Larry Summers on Secular Stagnation, Fiscal Policy, and Fed Policy

Lawrence Summers is the Charles W. Eliot University Professor and President Emeritus of Harvard University. Previously, he served as U.S. Treasury Secretary under President Bill Clinton and Director of the National Economic Council under President Obama. He joins Macro Musings to discuss his work as both an academic and a policymaker and also shares his thoughts on monetary and fiscal policy since the recent financial crisis and Great Recession. Finally, he explains why he has recently become more open to nominal GDP targeting.

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David Beckworth: Our guest today is Larry Summers. Larry was the secretary of treasury in the Clinton administration, the director of the White House National Economic Council in the Obama administration and a former chief economist of the World Bank. Larry also was a president of Harvard University from 2001 to 2006 and is currently a professor. He joins us today to talk about macroeconomic policy making and some of his recent work in macro. Larry, welcome to the show.

Larry Summers: Glad to be with you, David.

Beckworth: Oh, it's a real treat to have you. One, your work has been discussed in the show before so to get you here in person is a real honor. Now, your background is well known among our listeners, you come from a family of academics and economists, including two uncles who are Nobel laureates in economics. So what was it like growing up in that environment? Did you guys go to dinner table discussing fiscal policy? I mean, was it always economic?

Summers: It was a little bit, there was a little bit of it, but not that much. I have two brothers who took a very different path from economics. I left high school thinking I was going to be a mathematician or a physicist, but found my way to economics as I saw what real mathematicians and physicists were like at MIT.

Beckworth: Okay, so your relatives, they have any influence in that path? I mean...

Summers: Apart from whatever the impact of genetics is, I'm sure there was a certain amount of it in the air as I was growing up and I came to believe that I had two real interests. I was interested in quantitative analysis of things and I was interested in public policy and I saw that in economics. Those two things could come together. I guess it says something about my economics family that the first sentence of my college application essay was, "While some children came to believe in God, I was brought up to believe in the power of systems analysis."

Beckworth: Nice. You'd frame that on the wall. Let's move into your career now. So you went to Harvard, became one of the youngest professors who got tenured there. You've also served in government number of times. I mentioned, you served in the Obama administration, the Clinton administration. You also served briefly in the Reagan administration as CEA. Is that correct?

Summers: Yes. I was a staff person for Marty Feldstein who had been my thesis advisor, although I was sufficiently junior that it was clear that it was not a political position. So it was a technical position, but I thought I would gain government experience, see how the world worked a bit, which I did.

Beckworth: Now, you were there 1982 to 1983, if I read correctly. So you were there at the tail end of that double dip recession and Paul Volcker's second recession. So I'm just curious, you were there real time on the ground. Was there a sense of crisis at the CEA? Did you guys feel like panic? Was there anything like the great recession experience or was it milder?

Summers: It was a long time ago. By the time I got there in August, in 1982, things were starting to turn. So I don't remember anything like the degree of panic and certainly there was no sense of imminent financial collapse. There was in that period very serious concerns about the health of the banking system coming out of the Latin American debt crisis. But my portfolio was on the domestic side at that point, so I wasn't very involved in the financial crisis aspects.

Beckworth: One more question from that period, was it clear in real time that the Federal Reserve had caused those recessions or was there debate on the source of it?

Summers: I think it was pretty clear that they were related to the process of disinflation, but that the process of disinflation was in many ways a necessary process. I don't remember exactly, but I think there was a sense that things had sort of gotten out of control prior to Volcker's arrival.

Beckworth: All right. Let's move forward in time to your time at the Clinton administration. You were there during the Mexico crisis in 1994, the emerging market crisis, '97, '98. You were also the Obama administration during the great recession. If you had to rank crisis in terms of intensity, how would you rank those three?

Serving During Times of Economic Crises

Summers: It's very different when you have a crisis in your country and when you have a crisis in another country. And so by far the most intense experience was our financial crisis. It was Americans who were out of work. It was the American financial system that was in jeopardy. So that was by far the most serious of the crises. That was much more of a presidential preoccupation of the entire government than the Asian financial crisis or the Mexican financial crisis.

