“All of this has happened before. But the question remains, does all of this have to happen again?”
Insight: Seeing what others don't.
Recently, Ben Bernanke inaugurated his new blog with a simple question: “Why are interest rates so low?” Bernanke argues that low interest rates are not a short-term aberration, but part of a long-term trend. Has the world economy entered a period of ‘secular stagnation’? So what are the macroeconomic forces and dynamics that underlie global capital flow in today’s modern economy? How might that affect currency exchange rates going forward? The following excerpts from recent public discourse among the world’s leading economists reflect diverse, and sometimes contradictory, viewpoints that may provide interesting clues to our future:
“In modern economies short-term safe interest rates cannot fall appreciably below zero because of the possibility of currency substitution. So interest rates are not fully flexible in modern economies. Hence the possibility exists that no attainable interest rate will permit the balancing of saving and investment at full employment. This is the secular stagnation hypothesis first put forward by Alvin Hansen in the 1930s.”
Diagnosing an Economic Malaise: Global Savings Glut or Secular Stagnation or Both? (Image Credit: Economist).
“Wage and price flexibility may well exacerbate the problem. The more flexible wages and prices are, the more they will be expected to fall during an output slowdown, leading to an increase in real interest rates. Indeed, there is the possibility of destabilising deflation, with falling prices leading to higher real interest rates leading to greater output shortfalls leading to more rapidly falling prices, and onwards in a vicious cycle.”
— Lawrence Summers (2014)
“Currently, many major economies are in cyclically weak positions, so that foreign investment opportunities for US households and firms are limited. But unless the whole world is in the grip of secular stagnation, at some point attractive investment opportunities abroad will reappear.”
“If that’s so, then any tendency to secular stagnation in the US alone should be mitigated or eliminated by foreign investment and trade. Profitable foreign investments generate capital income (and thus spending) at home; and the associated capital outflows should weaken the dollar, promoting exports. At least in principle, foreign investment and strong export performance can compensate for weak demand at home.”
“In a world with integrated capital markets real rates anywhere will depend on conditions everywhere. If there are more countries tending to have excess saving than there are tending towards excess investment, there will be a global shortage of demand. In this case countries able to devalue their currencies will benefit from generating more demand. Policies that seek to stimulate demand through exchange rate changes are a zero-sum game, as demand gained in one place will be lost in another. Secular stagnation and excess foreign saving are best seen alternative ways of describing the same phenomenon.”
— Lawrence Summers (2015)
“There is some similarity between the global saving glut and secular stagnation ideas: Both posit an excess of desired saving over desired capital investment at “normal” interest rates, implying substantial downward pressure on market rates. Both can account for slower US growth: Secular stagnation works through reduced domestic investment and consumption, the global savings glut through weaker exports and a larger trade deficit.”
“Slow or negative growth in the working-age population means low demand for new investments, both in housing and in productive capital, and therefore reduces the natural rate of interest still further.”
— Paul Krugman (2014)
“Numerous items have disappeared from GDP because they are already provided for free with a smart phone – not only the print dictionary or encyclopaedia, but the music-playing capability that makes the separate iPod obsolete, the restaurant locator that makes the printed Zagat guide obsolete, the growth in companies like Uber and Lyft that may make the urban taxi obsolete, and many more… GDP has always been understated.”
— Robert Gordon (2014)
“Indeed, this proliferation of inventions should make us quite nervous about the price indices used to compute GDP figures. The theory of price indices is that an individual should be indifferent between living today and living in the past with the same real income. How many people would really be indifferent between earning $23,000 in 1984 and earning $50,000 in 2014?”
— Edward Glaeser (2014)
“Lower-priced capital goods means that a given level of saving can purchase much more capital than was previously the case. Information technology continues to decline rapidly in price and to account for a larger share of total capital investment. It is revealing that the iconic cutting-edge companies have traditionally needed to go the market to support expansion. Today, leading-edge companies like Apple and Google are attacked for holding on to huge cash hoards.”
— Lawrence Summers (2014)
“Start with the fact that people can do three things with their incomes. They can:
- buy things to consume,
- invest – that is, buy things that will boost their income in the future,
- hoard – that is, hold on to some of the cash they were paid, or park more of their wealth in something else they value not because it gives them utility or boosts their future income, but rather simply serves as a safe-and-liquid-store-of-value, so they can boost their spending above their income at some point in the future.”
