The Economy does not always need Bubbles

Larry Summers is right that the US is at risk of Japanese style stagnation, myself and others have said much the same thing, but I do not agree that the US economy needs bubbles to get out of this situation.

But let's be more specific. I don't think that asset bubbles, such as the late 90s internet boom (and the current internet 2.0 boom) is bad or harmful or necessary. When a new technology appears, there may be a fad for it where investors become overly optimistic about the new sector's prospects and invest too much money, or perhaps the new sector has a "winner take all" element to it and the amounts invested are correct, they just don't pan out for most people.

This sort of asset bubble produces leverage through lofty forward-looking valuations, but there are no debt instruments that need to be written down when the expected cash does not flow. The internet bubble was largely a transfer from investors to dot com employees, but the economy did not produce debt instruments which generated the type of increase in gross financial assets that a debt driven bubble does.

This brings us to our specific problem -- credit fueled booms like the real estate speculation which ushered in Japan's own lost generation, and the one that the US has been mired in for the past 6 years or so.

Sankowski has a reading of it I'm not sure I agree with

“There is something economists have known since 1958 that we don’t talk about much, except in private, like in economics journals that nobody else reads. It’s a bit too weird. 

There are two sorts of world. In a normal world, the equilibrium rate of interest is above the growth rate of the economy. In a weird world, the equilibrium rate of interest is below the growth rate of the economy. What’s weird about a weird world is that it needs a bubble, a Ponzi scheme, a chain-letter swindle, for the economy to work well. 

Maybe the world we live in is a weird world. And it needs a bubble to work well. And the economy keeps trying to create a bubble. And when it succeeds the economy does work well. But bubbles are unstable and eventually burst. Then it works badly again. Until the next bubble.”

It's a pity he did not define what the "equilibrium" rate of interest is, or talk about how that may differ from the "natural" rate of interest because then his point may be clearer here. He continues:

My take on this is the economy demands bubbles when r demands bubbles. If the bubble is not met, it will try and find a way to create this bubble. (See real estate, stock market, S&L, Emerging Markets) Artificially constraining the bubble forces unnecessary misery on people, and causes involuntary unemployment and unused capacity, which is bad because it causes an economic incentive for war.

I interpret this as, when the economy (g) is growing faster (g) than the interest rate (r) than the economy needs a bubble. Why? Wouldn't that just make g grow even faster? Or are you saying that a bubble is what will compel the Fed to raise interest rates (which seems a strange argument)?

Summers is easier to understand but still wrong. His position is that interest rates are essentially at zero and the economy is still not growing. Therefore, we need a bubble because what else can we do?

A reasonable argument that begs the question because it assumes that interest rates are the key factor when agents make investment decisions as they represent the discount rate which drives intertemporal decision making.

But consumption is actually very hard to move intertemporally, and besides, there is another more important factor when an agent decides to make a consumption decision or not and that is the good old budget constraint. So, not only do I need to decide how much consumption tomorrow is worth versus consumption today, but I also need to see how much money is in my pocket. And that is most straightforwardly determined by good ole fiscal policy. In fact, budget constraints, I believe, far outweigh consumption decisions for most sectors (or more specifically, all sectors where interest rates are not primary determinants of prices, QED).

So, Summers controversial assertion becomes a tautology -- since interest rates do not impact economic activity outside of interest rates driven price sectors (which practically speaking means primarily residential real estate), interest rates become impotent why operating in an economy where residential real estate becomes non-interest rate driven, such as an economy which has been in ZIRP for a long time and has real estate prices that are too high.

The next step here is not trying to find some other debt driven bubble, I don't think there are any, but simply to pull the fiscal lever and keep it pulled until balance sheets are repaired and non-government activity comes back, as evidenced by "natural unemployment" (whatever that means -- I'll need to write a follow-on post to this).

Happy Thanksgiving!

Happy Thanksgiving to all winterspeak readers!

The future of money

This is a very commercial post : )

I think the Coin is fantastic.

Carry it in this overpriced but wonderfully designed wallet and you are done.

What is the natural rate of interest?

I very much look forward to Michael Sankowski writing about the natural rate of interest. First question of course is, what is the definition?

Sankowski uses Roger Ferguson of the Fed's definition:

One way of providing that benchmark is to consider what level of the real federal funds rate, if allowed to prevail for several years, would place economic activity at its potential and keep inflation low and stable

He then adds some variations on that theme, including:

If it were in our power to regulate completely the price system of the future, the ideal position . . . would undoubtedly be one in which, without interfering with the inevitable variations in the relative prices of commodities, the general average level of money prices . . . would be perfectly invariable and stable.

Note that implicit in all of this is the idea that somehow there is a tight causal coupling between the Federal Funds rate and inflation, and if the experience of the US since 2008, or Japan since 1990 have taught us anything, it's that this is not so. And without this tight, causal coupling, having a "natural rate of interest" flow from a non-inflationary, high economic activity state becomes problematic.

An alternative view on the "natural rate of interest" is from Warren Mosler, who perhaps inspired Sankowski posing the question at all. Mosler argues that the natural rate of interest is zero, at least under a floating rate, fiat regime. His argument is that, absent active management from the Fed, the overnight interbank interest rate would be zero because having a surplus of reserves drives the rate down to zero (as we see in our current excess reserve regime). Moreover, having a deficit of reserves risks breaking the payment settlement system itself, which would be catastrophic.

Having the FFR be permanently set at zero is a strange idea to wrap your head around, but it's also where we've been for five years and where Japan has been for a generation. It's been hard for the Fed to taper off this state, so maybe it would be for the best if they declared it permanent and left future economic stimulus firmly in the realm of fiscal interventions.