Larry Summers on Why Austerity Might be a Bad Idea

“Austerity”, as currently used, is the meme that the problem with developed economies is that governments spend too much. It’s essentially anti-Keynesianism: government spending and GDP go in opposite directions.

To the public, particularly conservatives, this is a trending idea. Macroeconomists aren’t necessarily against it, but you have to make an awfully convoluted theoretical argument to justify the position (i.e., it fails Occam’s razor).

Here’s Summers again … so this is coming from the moderate Democratic viewpoint. It’s a long piece, but should be digestible for undergraduates:

… It has now been nearly five years since the trough of the recession in the early summer of 2009. …

The record of growth for the last five years is disturbing, but I think that is not the whole of what should concern us. It is true that prior to the downturn in 2007, through the period from, say, 2002 until 2007, the economy grew at a satisfactory rate. …

Did it do so in a sustainable way? …

It is fair to say that critiques of macroeconomic policy during this period … suggest that … fiscal policy was excessively expansive, and that monetary policy was excessively loose.

As a reminder, prior to this period, the economy suffered the relatively small, but somewhat prolonged, downturn of 2001. Before that, there was very strong economic performance that in retrospect we now know was associated with the substantial stock market bubble of the late 1990s. The question arises, then, in the last 15 years, can we identify any sustained stretch during which the economy grew satisfactorily with conditions that were financially sustainable?

Part of me agrees with this. And part of me thinks we need to be very careful about how we select our samples: no one was saying any of this looked bad in 2007.

Then Summers does a thought experiment: what sort of underlying problem would cause this sort of behavior:

… I would suggest that in understanding this phenomenon, it is useful at the outset to consider the possibility that changes in the structure of the economy have led to a significant shift in the natural balance between savings and investment, causing a decline in the equilibrium or normal real rate of interest that is associated with full employment.

Let us imagine, as a hypothesis, that this has taken place. What would one expect to see? One would expect increasing difficulty, particularly in the down phase of the cycle, in achieving full employment and strong growth, because of the constraints associated with the zero lower bound on interest rates. One would expect that, as a normal matter, real interest rates would be lower. With very low real interest rates and with low inflation, this also means very low nominal interest rates, so one would expect increasing risk-seeking by investors. As such, one would expect greater reliance on Ponzi finance and increased financial instability.

I’m not sure I agree with the logic laid out here, but I’d be the first to argue that we have a lot of wealth around, and that the middle of the investing market has disappeared: everyone wants both low-risk for part of their portfolio, and absurdly high returns for the rest. To get the latter, why not just invest in Peru? There’s a lot of places like Peru that could use the investment, but not enough people are doing that. This is … weird … the world has more money to blow than it’s ever had, and people are unwilling to take a flyer on investing in physical capital projects in places that need them the most.

Recall that real interest rates — what lenders expect to get in real terms at the time they make the load — are not observable. So why does Summers think they’ve dropped? He gives 6 reasons:

1. We don’t need as much debt finance, due to over leverage, tightened regulations, and the proliferation of new ventures (like WhatsApp) that require very little capital.
2. It’s an old macro result, but it’s well accepted that real interest rates can’t stray far from population growth rates … which are in decline everywhere.
3. Worsening income inequality and economic growth mean we have a lot more savings combined with a lot less need to earn high returns on those savings.
4. We don’t need to borrow as much because all forms of physical capital have gotten a lot cheaper.
5. We pay taxes on nominal interest rates, but get real rates by subtracting expected inflation from nominal rates. With low nominal rates, this means that real rates can hit zero for even very low expected inflation rates.
6. Everyone wants “safe” assets, rather than even low-return assets: but all those T-bills are funding borrowing that probably isn’t very productive.

From Summers’ moderate Democratic perspective, he recommends three things:

… The first is patience. These things happen. Policy has limited impact. …

I would suggest that this is the strategy that Japan pursued for many years, and it has been the strategy that the U.S. fiscal authorities have been pursuing for the last three or four years. …

A second response as a matter of logic is, if the natural real rate of interest has declined, then it is appropriate to reduce the actual real rate of interest, so as to permit adequate economic growth. This is one interpretation of the Federal Reserve’s policy in the last three to four years. …

This is surely, in my judgment, better than no response. It does, however, raise a number of questions. Just how much extra economic activity can be stimulated by further actions once the federal funds rate is zero? What are the risks when interest rates are at zero, promised to remain at zero for a substantial interval …

… There’s also the concern pointed out by Japanese observers that in a period of zero interest rates or very low interest rates, it is very easy to roll over loans, and therefore there is very little pressure to restructure inefficient or even zombie enterprises. …

The preferable strategy, I would argue, is to raise the level of demand …

Anything that stimulates demand will operate in a positive direction from this perspective. Austerity, from this perspective, is counterproductive unless it generates so much confidence that it is a net increaser of demand.

His conclusion is that we need more Keyensian expansionary fiscal policy. Interestingly, he supports this view with an “old school” econometric model, rather than the DSGE models (discussed back in January) that would be better suited to this task.