“Continue with John Stuart Mill’s 1829 insight when the quantity demanded of safe-and-liquid-store-of-value assets to hoard is greater than the quantity supplied, demand for consumption goods and services and for real produced capital assets will be less than the supply. Businesses will then lose money and people will get fired. When people get fired and you lose full employment, incomes and planned spending both drop economy wide.”
“Another way of looking at the secular rise in joblessness is that it represents a failure of entrepreneurial imagination. Why haven’t smart innovators figured out ways to make money by employing the jobless?”
— Edward Glaeser (2014)
“Let the situation stew for long enough, and eventually somebody in the private sector will probably figure out some circuitous and way to put the unemployed to work making the safe-and-liquid-store-of-value assets people want to buy to hoard. But that may take a very long time. And it takes an especially long time when nobody sane trusts the promises of anybody in the private sector that this is in fact a safe-and-liquid-store-of-value asset that you can hoard and then sleep easy on.”
"A bubble [is] an asset whose price exceeds the present value of its associated income stream. ... Bubbles are an alternative way for society to deal with excess saving when fiscal policy does not take up the challenge. Buying bubbly assets with the intention of selling them at a later date is an alternative route of saving for future consumption. When nobody wants to invest because r is below g, and hence buys bubbly assets, the price of these assets goes up, yielding windfall profits to their sellers who are therefore able to increase their consumption. This additional consumption restores the balance between supply and demand for loanable funds on the capital market. This explains why so many high-valued apartments in Shanghai are vacant. They are just bubbly assets, stores of value."
— Coen Tuelings and Richard Baldwin (2014)
“Low interest rate environments are known to be prone to speculative episodes and the emergence of financial bubbles. … financial bubbles increase wealth and asset values, alleviate the shortage of assets, and stimulate the economy. But the stimulus is temporary: the economy returns to the zero lower bound as soon as the bubble bursts. A financial bubble can therefore arise as an imperfect market solution to a shortage of financial assets. The solution is no panacea because it is temporary and comes with risks to financial stability.”
— Ricardo Caballero and Emmanuel Farhi (2014)
"The more price elastic the supply of a bubbly asset, the greater the risk that a bubble goes bust, as more and more people start investing in the production of the bubbly asset."
— Coen Tuelings and Richard Baldwin (2014)
“Infrastructure investments, even if not immediately paid for with new revenue sources, can easily contribute to reductions in long-term debt-to-income ratios because they spur economic growth, raise long-run capacity, and reduce the obligations of future generations. It is an accounting convention, not an economic reality, that borrowing money shows up as a debt, but deferring maintenance that will inevitably have to be done at some point does not.”
“… but there are reasons to be sceptical. Much infrastructure investment is now capital intensive. America’s infrastructure programmes have often been criticised for waste and inefficiency.”
— Robert Gordon (2014)
“A safe asset is one that is expected to preserve its economic value following bad macroeconomic shocks. It is extremely difficult for the corporate and financial sector of a shell-shocked economy to produce such assets. … when the securitisation capacities of the economy (understood to be the physical, institutional, legal, and reputational resources that are required to isolate safe financial assets from risky real assets) have been impaired.”
“On one hand, safe asset shortages shape corporations’ capital costs and create incentives to cut back on risky investment and to either accumulate cash, return money to investors through equity buybacks and dividend payments, or substitute towards safer or easier-to-securitise forms of investment, sacrificing output for safe asset production.”
“On the other hand, safe asset shortages also create strong incentives for the financial system to engage in subprime-like forms of financial engineering, which can be thought as the process of extracting a ‘safe’ tranche from inherently risky loans backed by systemically exposed real estate collateral. And as the recent crisis demonstrated, this process can go to extremes, leading to waves of ‘fake’ safe asset creation, followed by sudden and violent episodes of collective realisation of their actual riskiness.”
— Ricardo Caballero and Emmanuel Farhi (2014)
“In a national economy, if someone is saving money or paying down debt, someone else must be borrowing and spending the same amount for the economy to move forward. But after the bursting of a nationwide asset price bubble, those with balance sheets under water are not interested in increasing borrowing at any interest rate. There will not be many lenders either, especially when the lenders themselves have balance sheet problems. The lack of borrowers means a significant portion of the newly saved and deleveraged funds that are entrusted to the financial sector are unable to re-enter the real economy. This in turn means that those unborrowed savings become a leakage in the income stream and a deflationary gap for the economy. If left unattended, this deflationary gap will push the economy ever deeper into balance sheet recession, a highly unusual recession that happens only after the bursting of a nationwide asset price bubble.”