Summers: For me personally, the Mexican and Asian financial crises, when I was the senior international economic official at the treasury as I was for both those crises, I felt very much on point with respect to our bailouts. I remember remarking during the Mexican crisis that I felt like my human capital was peso denominated and even how things were going in Mexico, that was a bit scary.

Beckworth: Very interesting. Now, during the great recession you were working for president Obama. Did you ever feel, as a macroeconomist stepping into the policy world that you couldn't do the things you'd want to do ideally? Like you couldn't have a big enough stimulus, you couldn't move quickly enough just because of the way politics work?

Summers: Yeah, I mean, I was of the view. I said at the first meeting with president Obama that when the question was asked, how much fiscal stimulus we should have, I said, it's like how much weight should I lose? There's really very little danger that I'm going to lose too much weight and there's really very little danger that we're going to have too much fiscal stimulus. We need to get as much as we possibly can. And so yeah, I was frustrated when the political constraints held the number down. Yeah, I was frustrated when things got put in a package, like the extension of the alternative minimum tax that were going to happen for sure anyway.

Summers: And so they showed up as part of the size of the package, but they didn't really represent incremental expenditures relative to any sensible baseline. And I was particularly sorry when the economy started to turn a little bit in late 2009, and the whole conversation started pivoting towards deficit reduction rather than towards accelerating recovery. So yes, I was frustrated as one sometimes is in government by the political constraints, but they don't elect technocrats, they elect presidents and they elect congressional officials. And so it's as it should be.

Beckworth: What about the observation that often comes up that there's the lag effect as well. So you have the political constraints, the lag effects, you don't know in real time exactly what is happening in the economy. So, for example, late 2008 GDP numbers came in and then later next year they revised sharply downwards. So it was worse than we even imagined in late 2008. Do you see that also as a constraint on being able to be effective in real time?

Summers: Better to have more accurate information and you don't have precise information, but frankly, I don't think if the actual numbers had come in earlier, it would have changed very much. The issue was how much fiscal stimulus could we get done in the constraints where people who were worried about sticker shock around big budget deficits, people who were worried about what the impact on market psychology would be of large budget deficits, issues of how fast the government could mobilize to spend money in an efficient way.

Summers: Those things were more of the constraints, their lack of understanding of the gravity of the situation. So yes, we'd have liked more accurate data, but we knew that the economy was falling out of bed.

Beckworth: Okay. Let's move to another topic that you've reintroduced, you've kind of brought back to discussion. That secular stagnation. You've made it fashionable again. We had Paul Krugman on the show and he was almost jealous, he said, because you kind of beat him to the punch and articulated it in a very formal way, because he said he was thinking similar thoughts but you're the one who kind of really laid out, this is secular stagnation.

Beckworth: So can you tell our listeners, some of them already know, but tell our listeners what is secular stagnation and where does it stand today?

Secular Stagnation: What, Where, and Why?

Summers: Secular stagnation was framed by Alvin Hansen in late 1930s. His idea was there was a rising savings propensity as the economy grew and that there was a declining investment propensity because population growth was slowing because of the exhaustion of the frontier and because of some reduction in what he thought was due to technological energy. And that with a high propensity to save and a low propensity to invest, there'll be a tendency to economic weakness manifest in low interest rates, manifest in weak expansions and long recessions, and manifest in difficulty in maintaining a positive rates of inflation.

Summers: And I think those were powerful ideas and they quite likely would have played out at that time, but for the arrival of the Second World War and the associated massive fiscal stimulus. And looking at the economy in 2013, when we were four years past the financial crisis, still suffering very slow growth despite substantial financial repair, people being surprised by low levels of inflation. The Fed constantly predicting that it would raise rates in nine months, but never feeling that it was in a position to act. It seemed to me that if there had been an increase in savings propensity in decline in the investment propensity that drove down the interest rate, that would have produced an outcome very much like the secular stagnation that Hansen described.

