Krugman, Following Summers, Weighs In on Bubble Debate

We have now passed the event horizon into a world run by Dr. Pangloss. In a Sunday afternoon post, Paul Krugman enthusiastically endorses an IMF presentation by Larry Summers which depicts asset bubbles as necessary and desirable. And that means they both agree they should not only continue, they should be encouraged.

I am not making this up. Here are the key bits of Krugman’s post. He starts by saying that the economy is in a liquidity trap, and Summers pretty much agrees even though he does not use that turn of phrase. Krugman continues:

We now know that the economic expansion of 2003-2007 was driven by a bubble. You can say the same about the latter part of the 90s expansion; and you can in fact say the same about the later years of the Reagan expansion, which was driven at that point by runaway thrift institutions and a large bubble in commercial real estate…

So how can you reconcile repeated bubbles with an economy showing no sign of inflationary pressures? Summers’s answer is that we may be an economy that needs bubbles just to achieve something near full employment – that in the absence of bubbles the economy has a negative natural rate of interest…

So with all that household borrowing, you might have expected the period 1985-2007 to be one of strong inflationary pressure, high interest rates, or both. In fact, you see neither – this was the era of the Great Moderation, a time of low inflation and generally low interest rates. Without all that increase in household debt, interest rates would presumably have to have been considerably lower – maybe negative…

Currently, even policymakers who are willing to concede that the liquidity trap makes nonsense of conventional notions of policy prudence are busy preparing for the time when normality returns. This means that they are preoccupied with the idea that they must act now to head off future crises. Yet this crisis isn’t over – and as Larry says, “Most of what would be done under the aegis of preventing a future crisis would be counterproductive.”…

Of course, the underlying problem in all of this is simply that real interest rates are too high. But, you say, they’re negative – zero nominal rates minus at least some expected inflation. To which the answer is, so? If the market wants a strongly negative real interest rate, we’ll have persistent problems until we find a way to deliver such a rate.

One way to get there would be to reconstruct our whole monetary system – say, eliminate paper money and pay negative interest rates on deposits. Another way would be to take advantage of the next boom – whether it’s a bubble or driven by expansionary fiscal policy – to push inflation substantially higher, and keep it there. Or maybe, possibly, we could go the Krugman 1998/Abe 2013 route of pushing up inflation through the sheer power of self-fulfilling expectations.

The insanity of all this is that it finesses the elephants in the room: government spending (as in deficits) and business investment. In this topsy-turvy account, Krugman treats the rise in household debt as a good thing, when economic studies have concluded that rising levels of household debt fund generally unproductive activities (as in they are not pro-growth).

So why haven’t businesses invested more? In a section I’ve skipped over, Krugman contends that investment is correlated with household growth, and it has slowed since the baby boom era, but not as dramatically as Krugman suggests. A fall in average household size has offset slowing population growth rates. Per Census data, the increase in the number of households from 1960 to 1970 was a compounded annual growth rate of 1.65% versus 1.47% from 1980 to 1990 and 1.3%. And for a trade economist, he curiously omits the role of persistent trade deficits from the Reagan era onward, which is tantamount to America exporting jobs. As Dean Baker points out:

Summers and Krugman seem to be leaving net exports out of the picture. In the old textbooks, rich countries like the United States were supposed to be net exporters of capital to developing countries. This implies that instead of running trade deficits we should be running surpluses This would both mean a higher return on capital in rich countries and more rapid growth in developing countries, which would be able to use imported goods and services to build up their capital stock even as they sustained a decent level of consumption for their populations.

The real world never followed the textbook story very closely, but it followed especially badly in the years following the 1997 East Asian financial crisis. The harsh terms of the bailout (led in part by Larry Summers) led to a situation in which developing countries began to accumulate massive amounts of reserves to protect themselves from ever being dictated to by the IMF in the same way. Instead of being importers of capital from rich countries developing countries became huge exporters of capital. This meant that the United States in particular had a huge trade deficit that created a huge drag on demand.

