Yes, Larry Summers Is Saying Central Bank Policy Encourages Bubbles (Which He Thinks Is a Second-Best Solution Because of Secular Stagnation)
OK it took me a bit to understand the point that Keshav (and then Ken B.) were making in response to my Summers/Krugman commentary on bubbles. They (and maybe others, sorry if I’m leaving people out) were saying that yes Summers/Krugman were warning that we would have a string of bubbles, but that no they weren’t saying it was due to countercyclical (or “pedal to the metal” as Krugman put it) monetary policy. The bubbles were going to happen either way, it’s just that in conjunction with ultra-accommodative central bank policy–which is necessary because the natural rate of interest is negative, and has been for a while now–it will look like the inflation hawks are right. But actually (so say Keshav and Ken B.), Krugman/Summers were denying this connection; it wasn’t monetary policy causing the bubbles at all.
Although there are isolated passages from Krugman’s commentary that are consistent with the above interpretation, I don’t think it works. First, we have the infamous Krugman quote from 2002 saying that
Bernanke Greenspan needs to replace the dot-com bubble with a housing bubble. Here’s Krugman himself in 2010 discussing that piece:
So did I call for a bubble? The quote comes from this 2002 piece, in which I was pessimistic about the Fed’s ability to generate a sustained economy. If you read it in context, you’ll see that I wasn’t calling for a bubble — I was talking about the limits to the Fed’s powers, saying that the only way Greenspan could achieve recovery would be if he were able to create a new bubble, which is NOT the same thing as saying that this was a good idea…
But did I call for low interest rates? Yes. In my view, that’s not what the Fed did wrong. We needed better regulation to curb the bubble — not a policy that sacrificed output and employment in order to limit irrational exuberance. You can disagree if you like, but that doesn’t make me someone who deliberately sought a bubble.
OK, so it’s crystal clear that Krugman thought (at least from 2002 through 2010) that, at least in principle, the Fed can create bubbles. Now from the above, it’s not totally clear whether Krugman thinks interest rates are the mechanism, but for sure Krugman thinks central banks have the power to make and break bubbles. (To clarify what I’m saying: Krugman says that better regulation could have curbed the housing bubble without the need to raise interest rates. But that still means it could have been low interest rates that set the bubble in motion; surely when Krugman said “Greenspan needs to replace…” he wasn’t suggesting that Greenspan needed to weaken oversight of the financial sector. No, Krugman meant Greenspan needed to engage in looser monetary policy.)
Now, turn to Summers’ IMF speech, which started all of this. In the excerpts below, it is pretty clear that Summers is saying that absent major reforms, the central bank will be left fighting high unemployment with tools that will promote bubbles. Those bubbles are the unavoidable consequence of not doing the major reforms, but–if those reforms are off the table–then it’s better to accept the bubbles as a necessary evil. However, if we could get the major reforms, then the central bank wouldn’t have to engage in such loose policy, and we would not get as many bubbles.
I hope no one will deny that if Summers is in fact saying what I’m claiming, then my original point in all this is vindicated: Krugman/Summers are finally saying what hard-money types have been claiming for years: Namely, that the ZIRP/QE policies have promoted asset bubbles, even though price inflation hasn’t gone through the roof and unemployment remains high.
OK on to the Summers quotes from his IMF speech, to bolster my interpretation given above:
If you go back and study the economy prior to the crisis, there is something a little bit odd. Many people believe that monetary policy was too easy. Everybody agrees that there was a vast amount of imprudent lending going on. Almost everybody agrees that wealth, as it was experienced by households, was in excess of its reality. Too easy money, too much borrowing, too much wealth. Was there a great boom? Capacity utilisation wasn’t under any great pressure; unemployment wasn’t under any remarkably low level; inflation was entirely quiescent, so somehow even a great bubble wasn’t enough to produce any excess in aggregate demand.
So what’s an explanation that would fit both of these explanations? Suppose that the short-term real interest rate that was consistent with full employment had fallen to -2% or -3% sometime in the middle of the last decade. Then what would happen? That even with artificial stimulus to demand coming from all this financial imprudence you wouldn’t see any excess demand. And even with a relative resumption of normal credit conditions you’d have a lot of difficulty getting back to full employment.
Yes, it has been demonstrated absolutely conclusively, that panics are terrible and that monetary policy can contain them when the interest rate is zero. It has been demonstrated, less conclusively but presumptively, that when short-term interest rates are zero, monetary policy can affect a constellation of other asset prices in ways that support demand, even when the short-term interest rate can’t be lowered. Just how large that impact is on demand is less clear but it is there.
But imagine a situation where natural and equilibrium interest rates have fallen significantly below zero. Then conventional macroeconomic thinking leaves us in a very serious problem, because while we all seem to agree that whereas you can keep the federal funds rate at a low level forever, it is much harder to do extraordinary measures beyond that forever, but the underlying problem may be there forever.
Why does Summers say, at the very end, you can’t do extraordinary measures (which means things like QE) beyond that forever? He doesn’t give his answer, but in the context of his (short) speech, I think he’s saying because it will blow up asset prices too much and policymakers will back off.
And now, to me, the smoking gun. Here’s what Summers is worried that policymakers will do, who misread the situation (not realizing we have secular stagnation) and tighten:
One has to be concerned about a policy agenda that is doing less with monetary policy than has been done before, doing less with fiscal policy than has been done before and taking steps whose basic purpose is to cause there to be less lending, borrowing and inflated asset prices than there was before.
OK, so earlier we have Summers saying that even when interest rates are at zero, central banks have demonstrated their ability to increase asset prices through unconventional measures. (I put that part in bold in the second last block quotation.) And then here, in the final block quotation, he says that he’s worried policymakers will stop trying to inflate asset prices.
In conclusion, it seems clear to me that both Krugman and Summers believe the central bank has the power to create asset bubbles, and that the looser monetary policy is, the more likely bubbles are to occur. I am surprised I have had to post three separate times to establish this point, but hey, the critics in the comments keep me honest.