In this article, we will argue that there is an upside to the downside provided by 'secular stagnation.' The latter refers to a thesis most eloquently argued by Larry Summers, which argues that in the last decades, even credit induced asset bubbles haven't created enough demand in the economy as to strain production capacity or set off inflation, the normal state of the economy is one of insufficient demand.
We will further argue that instead of infusing new bubbles, like we're doing with QE now, we can use newly created money in a much more useful and effective way, injecting it directly into the veins of the economy. Since the 'normal' state of the economy is one of insufficient demand, there is surprisingly little downside, and considerable upside to this strategy, especially when compared with alternatives.
In short, the secular stagnation thesis most eloquently argued recently by Larry Summers argues that:
since about the mid-1990s, it has been the case that it has only been possible to achieve anything like full employment in America during periods when the private sector has been chronically over-consuming and increasing its debt levels. [Crooked Timber]
Or, in Summer's own words:
Even a great bubble [first in high-tech and then in housing] wasn't enough to produce any excess of aggregate demand.... Even with artificial stimulus to demand, coming from all this financial imprudence, you wouldn't see any excess...
The main manifestations are a decline in investment and an increase in (world) savings, producing a secular reduction in interest rates. Basically, if not during some asset bubble, we're in a permanent liquidity trap. This, as Antonio Fatás argues, can also explain the growth of world imbalances with a block whose savings increased and the rest of the world.
The increase in world savings and downtrend in interest rates should have produced an increase, not a decrease in investment. We can speculate over the root causes, but the thesis fits the data rather well at least after 2008. This is rather uncomfortable as some (like Clive Crook) have (mistakenly) arrived at the conclusion that Summers was basically asking for another bubble.
During the bubble years, neither inflation took off, little or no constraints in capacity utilization or the labor market did appear, the latter two might very well have everything to do with inflation not taking off, of course.
For starters, it shows that those who worried for years accelerating inflation was just around the corner because all the "money printing" (or "currency debasement") by the Fed had no reason to worry. If inflation fails to take off during the heights of a credit infused asset bubble, it's hardly going to do so in a depressed economy.
But the risk of another asset bubble is real. It's debatable whether we're there already (we're not convinced) but this is a risk that has to be taken seriously. Why, you might retort, if a bubble is necessary to get the economy back to full employment. Well, we think there are more efficient and less risky ways to do that, after all, bubbles are bubbles only because they sooner or later implode.
QE frustration and risks
Since using fiscal policy is out of the question due to political constraints and worries about public deficits and debts, the heavy lifting of filling the demand gap falls on monetary policy. Interest rates are already zero, so QE had to step in, but QE is rather ineffective and not without risks.
Frustrated with the moderate (at best) positive effects of its QE policy and wary of the risks and negative side effects, even the Fed is contemplating (all too loudly) about winding it down. However, the economy is still far from out of the woods, is there anything we can do to improve on that?
The obvious way is an expansionary fiscal policy, which, due to low interest rates and high multipliers under the present conditions, should give considerable more bang for the buck compared to QE. But this route is blocked because too many people in positions that matter worry about public deficits and debts.
The Fed has the advantage that it is independent, so it could really design its policy based on the risks and rewards of the options, rather than having to rely on political expediency. It might occasionally meet an open letter from critics, or be grilled in the occasional Congressional hearing, but these are not things a Fed president couldn't handle.
To assess the possibilities of monetary alternatives, it's important to understand the limitations and risks of QE. Since we have dealt with these in some detail (here), we're just going to summarize here:
- Effectiveness: QE doesn't give much bang for the buck (as most academic studies show) because the main way it should get into the "veins of the economy" is via credit creation. There simply isn't a huge amount of credit demand (witness the mountain of excess reserves at banks), and the moderately lower long-term interest rates are unlikely to have spurred this by much
- There is some effectiveness via lower public sector borrowing cost and a wealth effect (higher asset prices), but against that stand lower income for savers
- While the downward effect of QE on long-term interest rates has likely been only modest, there could very well be an asymmetry here, rates could rise considerably with the winding down of asset purchases, at least temporarily
- Risks of inflating asset bubbles, many see that as the main risk.
- Inflation risk. We will go into this some more below, as a new argument appeared.
There has to be a better way than risk inflating a new asset bubble, increasing inequality and not getting much bang for the buck. And indeed, there is.
There is an upside to the gloomy secular stagnation thesis, and this upside is huge. Basically, under the conditions of secular stagnation the Fed could embark on injecting money directly into the veins of the economy, rather than to be pushing on the string of QE.
The Fed could finance directly stuff like a huge infrastructure fund, an alternative energy fund (or Green QE or the Green New Deal, as UK professor Werner proposed), improve energy distribution and broadband networks, etc. The UK professor sums it up quite nicely
Central banks only create 3% of the money supply. Normally, 97% is created by banks through their extension of bank credit... The central banks' focus on entrusting banks to expand the money supply is standard practice. But it hardly makes sense at a time when the very problem is stagnating bank credit.
Before some commentators are about to argue that this is a liberal wish list paid by free money, Fed money could just as well give everybody a lump sum payment or a tax break, or anything on a conservative wish list (although we have a feeling free money isn't on that list). It could also permanently retire public debt to assuage the worries of deficit hawks, although we have a feeling that debt monetization isn't part of their solution.
It is essentially a free lunch. Why?
- Unlike QE, which works through the financial and credit system, this doesn't increase the risk of an asset bubble
- Due to the secular stagnation, there really isn't much of an inflation risk even during frenzy bubbles (and raising reserve ratios at banks is a powerful instrument even if these risk should appear).
Meaning there aren't any obvious downsides. It's a way more effective and inherent less risky policy option compared to QE. The free lunch simply is produced by the fact that we have unused production factors and are using inefficient, and potentially risky means to activate these (QE).
It simply takes money to activate these otherwise wasted production factors, and rather than buying assets in the financial markets, the Fed can create money out of thin air by simply crediting the required accounts directly. In case you think this is stupid, or dangerous, or both, you haven't read your Milton Friedman.
The longer we let the present situation in which a significant amount of productive factors are wasted continue, the bigger the (negative) effect will be on our future production capacity. Workers lose skills and motivation, withdraw from the labor market altogether. Firms invest little when they already have excess capacity, so there will be less new capital formation and less incorporation of newer production technologies.
If we leave it in the hands of the technocrats of the Fed (and other central banks), they can decide on the size of the free lunch, in order for it not to exceed the production capacity (which would indeed increase inflationary risks). We could also be more imaginative.
For instance, let every adult have an account at the central bank, in which (part of) the profits from normal monetary operations are deposited (they now go to the Treasury). In times when there is a large output gap and normal monetary policy is unable to get much traction due to the zero lower bound in interest rates, these accounts can be activated, in which case they provide a direct stimulus of demand. This would:
- Give much more bang for the buck, as it bypasses the banking system altogether, it's not dependent upon new credit creation
- Doesn't suffer from QE's inefficiencies and drawbacks, like inflating asset bubbles
- The asset bubbles disproportionally benefit top wealth and income tranches, since we believe one of the reasons behind the secular stagnation is the rise in inequality, providing everybody with such an account, which counterbalances, rather than reinforces the rise in inequality.
It seems a better idea than all the QE in the world..