1. When prudence is folly
Larry’s formulation of our current economic situation is the same as my own. Although he doesn’t use the words “liquidity trap”, he works from the understanding that we are an economy in which monetary policy is de facto constrained by the zero lower bound (even if you think central banks could be doing more), and that this corresponds to a situation in which the “natural” rate of interest – the rate at which desired savings and desired investment would be equal at full employment – is negative.
But now comes the radical part of Larry’s presentation: his suggestion that this may not be a temporary state of affairs.
2. An economy that needs bubbles?
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 you might be tempted to say that monetary policy has consistently been too loose. After all, haven’t low interest rates been encouraging repeated bubbles?
But as Larry emphasizes, there’s a big problem with the claim that monetary policy has been too loose: where’s the inflation? Where has the overheated economy been visible?
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. And this hasn’t just been true since the 2008 financial crisis; it has arguably been true, although perhaps with increasing severity, since the 1980s.
The ‘bad’ in the title of this post refers to the control/elimination of inflation. And I have strong feelings that that endeavor, which began to spread around the world a little over 20 years ago, and was very successful, is the root cause of the present problems, including the doubts and antagonisms that pervade the discussions and debates floating about.
Because once you eliminate the ‘devil’, which constrained behavior, everything becomes a ‘bubble’, with the economy only able to function if geared by ‘bubbles’.
“We now know that the economic expansion of 2003-2007 was driven by a bubble….” That is one of the great misunderstandings of the ‘modern’ discourse. The monetary policy mistakes of the late 1990s and early 2000s were finally corrected after 2003 (see here). More generally, what the US was doing after the Volcker transition was ‘controlling’ a ‘good’ to wit, nominal aggregate spending (or NGDP).
And that´s what it lost control of, not the ‘bad’, which is still very much under wraps, even more tightly contained than the ‘officially required’.
These previously posted charts of mine illustrate the problem very clearly. The upper panel shows the route to nominal stability, finally secured between 1987 and 2005 and how it was lost during Bernanke´s leadership of the Fed. And it happened because, as shown in the lower panel he, for some unfathomable reason, was afraid to lose control of the ‘bad’!
The solution? Let´s put up the ‘good’ clearly on the table and let everyone know that´s the real ‘object of desire’ of the monetary authorities. With that, ‘vampire hunters’ like Charles Plosser, that cause so much damage, would quickly fade away or better, become irrelevant.
HT James Pethokoukis