Summers: And so that seemed to me a plausible hypothesis to put forward in 2013. Since that time, two things have happened, both of which I think strongly corroborate what I said in 2013. The first is that the surprises in the data relative to what people have expected in 2013 are entirely consistent with secular stagnation. The level of growth has been slower than people thought, the level of inflation has been lower than people thought, despite the fact that the level of the interest rate has been much lower than people thought. That's exactly what you'd expect if savings were higher and investment were lower and the IS curve was shifted to the left relative to expectations, it doesn't fit other stories.

Summers: If for example, had been an adverse supply shock, you'd expect to see higher prices not to see lower prices. So the theory was constructed on the basis of one bunch of data. It provided predictions and those predictions were worn out in the subsequent years. That's one aspect in which it seems to me secular stagnation has been corroborated. Second aspect in which it seems to me secular stagnation has been corroborated, is that there has been a wealth of research documenting a variety of forces that have operated to promote savings and to reduce investment propensities, explaining the decline in equilibrium real interest rates.

Summers: On the savings side, you have the savings glut that Ben Bernanke had earlier referenced. You have demographic changes, you have increases in inequality, increases in the share of income going to corporations, both of which operate to raise saving. You have declining availability of consumer credit and mortgage credit, which operates to reduce the saving. On the investment side, you have a more slowly growing labor force, lower level of family formation, which to press investment. You have a dramatic decline in the relative price of capital goods, which reduces the dollar volume of capital goods.

Summers: You have a demassification of the economy. Think about Amazon rather than malls. Think about the fact that an office building for lawyers now requires 600 square feet of space per lawyer where it used to require 1200 square feet of space per lawyer because they no longer need filing cabinets or paralegals to deal with the content of those filing cabinets because of the cloud. And think about the fact that the country's leading technology companies and most valuable companies in the world, Google and Apple, have as their major business problem, a surfeit of cashflow and how to manage that cashflow. All of these things taken together suggest ample reason for believing that real interest rates would have trended downwards.

Summers: And that's in fact what we have seen and while many at the Fed were very quick to attribute low interest rates to so-called headwinds, I thought by 2013 that the headwinds theory was implausible and by 2017 that the headwinds theory was ludicrous, that it was hard to see what headwind there was by 2017 that one wouldn't expect to be semi-permanent. And in fact, if you fit a trend from the late nineties through the period before the crisis, it more or less tracks the current level of real interest rates. So I think we're living in a world, David, where the neutral real interest rate is close to zero, where that low neutral real interest stray means a couple things.

Summers: It means that we're likely to live in a more levered, more bubble prone economy than we have historically. Some ways, the way to understand where the puzzle before the crisis was here it was, we had the mother of all housing bubbles, we had vast erosion of credit standards and all of that was only sufficient to produce adequate growth, not overheating. And in the same way, we're going to have to keep interest rates low enough that we're going to promote high leverage, problematic credit in order to generate growth and when and if, and it will happen sometime, growth slows or collapses, historically, the Fed has cut rates by 400 basis points in recessions and there isn't going to be that kind of room next time around. So that's the kind of secular stagnation theory as I see it.

Beckworth: Now, one way out would be for a rapid productivity boost if the economy took off, or there's some kind of innovation that could drive up expected productivity growth that would drive up real rates. But you've argued in a paper with Antonio Fatas in 2016, an NBER working paper, the permanent effect of fiscal consolidations. I think if I understand it correctly, that even potential GDP and by implication productivity itself is being affected by this persistent shortfall in demand. So we don't see the rapid gains in productivity in part because there's been this systemic shortfall and aggregate demand.

Summers: I've worked with Antonio and I've worked with Olivier Blanchard, Rico Cerruti from the IMF on these issues relating to hysteresis. And I guess the way I would say it is, my reading of the evidence is suggestive. That there's a kind of inverse say's law. Lack of demand creates its own lack of supply and that when the economy is lacking demand for a protracted period, a variety of mechanisms, labor force withdrawals, slower capital investment, less risk taking, less R&D lead to a reduction in subsequent potential GDP.

Summers: Where Fatas and I were able to show was that when you had unexpected fiscal consolidations, not just did the economy contract, that's the standard fiscal multiplier, but that estimates of potential GDP or reality of actual GDP five to 10 years later declined just in the way you would expect if these hysteresis effects were important.

