photo: Chris Potter
Secular stagnation and escape routes
Paul Krugman and Larry Summers are having an interesting conversation on secular stagnation and the continuing decline in global real interest rates. The ‘new secular stagnation hypothesis’ was first evoked by Larry Summers in his now famous speech at the IMF in 2013, and subsequent elaborations, to explain the persistent under-performance of output growth in industrial economies. Summers conjectures that aggregate demand may have collapsed (even long before the crisis, although it was then masked by unsustainable finances) due to substantial shocks that have led people to raise their savings while simultaneously reducing investment propensities. Under normal circumstances, Summers argues, interest rates would fall (driven either by market forces or policy actions) until saving and investment are equated at the full employment level. However, this adjustment process comes to a stop if interest rates cannot fall enough to discourage saving and encourage investment, which is typically the case when nominal interest rates approach the zero lower bound. In fact, Summers warns that even if interest rates are not constrained from below, efforts to lower them give rise to financial stability problems. For this reason, he recommends policy strategies aimed to raise the natural interest rate by increasing public investment, reducing structural barriers to private investment, and taking measures to promote business confidence, maintain spending power and redistribute income towards people with a higher propensity to spend.
Krugman shares much of Summers’ analysis. However, his approach is framed in the Hicksian liquidity trap logic, the same that he used to understand Japan’s depression going back to the late 1990s (Krugman 1998). The approach represents a situation where people have low expectations about their future incomes and want to save more than the economy can absorb, leading to a negative natural rate of interest. In such a situation, since nominal interest rates are bound from below by zero, the economy is caught in a liquidity trap where conventional monetary policies become impotent and injecting monetary base into the economy has no effect on spending: money and bonds are viewed by the private sector as perfect substitutes and no open market operation, however large, can get the economy to full employment. Krugman’s recommendation was, then, that the central bank would increase the money supply to raise prices by the same proportion, thus lowering the real interest rate until it equaled its natural level. In Krugman’s view, key to achieving this objective was that the money increase be perceived as permanent, so that escaping the liquidity trap could be engineered by influencing expectations, and that central bank action to push for higher inflation be bold enough (if necessary, even through a credible promise to be irresponsible) so as to gain the necessary traction on expectations.
Summers, by his own admission, has never related well to Krugman’s liquidity trap analysis, from which the economy is lifted out by assuming a sufficiently inflationary policy that drives ex-ante real rates down enough to stimulate spending. He sees that assumption as a deus ex machina that inexplicably happens to be there at the right time. Krugman, on his side, acknowledges that the approach he took back in 1998 is today inadequate, and recognizes that even a central bank’s credible promise to be irresponsible might do nothing if people don’t believe that inflation will rise. He thus concludes that the only way for policymakers to generate a sustained rise in inflation is to accompany a changed monetary regime with a burst of fiscal stimulus. From the conversation emerges a substantial convergence on the idea that escaping secular stagnation necessarily requires the active use of fiscal policy.
Liquidity traps and fiscal policy
Convergence on the need for active fiscal policy in situations where the natural interest rate is negative reveals an appreciation of the crucial fallacy of pre-crisis mainstream macroeconomics, which has led many to believe that monetary policy alone can extricate the economy from recessions. The fallacy rests on the engrained belief that, aside from transient rigidities, monetary expansion always and necessarily raises the equilibrium price level. Combined with rational expectations, this belief underpins the tenet whereby an increase in the expected rate of money supply growth always and necessarily produces an equiproportional increase in expected inflation. The tenet fails to consider two important factors. First, it neglects whether or not the economy is at full employment (typically it is not, if the natural interest rate is negative and lower than actual real interest rates): in the presence of large resource slacks, monetary impulses may have price as well as real effects. Second, and even more importantly, the tenet neglects whether the velocity of money circulation changes in response to monetary stimulus. Even if one approaches money from the classical quantity theory standpoint (mv=py), where y is given, any addition to m must be put in circulation first and circulate at constant v for it to produce an equiproportional increase in p. The impact of m on p depends on whether the money is actually spent, and the expected inflationary impact of money depends on people expecting money to be spent: if people refrain from spending and expect others to do the same, they don’t buy into the money neutrality tenet and (expected) inflation simply won’t rise. There cannot be any ‘immaculate’ inflation effect in a flesh-and-blood economy, while there must be a transmission mechanism that transforms monetary impulses into price effects. Yet, the assumption of immaculate inflation is so deeply entrenched in macro-economic theorizing that some economists (under the new rubric of ‘Neo-Fisherism’) today even believe that low interest rates are deflationary and that achieving higher inflation simply requires the central bank to announce a policy of higher nominal interest rates.
