Is zero the new normal?

Larry Summers talk on secular stagnation has led to a burst of discussion on whether nominal interest rates may be at their Zero Lower Bound (ZLB) for longer than we might have thought. I would like to use this post to clarify a number of different ideas that may be involved here. Crucial to this discussion is the concept of the natural real interest rate (NRR). I will define this as the real interest rate that keeps inflation constant. (Sometimes economists define the NRR as the real interest rate that would occur if all prices were flexible, but I think that can be misleading when we are at the ZLB.) There are important issues about risk and different real rates that Tyler Cowen mentions which I will have to ignore.

Crucial to Summer’s argument is that our problems did not all start with the recession. However it may be worth just noting some arguments that the ZLB may be around for some time that do begin with the recession.

1) It takes a long time to adjust balance sheets

One way many economists think about the current recession is that it involves balance sheet adjustment: consumers and firms need to save to reduce their borrowing or increase their wealth. Ideally we would try and offset this by encouraging them to make this adjustment more slowly, or encouraging others to offset this, through negative real interest rates. If adjusting balance sheets takes a decade rather than five years, this may mean that the NRR is negative for much of this period, so we will be stuck at the ZLB for some time to come.

2) Fiscal policy

Tightening fiscal policy lowers the NRR. One of the unusual features of this recession relative to earlier downturns is fiscal austerity, and this will reduce the NRR.

3) Financial intermediation

There has been a lot of discussion about how recessions that result from a financial crisis may be longer lasting. In some countries there is a concern that banks are still carrying a large amount of bad loans, and that this may inhibit their lending for some time. Others worry that tighter regulation could have the same impact, although this is disputed. Just as a reduction in credit rationing can lead to a prolonged economic boom, an increase in rationing can have the opposite effect. There are also more complicated arguments involving a shortage of safe assets (like government debt) that can be used as collateral.

 4) Pessimistic expectations

The way the global economy eliminates deficient demand is not through price flexibility per se, but through movements in real interest rates. If the ZLB means that output is below the natural rate for some time, this could lead consumers and firms to revise down their estimate of what long run output will be. (We can see this happening already when some argue that productivity has permanently fallen as a result of the recession.) If these expectations are more pessimistic than those of policymakers, interest rates might have to be at the ZLB until these expectations are revised. (I discuss some related ideas here.)

All these stories generally start with the recession. However in the decade before the recession, the real interest rate associated with stable inflation appeared to be much lower than before: this is Bernanke’s savings glut. It seems clear that we have to take a global perspective on this, otherwise we end up chasing contradictory red herrings: worrying about the lack of investment in the US, and also worrying about overinvestment in China. The importance of thinking globally is emphasised in Daniel Alpert’s book, and by many others.

One straightforward possibility is that the long run equilibrium NRR has fallen. In standard macroeconomic models, this rate is usually related to impatience, population growth, and technical progress. We know that population growth has shown substantial declines in the developed world, and will show similar declines in the developing world, so that world population may eventually stabilise in around 100 years. Some have also argued that the rate of technical progress has already, or is about to, decline. So there are good reasons for believing that the long run equilibrium NRR has fallen. It might be possible to construct demographic arguments for the medium term NRR to be below the long run NRR, but I will leave that to those who know more about savings behaviour in China and its neighbours.

Another, but rather different, popular argument relates to inequality. It is often put very simply: as the rich have a lower propensity to consume out of income, shifts in the distribution of income towards the rich will tend to reduce aggregate consumption. For a more sophisticated discussion, see Interfluidity.

Often solutions to problems depend on a good diagnosis of why these problems have arisen, but I can think of two solutions that appear to be robust to any of the stories outlined above. The first, discussed by Ryan Avent and made fairly explicitly in recent remarks by Blanchard, is to raise the inflation rate. The second, which a great many economists would sign up to even if they swear they are not Keynesian, is a sustained increase in public investment. The advantage of the latter over the former is that the former has clear costs, whereas the latter could have clear benefits. Of course we may need to do both.

Let me finish with a point about government debt. A major reason why high government debt is a problem in the medium to long term is that - unless Ricardian Equivalence holds - it crowds out private capital. It does that by raising the NRR. Too much saving goes into buying government debt, so there is not enough to invest in private capital. Yet if the NRR is actually negative, and likely to stay very low for some time, and this is a problem because of the ZLB, then the fact that government debt is currently raising the NRR is useful. To put it another way, this means we have plenty of time to deal with the problem of government debt. Which is good, because all the analysis suggests that it is optimal to reduce debt slowly. In the short term, high public debt is helping, not hurting. (Similar arguments can be made in relation to unfunded social security schemes.)