Why inflation remains best way to avoid stagnation
The prospect is that central banks will find themselves helpless, writes Tim Harford
People who were not born when the financial crisis began are now old enough to read about it. We have been able to distract ourselves with two Olympics, two World Cups and two US presidential elections. Yet no matter how stale our economic troubles feel, they manage to linger.
Given the severity of the crisis and the inadequacy of the policy response, it should be no surprise that recovery has been slow and anaemic: that is what economic history always suggested. Yet some economists are growing disheartened. The talk is of “secular stagnation” – a phrase which could mean two things, neither of them good.
One fear has been well-aired: that future growth possibilities will be limited by an ageing population or perhaps even technological stagnation.
The second meaning of secular stagnation is altogether stranger: it is that regardless of their potential for growth, modern economies may suffer from a persistent tendency to slip below that potential, sliding into stubborn recessions. The west’s lost decade of economic growth may be a taste of things to come.
This view was put forward most forcefully by Lawrence Summers, who was Treasury secretary under Bill Clinton and a senior adviser to President Barack Obama. It has been discussed at length in a collection of essays published last week by the Centre for Economic Policy Research. But what could it mean?
Normally, when an economy slips into recession, the standard response is to cut interest rates. This encourages us to spend, rather than save, giving the economy an immediate boost.
Things become more difficult if nominal interest rates are already low. Central banks have to employ radical tactics of uncertain effectiveness, such as quantitative easing. Governments could and should borrow and spend to support the economy. In practice they have proved politically gridlocked (in the US), institutionally hamstrung (in the EU) or ideologically blinkered (in the UK). There is not much reason to think the politics of fiscal stimulus would be very different in the future, so the zero-interest rate boundary is a problem.
The awful prospect of secular stagnation is that this is the new normal. Interest rates will be very low as a matter of course, and central banks will routinely find themselves nearly helpless.
“A cut in interest rates encourages us to spend, rather than save, giving the economy an immediate boost”
Before we startle ourselves at shadows, let us ask why Prof Summers might be right. Real interest rates – the rates paid after adjusting for inflation – have been falling. In the US, real rates averaged about 5 per cent in the 1980s, 2 per cent in the 1990s and 1 per cent in the Noughties. (Since Lehman Brothers failed they have been negative, but the long-term trend speaks more eloquently.) Real interest rates have also been declining in the EU for 20 years. The International Monetary Fund’s estimate of global real interest rates has been declining for 30 years.
This does not look good, so why is it happening? The background level of real interest rates is set not by central banks but by supply and demand. Low real rates suggest lots of people are trying to save, and particularly in safe assets, while few people are trying to borrow and invest. Only with rates at a very low level can enough borrowers be found to mop up all the savings.
If secular stagnation is a real risk, we need policies to address it. One approach is to try to change the forces of supply and demand to boost the demand for cash to invest, while stemming the supply of savings, and reducing the bias towards super-safe assets.
This looks tricky. Much policy has pushed in the opposite direction. Consider the austerity drive and long-term goals to reduce government debt burdens; this reduces the supply of safe assets and pushes down real rates. Or the tendency in the UK to push pension risk away from companies and the government, and towards individuals; this encourages extra saving, just in case. Or the way in which (understandably) regulators insist that banks and pension funds hold more safe assets; again, this increases the demand for safe assets and pushes down real interest rates. To reverse all these policies, sacrificing microeconomic particulars for a rather abstract macroeconomic hunch, looks like a hard sell.
There is a simple alternative, albeit one that carries risks. Central bank targets for inflation should be raised to 4 per cent. A credible higher inflation target would provide immediate stimulus (who wants to squirrel away money that is eroding at 4 per cent a year?) and would give central banks more leeway to cut real rates in future. If equilibrium real interest rates are zero, that might not matter when central banks can produce real rates of minus 4 per cent.
If all that makes you feel queasy, it should. As Prof Summers argues, unpleasant things have a tendency to happen when real interest rates are very low. Bubbles inflate, Ponzi schemes prosper and investors are reckless in their scrabble for yield.
One thing that need not worry anyone, though, is the prospect of an inflation target of 4 per cent. It will not happen. That is particularly true in the place where the world economy most needs more inflation: in the eurozone. The German folk memory of hyperinflation in 1923 is just too strong. That economic catastrophe, which helped lay the foundations for Nazism and ruin much of the 20th century, continues to resonate today.
What practical policy options remain? That is easy to see. We must cross our fingers and hope that Prof Summers is mistaken.
Also published at ft.com.