Keynes’ liquidity preference theory (LPT) helps understand the nature of the fallacy. According to Keynes, liquidity preference is the decision about the degree of liquidity at which savings should be held, and it is determined by agents’ expectations and state of mood: it is a decision concerning the stock of savings – wealth – at any point in time, rather than the flow of saving. In Keynes’ LPT, the rate of interest is not determined by the supply and demand for saving flows, but by the supply and demand for assets into which holdings of the stocks of wealth can be placed. In other words, the interest rate depends not on the strength of the desire to hold wealth, but on the strengths of the desire to hold it in liquid and illiquid forms respectively, coupled with the amount of the supply of wealth in one form relatively to the other.
In LPT terms, the low interest rates prevailing during the global crisis and since then can be explained by the extremely strong liquidity preference dominating all sectors of the economy (including the financial and the external sectors), rather than by a persistent tendency for planned savings to exceed planned investment. Strong liquidity preference means that agents want to stay liquid: consumption, investment and investment finance all freeze, causing economic activity to come to a gridlock, and the economy falls into a liquidity trap where, contrary to mainstream predictions (see above), any money injected into the system would be hoarded, with no effects whatsoever on prices or output.
In a liquidity trap, the high premium on liquidity is such that nominal interest rates on liquid assets should move into the negative territory to such an extent as to neutralize the premium and incentivize private sector spending. If this is not feasible or, as Summers warns us, if doing so carries risks of its own, the only available alternative is fiscal action, meaning that either the government undertakes direct spending programs or transfers money to those agents who are ready and willing to spend it.
Fiscal policy and recovery in Eurozone crisis-countries
The convergence on fiscal policy as the necessary escape route from secular stagnation has deep implications for the Eurozone. Here GDP is today almost 15% below its 2008-estimated potential. Even if the worst of the recession seems to be over, the crisis-hit countries of the Eurozone still struggle with too low inflation and weak output growth. Recovering pre-crisis conditions will be very hard for them and will take very long, in the absence of extraordinary measures.
Some believe that internal devaluation and structural reforms are the only solid conduit to growth and stability, and point to cases like Spain to support their belief (Buck 2015). Yet, while there are strong reasons to consider such belief as much less than persuasive (Tilford 2015), fallacy of composition arguments make it unreasonable to expect that countries can export their way out of the crisis all at the same time, each cutting prices and making markets more flexible than the others. At best, some countries will gain as others lose in a dangerous ‘beggar thy neighbor’, race-to-the-bottom game.
The ECB has so far pumped billions of QE money into the banking systems, but little of it has gone into new lending at more favorable terms to borrowers. Sure, the money pumped in has lowered interest spreads on riskier government bonds, giving some relief to tightly constrained national public finances, and has given oxygen to exporting industries by weakening the euro. But is this enough? Can this have lasting and large enough effects? Would an expansion of the current QE program prove an effective complement to fiscal rigor and competition policies for delivering speedy recovery in crisis-hit countries? If not, what else can these countries do that is not inconsistent with given rules?
In countries where rules constrain the fiscal space available for governments to support economic growth, the introduction of Tax Credit Certificates (TCC) has been proposed as a way form national governments to boost demand and improve competitiveness to levels that would not be possible under the current fiscal constraints and yet without breaching existing rules. The details of the TCC proposal are discussed elsewhere. Here I just want to emphasize some of its major features. TCC entitle their holders with the right to receive tax rebates equal to the TCC face value; the right to tax rebates may be exercised two years after TCC issue-date. TCC do not commit issuing governments to future debt payment obligations, but to accept TCC at redemption in exchange for equivalent tax reductions to TCC redeemers. TCC are transferable and can be converted in euro at a discount. People who sell TCC get liquidity that can be immediately spent; those who buy them purchase titles to future tax cuts. Intermediaries facilitate TCC trading, making money from bid-ask spreads.