Beckworth: Would productivity growth be higher though, if we were able to generate rapid aggregate demand growth?

Summers: I suspect it would be. I suspect you would be and I certainly suspect that it would have been. And that's through a variety of mechanisms, we would have had more capital investment, we would've had more R&D, we would've had more accumulation of human capital by workers, we would have had less atrophying skills while people were on the sidelines looking for work.

Beckworth: Is there a ceiling or a limit on how much potential GDP could go up though? If we were able to be fiscal policy, monetary policy generate rapid aggregate demand growth. Are we-

Summers: There is a ceiling, I don't know what that ceiling is-

Beckworth: But we're below.

Summers: Clearly, I think it appears that we are below it. If we were well above it, we would be seeing much more rapidly accelerating inflation than we are.

Beckworth: Yeah. What about the global nature of this event? So there seems to be a decline in safe asset yields across the world. Germany had negative yields for a while, tenured, West UK. Any relatively safe country, long-term yields are going down. So is this part of the story?

Summers: In a world with capital mobility, you'd expect there to be a strong tendency for real interest rates to be equalized among credit worthy countries. And so I think the phenomena I described as higher savings and propensity and reduced investment propensity should be thought of as a global phenomenon rather than as a purely domestic phenomenon. It plays out in each country, but the basic mechanism is taking place globally. And as you'd expect, the differences between the current account surpluses and deficits of different countries reflect relative savings and investment propensities in countries like Germany with very high savings propensity and a limited investment propensity.

Summers: There's a very strong current account surplus. In the United States, we tend to save relatively little and be in a relatively attractive place for capital investment, there's a tendency for us to run chronic deficits.

Beckworth: So one of the, I think more fascinating proposals, I'd like to hear your take on this, is to introduce a sovereign wealth fund for the United States. So you're a former treasury secretary, so maybe you have some insights on this, but basically, Norway has a sovereign wealth fund based on its oil. What is our competitive advantage is issuing treasury safe liabilities from the government? Could something like that work in the US where we would issue liabilities from the sovereign wealth fund and that would … to demand for some of that safe assets and also address some of the secular stagnation concerns.

Creating a Sovereign Wealth Fund

Summers: I would not at this point be prepared to advocate a proposal of that kind. First, I'm not where Ricardo Caballero and some others are. I read the low real interest rates as telling you more about overall savings and investment propensities than I do about some kind of shortage of safe assets and changes in risk premiums. If it were all about risk premiums, then you'd think this was a particularly attractive moment to invest in stocks relative to bonds because there was an extraordinarily high risk premium. I think most sophisticated people in markets kind of think the opposite.

Summers: Some people think the stock market's a bubble, some people think it's not. I don't know many people who think it's unusually cheap, which would be the corollary of the view that the risk premium is extremely high. So I don't particularly relate to the safe asset paradigm. If you had that paradigm, then you would say that if the spread between bond yield and stock yields was super wide, this was a good moment for the government to issue bonds and buy stocks, but I don't find that a plausible guide to my own investment behavior and so I'd be hesitant to inflict it on the government.

Summers: Beyond that, I think you have some complex issues given American political institutions as to what a sovereign wealth fund would mean in terms of government involvement in companies and how companies would use their shares and all of that. If you look at foreign sovereign wealth funds, they mostly invest disproportionately abroad. The idea of an American fund would be to significantly invest in America. It's more complicated to be neutral when you're investing in your own country. I also think one thing to do of necessity when you have the kind of huge and temporary oil revenues that Norway or Abu Dhabi have, it's another thing when it's simply based on your ability to issue debt.

Summers: So I think that there would be some arguments that the United States could explore the role of equities in the social security trust fund, but as far as establishing a sovereign wealth fund, that wouldn't be something I would favor.

Beckworth: … and the government would be a price maker, many markets as big as it is. Those are the concerns that typically come up. What would you do then to eliminate the secular stagnation? what role could government play or monetary policy, fiscal policy play?