— Richard Koo (2014)
“We may be headed into a world where capital is abundant and deflationary pressures are substantial. Demand could be in short supply for some time.”
“Certainly, population growth is starting to fall in many countries, especially in the more advanced economies. Yet, the global population is still increasing. This would suggest that globally, there should still be ample investment opportunities if framework conditions are put right. This is where the role of the integration of Asian and African economies into the global economy becomes central. More than half of the world’s population is concentrated in a small circle in Asia, including China and India. The more they are integrated into the global economy, the more they should increase global demand, and the more opportunities for profitable investment should exist. To achieve this, a well-functioning financial system is critical. It would need to prevent excessive risk-taking while channeling savings to the right countries and deployments.”
— Guntram Wolff (2014)
“Fixed exchange rates facilitate business and communication in good times but intensify problems when times are bad. … The gold standard and the euro are extreme forms of fixed exchange rates, and these policies had their most potent effects in the worst peaceful economic periods in modern times. The point is that an exchange rate system is a system, in which countries on both sides of the exchange rate relationship have a responsibility for contributing to its stability and smooth operation. The actions of surplus as well as deficit countries have systemic implications. Their actions matter for the stability and smooth operation of the international system…”
— Barry Eichengreen and Peter Temin (“Fetters of Gold and Paper”, 2010)
“The Eurozone is in the process of transitioning towards a permanently smaller and more streamlined banking sector. This is leading naturally to the deepening of capital markets – if intermediation between savings and investment is taking place less through banks, then it must take place more elsewhere. This is a welcome development as it provides the impetus not only for a more diversified financing mix in Europe, but for the development of a genuine single capital market.”
— Juan Jimeno, Frank Smets, and Jonathan Yiangou (2014)
Connections that make sense of it all.
The supply of safe assets has fallen by half since the financial crisis, according to Caballero and Farhi. The price of safe assets such as the U.S. Treasury bonds depends, inter alia, on their supply and the safety preferences of financial investors. There are good reasons for supposing that both have shifted. During that time, pension funds, banks, and insurance companies were forced by regulators to increase their holdings of safe assets, leading to massive excess demand for safe assets. However, the financial technology for producing risk-free assets proved to be inadequate.
Not surprisingly, the risk-free interest rates dropped to a historic trough. What's more, negative interest rates have arrived in several countries. Indeed, the biggest effect of negative interest rates may be on currencies. Low interest rates pull down yields on all manner of local investments, encouraging both natives and foreigners to put their money elsewhere. As capital takes flight, the currency falls. To wit, the euro has fallen against the dollar by nearly 20% since the ECB introduced negative deposit rates; the krona fell to a six-year low against the dollar after Sweden adopted negative rates.
Is secular stagnation something to worry about, or just another passing fad? Will growth in the next decade or two be much lower than it was in the past? Predictions are hard to make, in particular about the future.
“This time I bet no. Mathematics. Law of averages. Let a complex system repeat itself long enough and eventually something surprising might occur.”
References:
- Hansen, Alvin (1939, March). Economic Progress and Declining Population Growth. The American Economic Review, Vol. 29, No. 1, pp. 1-15. Retrieved from: http://www.jstor.org/discover/10.2307/1806983?sid=21105867837671&uid=2&uid=4
- Summers, Lawrence H. (2014). U.S. Economic Prospects: Secular Stagnation, Hysteresis, and the Zero Lower Bound. Business Economics, Vol. 49, No. 2. Retrieved from: http://larrysummers.com/wp-content/uploads/2014/06/NABE-speech-Lawrence-H.-Summers1.pdf
- Tuelings, Coen and Baldwin, Richard (2014). Secular Stagnation: Facts, Causes and Cures. Centre for Economic Policy Research (CEPR). CEPR Press. Retrieved from: http://www.voxeu.org/sites/default/files/Vox_secular_stagnation.pdf
- Rognlie, Matthew (2015). Deciphering the Fall and Rise in the Net Capital Share. BPEA Conference Draft (March 19-20, 2015). Retrieved from: http://www.brookings.edu/~/media/projects/bpea/spring-2015/2015a_rognlie.pdf
- Eichengreen, Barry and Temin, Peter (2010, July). Fetters of Gold and Paper. NBER Working Paper 16202. Retrieved from: http://www.nber.org/papers/w16202.pdf
- Krugman, Paul (1998, August 14). Baby-Sitting the Economy. Retrieved from: http://www.pkarchive.org/theory/BabySittingCantAvoidRecessions.html