What if the natural rate of interest is negative?

Summers’s prediction of ‘secular stagnation’ sets blogosphere alight, writes Chris Johns

Lawrence “Larry” Summers, former U.S. treasury secretary, listens at a panel discussion during the Jacques Polak Annual Research Conference at the International Monetary Fund (IMF) in Washington. Photograph: Andrew Harrer/Bloomberg

Lawrence “Larry” Summers, former U.S. treasury secretary, listens at a panel discussion during the Jacques Polak Annual Research Conference at the International Monetary Fund (IMF) in Washington. Photograph: Andrew Harrer/Bloomberg


The economics blogosphere has been abuzz over the past week, following a recent speech made by Larry Summers to the IMF.

The ex-US treasury secretary, ex-president of Harvard and hero of the liberal, or progressive, wing of the profession, suggested that we are in danger of sinking into secular stagnation.

What we see is what we get: low growth, high and persistent unemployment (in the US, 2-3 per cent growth and 7 per cent unemployment counts as economic stagnation - eat your heart out Olli Rehn).

Paul Krugman, who has been thinking along similar stagnationist lines for some time, referenced the Summers speech in this newspaper a couple of days ago. Martin Wolf has picked up on the theme today.

Other prominent bloggers and commentators have written in similar vein. A lot of very clever people seem to think that Summers is on to something.

Summers anchored his talk around the idea that the “correct” level of interest rates in many developed economies is now negative, perhaps aggressively so. For most practical purposes, interest rates can’t go below zero, so we have a big problem. Most of us can appreciate that if interest rates are too high, the economic consequences are rarely positive. But surely, we might ask, with rates at zero in many countries, how can they be “too high”?

That concept of a normal or equilibrium interest rate is all important in trying to get to grips with all this. The “right” level of interest rates can be a very slippery, if not controversial, concept in monetary economics. It is clear that something very odd is going on: despite massive amounts of money creation by central banks, inflation, at worst, has not risen and, in Europe, has fallen to thepoint where we stand on the brink of falling prices or deflation: very Japanese.

Money is weird. Paradoxically perhaps, we struggle to define and measure it. Counting notes and coins in circulation is easy, but money can take many forms, most of which are controlled, sort of, by central banks. But sometimes that control is weak or even non-existent. Are Bitcoins money?

Monetary theory and policy can be very counter-intuitive. For example, low interest rates can be a signal that policy is, in fact way too tight. Scott Sumner, an economist at Bentley College in the US, has almost single-handedly revived interest in all of this, particularly in the idea of “nominal GDP targeting”, a policy that ensures the economy grows, one way or another.

Growth can come either from inflation or in real terms, but, argues Sumner, it is the responsibility of central banks to deliver growth, in whichever form it comes.

Sumner’s key insight has been forcefully to remind us that central banks can deliver acceptable levels of nominal growth and when they don’t - as they generally have not - they are simply falling down on the job.

Why is the right interest rate negative? Krugman has suggested it might have something to do with demographics. Some models of interest rates link population growth with the equilibrium interest rate. More generally, it must have something to do with saving behaviour: if everybody is trying to spend less than they earn we create a very unstable economic situation, one that involves at least stagnation if not persistent recession.

If everybody - households, government and corporations - is trying to save, the only thing that can restore economic normality could be a negative interest rate.

Economies need both saving and spending: interest rates make sure that everything stays in balance. Perhaps the only thing that can discourage massive excess saving, encourage more consumption and (especially) investment is a negative interest rate.

The practical import of all of this is that policy, especially but not exclusively interest rate policy, is still way too tight in Europe and the US. By contrast, after two decades of stagnation, the penny has finally dropped in Japan and rhetoric, if not yet actual policy, has caught up with reality.

Central banks have already pumped vast sums of money into the system. Banks have not lent out this money; individuals and companies, when they do have access to cash, have either kept it in the bank or paid down debt. It hasn’t worked: policy has not produced the growth that its advocates hoped nor the inflation its critics feared.

The combined insights of Summers and Sumner suggest that this isn’t some temporary thing that will run its course in good time.

The longer we allow it to go on, the deeper the problem gets, the more reluctant people become to spend, the more they want to save. In these circumstances, normality doesn’t get restored naturally, things just stay bad. Unless interest rates go negative.

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