Policy’s Role in Response to Secular Stagnation

Summers: I think that we probably need to adjust our monetary policy framework to one that provides for higher nominal interest rates in normal times, so that there's more room to cut rates and during downturns. I think that we probably need to think about changes in fiscal policy, which might be changes towards more borrowing to finance public investment, might be changes towards more you should pay as you go, social security, given how low interest rates are and given that growth rates exceed interest rates. I think there's a case for looking at measures that would increase business confidence that would operate to spur private investment as well.

Beckworth: All right, let's move on to the Federal Reserve. It's been very active by many standards on commissioner policy. This QE programs, forward guidance, things that seem very radical at the time, we've gotten used to them now. How would you evaluate the Fed since the crisis erupted?

Evaluating the Fed’s Last Decade

Summers: I think overall you have to give the Fed pretty high grades. We had a situation, it could have been a great depression. It wasn't really anything like the great depression. It wasn't 100% obvious that that would be the case, and so I'd give the Fed overall quite high grades.

Beckworth: All right, so was QE effective?

Summers: I think less effective than most others do. It's true that there's some studies suggesting that particular QE announcements had meaningful effects. But what I'm struck by is that at the same time, the Fed was buying long-term debt, the treasury was issuing huge amounts of long-term debt, both because they were lengthening the maturity structure of the debt and... How do we say it? And because they were running larger deficits than they had before. And so if you look at the amount of long term US government debt that the markets have to absorb, it's more than it used to be relative to GDP, not less.

Summers: So the argument that looks only at QE in gauging asset supplies seems to me to be an odd one to make. So I'm sure there are some effects, but my instinct would be that there's been a tendency to exaggerate their magnitude.

Beckworth: Yeah. My kind of reading the literature is that QE1 probably did make a big meaningful difference given the markets were freezing up. QE2, QE3, the whole argument for the portfolio balance channel subject to the critique you just said-

Summers: I think that's exactly right and I agree with you about QE1 when the markets were frozen. I'd also say whenever you thought a few years ago, the fact that we stopped QE and interest rates kept falling, it has to lead you to think QE is less effective than whatever you thought before we did that experiment.

Beckworth: No, I've looked at this regularly. If you look at the Fed share of marketable treasuries, it's been declining since end of 2014 because it keeps its balance sheets fixed, but deficits continue to grow. And per the portfolio balance channel, that should be a tightening of policy but we haven't seen-

Summers: That's the same point I'm making.

Beckworth: Yeah, exactly. I guess my takeaway from it is, to the extent QE was effective with QE2, QE3 was more of the signaling channel then the portfolio.

Summers: That would be my judgment as well.

Beckworth: Okay. What about current policy? So the Fed seems to be determined to raise interest rates. Since 2014, Yellen's, they've been trying to talk it up, talk it up. They often have to pull back. But lately, they've been talking it up based on either Phillips curve thinking or financial stability motivations. And you've been real critical of those perspectives. You have a, let me see the whites of the eyes of inflation. So talk us through that understanding.

Summers: Good number of points, huh? One, inflation is below target and is expected to remain below target for 10 to 20 years, even by markets which are expecting the Fed not to raise rates very much at all. And so in the face of that, I am not sure why you'd be confident that we need to raise rates in order to hit the inflation target. Second, I think that if you're serious about a symmetric target, you have to be prepared to exceed the target sometimes. If now, after nine years of recovery with years more of recovery forecast and with our employment rate below four and a half percent, if that's not the moment to exceed the 2% target, I don't know when that moment would ever come.

Summers: So it seems to me desirable to be planning for a mild excess of over the 2% target that will be worked off inadvertently whenever the next recession comes. Third, seems to me sensible to apply risk analysis to these things. If we turn out to be wrong and inflation rises, it will be easy to respond. If we turn out to be wrong and inflation declines, we've seen around the world that once you get to very low inflation, it's very difficult to get out of that situation. And I guess the last thing I'd say is, it seems to me the Phillip's curve has now not looked like a strong reliable statistical relationship for a generation.