But the really crazy part of this analysis is the primary role it gives to interest rate policy. This is the loanable funds fallacy. As we wrote in 2011:

In really simple terms, there is a “loanable funds” market in which borrowers and savers meet to determine the price of lending. Keynes argued that investors could have a change in liquidity preferences, which is econ-speak for they get freaked out and run for safe havens, which in his day was to pull it out of the banking system entirely. [John] Hicks endeavored to show that the loanable funds and liquidity preferences theories were complementary, since he contended that Keynes ignored the bond market (loanable funds) while his predecessors ignored money markets.

But that’s a deliberate misreading. Keynes saw the driver as the change in the mood of capitalists; the shift in liquidity preferences was an effect. (In addition, Keynes held that changes with respect to existing portfolio positions, meaning stocks of held assets, would tend to swamp flow effects captured by loanable funds models.)

Making money cheaper is not going to make anyone want to take risk if they think the fundamental outlook is poor. Except for finance-intensive firms (which for the most part is limited to financial services industry incumbents), the cost of money is usually not the driver in business decisions, Market potential, the absolute level of commitment required, competitor dynamics and so on are what drive the decision; funding cost might be a brake. So the idea that making financing cheaper in and of itself is going to spur business activity is dubious, and it has been borne out in this crisis, where banks complain that the reason they are not lending is lack of demand from qualified borrowers. Surveys of small businesses, for instance, show that most have been pessimistic for quite some time.

If you want to put it in more technical terms, what is happening is a large and sustained fall in what Keynes called the marginal efficiency of capital. Companies are not reinvesting at a rate sufficient rate to sustain growth, let alone reduce unemployment. Rob Parenteau and I discussed the drivers of this phenomenon in a New York Times op-ed on the corporate savings glut last year: that managers and investors have short term incentives, and financial reform has done nothing to reverse them. Add to that that in a balance sheet recession, the private sector (both households and businesses) want to reduce debt, which is tantamount to saving. Lowering interest rates is not going to change that behavior. And if you try to generate inflation in this scenario, when individuals and companies are feeling stresses, all you do is reduce their real spending (and savings power) and further reduce demand (and hence economic activity).

Why are big companies not investing? It’s not because they need negative interest rates as a kick in the pants. Why should that induce them to invest, as opposed to buy even more stock back, or buy other companies’ stocks (as in make acquisitions)? They are not investing because they have become hopelessly short term. Even in the last expansion, they were net saving. And the reason was executive incentives. I was hearing repeatedly from McKinsey that it was pretty much impossible to get clients to approve any investment or new product idea, no matter how fast the payback. They were absolutely intolerant of any hit to their income statement, and investments inevitably also entail spending (hiring staff, investing in advertising) before the revenues kick in. No amount of dorking with interest rates will solve that problem.

By e-mail, Marshall Auerback of INET also described the other yawning problem: that the real problem is demand, and that can only be solved by fiscal policy, not by monetary policy. Summers apparently did mention fiscal policy, but it’s not clear how much emphasis he gave it; Krugman treats it as a mere aside in his post. From Auerback:

The “liquidity trap” argument is a bit of a sideshow. While it is true that the very low interest rates also mean that the opportunity cost of cash (against storing the speculative balances in interest-bearing assets) is very low and so there is no difference between having a government bond or cash. Yet the mainstream view – for those who believe that liquidity traps “switch off” monetary policy effectiveness and “turn on” fiscal policy effectiveness – is that once the economy recovers, there is a massive inflation threat sitting in the system in the form of the build up of the monetary base.

The fact is that a recession occurs when spending persistently falls short of the sales expectations of firms, which conditioned their decisions to employ and produce. Not wanting to accumulate inventories, firms reduce production and lay off workers.

The reasons why private spending collapses are many as are the reasons why it might not recover quickly. They can mostly be summarised by the term “lack of confidence” which is exacerbated by rising unemployment and the loss of income that accompanies it.

And the incentive structure is all wrong because you have a financialised economy where using surplus cash to prop up stock prices facilitates higher compensation for CEOs (and higher bonuses for Wall Street brokers and fund managers). Add to that sluggish demand and why would a company invest in additional plant or other forms of investment? Especially when the consequences for control fraud are so meaningless. JPM or Steve Cohen get the equivalent of a speeding ticket, as Judge Rakoff noted.

At any rate, the key is fiscal policy, not the level of interest rates per se. Irrespective of the level of interest rates and the state of private desire to hold cash balances the way forward when private spending collapses is for public spending to take its place.

