestable negative that stands out is the accumulation of  a lot of government debt. In the Japanese case, and to date, it amounts to something like 245% of GDP. Obviously such a high level of sovereign indebtedness commands respect, but is it really, really problematic? Paul Krugman isn't convinced. As he tells us in his article "The Japan Story" (2013), "while there is much shaking of heads about Japanese debt, the ill-effects if any of that debt are by no means obvious."

Time Out With MMT

In fact there is a whole school of thought - known by the name of Modern Monetary Theory - which would argue that the ill effects are not obvious since they don't really exist. It's just a question of keystrokes.  I don't consider myself any kind of expert on the doctrines of MMT, but this critique of Paul Krugman and Larry Summers by blogger Ralph Musgrave seems to be reasonably representative of the general line of thought.

On occasion Paul has been rather dismissive of MMT writings, but the thing is his principal objection has normally been that the implementation of their approach would lead to - wait for it - inflation. Now this tack is not so surprising since it used to be the accepted basis for any mainstream critique of systematic money printing. But here's the rub, right now we seem incapable of generating systematic inflation. Not only that PK himself has been fiercely critical - and with reason - of those who had been predicting we were. In fact most of Paul's critique of MMT seems to date to an epoch before we started to ask ourselves whether the natural rate of interest might not have turned permanently negative. As he said, in a critique of MMT made back in March 2011:

"The key thing to remember is that current conditions — lots of excess capacity in the economy, and a liquidity trap in which short-term government debt carries a roughly zero interest rate — won’t always prevail. As long as those conditions DO prevail, it doesn’t matter how much the Fed increases the monetary base, and it therefore doesn’t matter how much of the deficit is monetized. But this too shall pass, and when it does, things will be very different."

It's the "won't always prevail" bit which grabbed my attention. Now it is clear we are contemplating the possibility that it might, in which case the August 2011 observation that:

"the MMT people are just wrong in believing that the only question you need to ask about the budget deficit is whether it supplies the right amount of aggregate demand; financeability matters too, even with fiat money."

would seem to be no longer valid, either that or it is highly relevant to the discussion about whether or not Japan government debt really is so benign. I think you can't have it both ways. For my part I'm not at all sure PK is right in being so complacent about Japan debt, and indeed I have explored some of the possible Japan end-games with Claus Vistesen in our piece Japan's Looming Singularity. But even beyond potential financeability problems  (eg just how deep into negative territory can you take a central bank balance sheet and live to tell the tale), there are other more traditional problems which arise, especially if the supplier for the newly induced aggregate demand lies outside the borders of your economy leading the current account balance to go west (see my "The Growing Mess Which Will Be Left Behind By The Abenomics Experiment").

Why Then Is There A Risk Of Bubbles?

 The characteristics of liquidity traps are well known. Central banks increase their balance sheets (M1, base money) but this increase fails to feed through either to expansions in  broader money indicators (M3, credit to the private sector), or to real economic activity (employment, consumption) or even to inflation.

 When their balance sheets are leveraged in a more targeted sense, such as in programmes to promote specific sectors of bank lending, the risk of sectoral mini bubbles increases, as we are currently seeing in the UK.

I won't go into all this more here, since I have recently written extensively on the topic (see the Hot Labour Phenomenon), but it seems clear that a lot of the liquidity which is being pumped into the system by the ECB in an attempt to reflate economies on the Euro periphery is in fact arriving in cities like London, Berlin and Geneva (and specifically their housing sectors) producing all sorts of "bubbly" type activity and distortions in the domestic economies of the countries concerned, distortions which will prove hard to correct later, and may become highly negative in their effect should they eventually unwind.

All this liquidity may not have helped restore the real economies in the intended recipient countries, but it certainly - via "carry trades" and suchlike - made its presence felt elsewhere. Emerging market economies like India, Turkey, Brazil, Indonesia and South Africa saw their economies on the receiving end of large quantities of short term inward fund flows,  flows which pushed the values of their currency strongly upwards, overheated the domestic economies with credit and generated long lasting distortions.

Naturally, when the US Federal Reserve started to talk about tapering its bond purchases (in May 2013) the impact was felt in one emerging economy after another across the globe, as funds suddenly began to flow out, and the values of the respective currencies suddenly started to fall sharply.

 

So you can understand Reserve Bank of India governor Raghuram Rajan's frustration when he went to Frankfurt last year and complained to his audience: "We seem to be in a situation where we are doomed to inflate bubbles elsewhere." As Larry Summers notes in his Financial Times article: "In the past decade, before the crisis, bubbles and loose credit were only sufficient to drive moderate growth". What one might ask will be needed to achieve that "moderate growth" outcome this time round?