Summers: And in that context, I'm not sure that we should be relying on it as the basis for our monetary policy going forward. I think the Fed in general as an urge to normalization, but I think it's better for the policies to follow from the arguments rather than for the arguments to follow from the desired policies. And I don't see the financial stability rationale either. I'm not sure that markets are extraordinarily overvalued. If I believed with confidence that markets were a bubble, I'm not sure that would be a reason to tighten policy, it might be a reason to ease policy because I think that when the bubble bursts, we're going to have a real problem.

Summers: And so I might as well get some stimulus into behind the economy. So I don't see the case for tightening. Things could happen in the data in the next several months that change my mind. But on the current evidence, it seems to me that you have to work a bit too hard to manufacture a case for tightening.

Beckworth: I mean, this goes back to your points about secular stagnation. We have a lower natural rate and the Fed is learning, it's getting ahead of the recovery, ahead of that natural rate and I think it's having to back down. I also wonder though to what extent that the Fed is fighting the last war. There's concerns about repeating 1970s, there's been some work that says people who are older at the FLMC tend to have this kind of bias... They don't want to repeat and therefore they're reluctant to overshoot.

Summers: Look, I think this is a broad point. Macroeconomics was transformed by the inflation of the 1970s. Actual rate hypothesis as a central doctrine in academic macroeconomics. The emergence of independent central banks with inflation targeting regimes in policy economics. From the point of view of surprise and the point of view of traumatic consequences for ordinary citizens, it gets easy to make the case that the financial crisis of 2008 was worse. And yet, there hasn't yet been nearly as much systematic rethinking of macroeconomics as there was in the aftermath of the 1970s.

Summers: So I think there is a need for quite profound and serious reconsideration. It does not appear that the problem of dynamically inconsistent central banks yielding to the temptation to inflate and lacking credibility and therefore having excessively high interest rates. That theoretical concern looks very remote relative to current reality and so it's troubling when a preoccupation with that concern is what's driving policy.

Beckworth: Well, my hope is that a kind of the younger generation will be thinking about this. Neel Kashkari, for example, is much more I think thoughtful and open about those ideas. All right, I want to close by switching to a topic that listeners will know is near and dear to my heart, and that is nominal GDP targeting. I think I'm a big fan of nominal GDP level targeting. I've written about it, listeners probably get sick of me talking about it, but you've lately have expressed some interest in it. You've even mentioned doing a paper on it at some point. Tell us why you lean toward it and your thoughts upon it.

Adopting a Nominal GDP Targeting Regime

Summers: I think you need a framework that allows for more expansionary policy and more room to cut rates when recessions come. So I think where we are is not okay. Then you have several options. What option is to raise the inflation target? Defining price stability as 4% inflation is awkward because after all, … price stability. I think defining a nominal GDP growth figure as a goal doesn't involve making a judgment about exactly what inflation rate we prefer and I think that's preferable.

Summers: I also think there's a tendency for slower growth to be associated with lower real interest rates and a nominal GDP growth target facilitates that because when real growth is slower, achievement to the nominal GDP target means a higher rate of inflation. And that means we can give an interest rate more room for negative real rates when the nominal interest rate is at the zero lower path. So I think the correlation property between growth and real interest rates is one attractive argument. I think achieving a different framework without acknowledging an explicit change in the inflation in target is a second virtue.

Summers: And I think that nominal GDP can be understood as velocity adjusted money and there's an attractive concept to have stable nominal growth, which is money adjusted for changes in velocity and that's just what nominal GDP growth is. All those things make an attractive case for nominal GDP. On the other hand, it's the sum of a good and a bad, and that seems a slightly awkward thing to target. And so I'm not absolutely certain that I would prefer it to a price level path target of some kind.

Beckworth: Do you think that if enough people did get on board, it's a policy that would be easily adopted, implemented? I mean, how tough would it would be to transition to a new monetary policy regime like nominal GDP targeting?

Summers: I think it probably would take new personnel, but we're likely to get new personnel at the Federal Reserve. I suspect it's more likely to happen in the context of a problem or a crisis and to happen simply … one day. But I think the odds are probably even or better that central banks will be in a somewhat different framework a decade from now than they are today.

Beckworth: Well, on that optimistic note, our time has come to an end. Our guest today has been Larry Summers. Larry, thank you for coming on the show.

Summers: Thank you.