Friday, April 3, 2015

Bernanke, Summers and Krugman on secular stagnation (saving glut and liquidity trap)

Here is a summary of the interesting debate on secular stagnation started by Bernanke on his blog at Brookings.

Achieving full employment, low and stable inflation, and financial stability are the three core objectives of economic policy. Larry Summers argued that achieving these three objectives simultaneously is difficult because slowdown in population growth and the pace of technological advance result in lower capital investment by firms and subdued household consumption. It means difficulty in attaining full employment.

So, inadequate aggregate demand leads to low growth and less than full employment. Low aggregate demand will eventually lead to low aggregate supply as productive capacity of the economy is restrained. The solution is to jack up public infrastructure spending in case real interest rate cannot be lowered below a threshold (zero) to stimulate private investment. In the face of secular stagnation and relatively ineffective monetary policy, the US should turn to fiscal policy (productivity-enhancing public infrastructure spending).

Bernanke is skeptical that the US economy is facing secular stagnation. First, if real interest rate (nominal interest rate minus inflation) is negative, then any investment will appear profitable. Hence, prolonged subdued capital investment is not realistic right now. Second, the current slowdown may be caused by temporary headwinds that may be dissipating soon. Third, better investment opportunities abroad will mean that there are will be more outward FDI, which would weaken dollar and then boost US exports. This in turn will increase growth and employment. Returns to capital investment may not be low everywhere at the same time.

Summers responded that (i) saving and investment may not equate at full employment smoothly due to interest rate adjustment (secular stagnation is all about saving > investment); (ii) excess saving may flow abroad if returns to investment are attractive; (iii) at zero real interest rate, government debt service is very cheap and hence it can borrow without adding much debt overload to finance public infrastructure spending (Keynesian fiscal stimulus effect kicks in); (iv) savings-investment balance is for the global economy, so economies with excess savings may consider reducing their savings or increasing their investment (narrow the gap between desired savings and desired investment).

Bernanke responded again arguing that the secular stagnation hypothesis holds true if the whole world is suffering from such a phenomena. Else, such trends in the US would be negated by FDI and exports boost to other countries that have relatively better aggregate demand. Hence, another policy implication is that the US should work on lowering or elimination of FDI outflows and export barriers.

Paul Krugman added that Summers paid insufficient attention to international capital flows (which he agreed in response to Bernanke). But, this does not mean that even if they were accounted for the secular stagnation concerns are obviated. Secular stagnation occurs when “countries face very persistent, quasi-permanent liquidity traps”. Japan is an example. Japan faced really low nominal interest rate since 1990 and persistent deflation as well. Real interest rate was still positive and the other economies offered relatively better investment opportunities (the US and the EU saw such low rates only after 2008). But still Japan was stuck in low growth equilibrium for a long time. Policies to boost demand are the call of the hour right now.

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