Of course, when you don’t believe in using fiscal policy to plug a hole in collective spending power (as appears to be the case all across the globe right now), then it follows that one might find some perverse logic in encouraging bubbles, in the hopes that private portfolio risk preferences will shift and drive economic activity. That is the real rationale behind QE, as NY Fed Executive Vice President, Brian Sack, noted when the policy was first introduced.

And, as Bill Janeway has noted:

[W]hen the damage of the speculation is limited to the market for equity and debt securities, the adverse economic consequences of the bubble’s popping may be muted. Further, when the object of speculation is a transformational technology, a new economy can emerge from the wreckage. That is why, for example, the consequences of the tech bubble in 2001 were radically different from those of the housing bubble in 2008.

The problem is that speculation has infected the credit system to a large degree and that problem has not been rectified, so encouraging bubble-like behaviour at this juncture is systemically dangerous, as Dean Baker notes:

In the case of the housing bubble in particular we saw millions of people lose much or all of their wealth from buying homes at bubble-inflated prices. The loss of housing wealth is especially devastating because housing is a highly leveraged asset even in normal times and it is an asset often held by middle and moderate income households. It was great that the bubble was able to spur growth and get the economy close to full employment, however the subsequent crash was pretty awful. It would be incredibly irresponsible to go through another round like this.

The second qualification is that it is reasonable to believe that aggregate consumption levels will depend at least in part on the distribution of income. The upward redistribution in the last three decades, from middle and lower end wage earners to the high end wage earners in the 80s and 90s, and to corporate profits in the last decade, likely had an effect in depressing consumption. The question here is whether the marginal propensity to consume out of income is higher for a retail clerk or factory worker than a doctor or CEO. I would be willing to argue that it is, which means that the upward redistribution of income over this period had a depressing effect on consumption. (As a practical matter, this depressing effect was offset by the asset bubbles in the 1990s and 2000s.)

The mainstream economists were totally wrong several years ago when they predicted the business cycle was dead (even though these very same economists continue to receive Nobel Prizes for their bogus scholarship). Once the crisis emerged they have consistently made predictions about inflation, interest rates and debt default that have been false (I am excluding the EMU nations here for obvious reasons).

As each year passes and the empirical reality further negates their story they continue unabashed. Krugman has been right on so much, and has emphasised the importance of pro-active fiscal policy, so it’s hard to see why he has to go back to the bankrupt theory of the liquidity trap to rationalise what is essentially a problem of political dysfunction..The slow recovery has nothing to do with a liquidity trap. It has all to do with a lack of overall spending which means if private individuals are reluctant to spend (for whatever reason) then governments have to fill the gap. There is nothing more simple than that proposition.

And if you want to add to political dysfunction, you can’t find better grist for generational warfare than keeping housing prices high, which puts young people who already face the impediments of a lousy job market and in many cases, student debt burdens, at a further disadvantage.

The bottom line is that it’s remarkable to see the lengths to which Krugman will go to defend a broken status quo, both in Washington and the economics profession.

This piece is cross-posted from Naked Capitalism with permission.

One Response to "Krugman, Following Summers, Weighs In on Bubble Debate"

  1. theyenguy   January 17, 2014 at 8:43 am

    With the bond vigilantes calling the Benchmark Interest Rate, ^TNX, higher from 2.48%, economic action, has changed from one of inflationism to one destructionism, where there is the “dreaded experiences”, specifically the death of fiat money, the death of fiat wealth, economic deflation, nation state default on Treasury Debt, economic destruction, disregard for personal property, disregard for person property rights, and disregard for people as persons.

    The Benchmark Interest Rate, ^TNX, that is the cost of US Treasury Debt, TLT, was formerly the Means of Economic Inflationism. But, with its rise from 2.48%, on October 23, 2013, it commenced the failure of trust in the monetary policies of credit stimulus of the Creature from Jekyll Island, and the economic policies of investment choice of democratic nation states. Now, The Interest Rate on the US Ten Year Note, ^TNX, is the Means of Economic Destructionism, establishing economic deflation and economic recession, terminating economic inflation and economic growth, and thus terminating the paradigm and age of liberalism, and birthing that of authoritarianism.