Government assigns TCC free of charge to households and business enterprises. By issuing and transferring massive amounts of TCC to households (in inverse proportion to their income), the government triggers an immediate, large demand increase financed by future tax cuts. TCC enable the private sector to monetize and spend today tax cuts that will come into effect only at a future date. The deferral before redemption allows sufficient time for demand-driven output to grow (via the income multiplier) and generate the tax revenues needed to cover for the budget shortfalls caused by redemptions. TCC assignments to business enterprises, on the other hand, allow firms to reduce their tax wedge, save on labor costs and reduce prices, thus becoming more competitive. Greater competitiveness translates into export and import substitution, thus offsetting the impact of demand on imports and the trade balance. TCC issuances can be calibrated so as to close the ‘output gap’ caused by the crisis. In the case of Italy, for example, where the output gap is larger than in the Eurozone average, they could start from a level as high as 5% of annual GDP, and increase gradually up to 10% as needed. They then would be modulated to ensure high levels of employment consistently with domestic (inflation) and external (trade) balance.
The TCC program is consistent with the lessons from Krugman and Summers, and their convergence on the need for aggressive fiscal policy as the necessary antidote to secular stagnation. The program stands as a type of fiscal intervention that can lift off the economies of the Eurozone from a low-growth, ultra low-inflation environment without endangering their financial stability and external balance position and, as important, without breaching EU fiscal rules or calling for euro exit strategies.
Andolfatto, D. (2015) “NeoFisherism without rational expectations,” MacroMania, 31 October.
Bossone, B., M. Cattaneo, E. Grazzini, and S. Sylos Labini (2015) “Fiscal Debit Cards and Tax Credit Certificates: the best way to boost economic recovery in Italy (and Other Euro Crisis Countries),” EconoMonitor, 8 September.
Buck, T. (2015) “Spain: Recovery position,” Financial Times, October 22.
Cohen-Setton, J. (2015) “Understanding the Neo-Fisherite rebellion,” Bruguel, 19 July 2015.
Krugman, P. (1998) “It’s baaack! Japan’s slump and the return of the liquidity trap,” Brookings Papers on Economic Activity 2.
Summers, L. H. (2014a) “U.S. Economic Prospects: Secular Stagnation, Hysteresis, and the Zero Lower Bound,” Business Economics, Vol. 49, No. 2, National Association for Business Economics.
Tilford, S. (2015) “The Pain in Spain,” Project Syndicate, 28 October.
Tily, G. (2012), “Keynes’s monetary theory of interest,” BIS Paper 65.
 See L. Summers, “Where Paul Krugman and I differ on secular stagnation,” The Washington Post, 2 November 2015, and P. Krugman,“Liquidity Traps, Temporary and Permanent,” The New York Times, 2 November 2015.
 Among such possible shocks, Summers includes slower population and technological growth, meaning a reduction in the demand for new capital goods to equip new workers; lower priced capital goods, meaning that a given level of saving can purchase much more capital than was previously the case; rising inequality and the consequent decline of the income share going to people with higher propensity to spend; and increasing frictions in financial intermediation as well as higher uncertainty and greater risk aversion engendered by the financial crisis.
 See P. Krugman, “Secular Stagnation, coalmines, bubbles, and Larry Summers,” The New York Times, 16 November 2013.
 For a discussion of Neo-Fisherism, see Cohen-Setton (2015). In commenting a recent contribution on by D. Andolfatto (2015) on this issue, Nick Rowe and I argue that the Neo-Fisherian effect can only hold as a result of an expansionary fiscal stimulus.
 For a comprehensive discussion of Keynes’ theory of liquidity preference, see the excellent work by Tily (2012).
 For a concise description of the TCC proposal, see Bossone et al (2015). The idea of TCC was originated by M. Cattaneo, and is the basis of an economic proposal elaborated in a public manifesto by M. Cattaneo, E. Grazzini, S. Sylos Labini and myself, and available in English translation here. An in-depth study of the various (economic, legal, accounting and institutional) aspects involved by the proposal is the subject of the recent e-book, “Per una moneta fiscale gratuita. Come uscire dall’austerità senza spaccare l’euro,” edited by the same authors and available here.