FOMC Preview December 2013
Fundamentals Update as at 10 December 2013 by Lorenzo Beriozza
The US, it is alleged, has fallen into “secular stagnation.” Not one but two academic heavyweights—Larry Summers and Paul Krugman —argue that to achieve full employment, the US needs not just low interest rates, but negative interest rates. If correct, investors should lock their doors and hunker down.
What is “secular stagnation” and why is it an idea whose time has not come? Summers starts by noting two troubling facts. First, in recent years, even major asset bubbles have failed to produce an economic boom and rising inflation. Doesn’t this suggest, he asks, that aggregate demand is so fundamentally weak that even bubbles can’t fix it? Second, despite super-easy monetary policy, the US has never recovered from the 2008-9 crisis. Putting the two together, he concludes that the “natural rate of interest” – the real rate of interest consistent with full employment – must be negative. Put in another way: we are in a “liquidity trap” where the central bank can’t get the interest rate low enough to get a real economic recovery.
In his New York Times column from November 16, Paul Krugman strongly endorsed this view and then extended it. He noted that the “economic expansion of 2003-2007 was driven by a bubble”, “you can say the same about the latter part of the 90s expansion” and the late 1980s expansion. “Looking forward you have to regard the liquidity trap not as an exceptional state of affairs but as the new normal.” According to Krugman, getting sufficient stimulus into the economy requires one of three radical responses.
- First, eliminate all paper money and pay a negative interest rate on deposits.
- Second, take advantage of the next pickup in growth to “push inflation substantially higher.”
- Third, encourage bubbles or irresponsible lending.
Since none of these policies have a “vampire’s chance in the sun” of being adopted, the economic outlook is grim. Krugman concludes on Summers’ “radical manifesto”: “I very much fear that he may be right.”
Before panicking, it’s worth examining more closely the case for a zombie economy and the last two business cycles.
The NASDAQ bubble of the 1990s came after the economy hit full employment. According to CBO estimates, the unemployment rate breached the 5.1% NAIRU in 1Q 1997. However, the NASDAQ did not go “vertical” and the S&P 500 did not hit very high valuations until 1998 or 1999. By that time, the unemployment rate was approaching 4%. Thus the lesson of the 1990s is not that you need an asset bubble to achieve full employment, but that pushing the unemployment rate well below full employment creates both inflation and bubble risks.
The lesson from the 2000 cycle is similar, albeit less obvious. The housing bubble did not start in earnest until 2005 when exotic products proliferated and investors flooded into hot markets. By that time the unemployment rate was already a healthy 5.5%. Again, the lesson of this period is not that you need bubbles to get low unemployment, but that it can be dangerous to push the economy too far and ignore bubble warning signals.
The view of the current business cycle may also be different. There is nothing surprising about the slow recovery: it always takes a long time to recover from a major banking and real estate collapse. Economic historians point to five such episodes for developed markets economies: Spain (1979), Norway (1987), Finland (1991), Sweden (1991) and Japan (1992). All suffered through sub-par recoveries despite aggressive policy responses, but only one— Japan— went into secular stagnation. Moreover, it is simply not true that easy Fed policy has failed to help the economy. Monetary policy has been highly successful in two respects:
- First, it has accelerated the rebuilding of balance sheets—banks, households, corporations, government budgets and the housing market are all in much better shape than four years ago.
- Second, monetary policy has done a reasonable job of offsetting a series of negative shocks. State and local budget consolidation, the Euro zone crisis, the Arab Spring, repeated brinkmanship moments in Washington and federal fiscal austerity have pummelled the economy, and yet the slow recovery continues.
On this last point, recall that Krugman and Summers are both big proponents of the power of fiscal policy when the economy is depressed. Both have pounded home the argument that current fiscal policy should be easy, not tight, and that the “multiplier effects” are larger than normal when the economy is depressed and near the zero bound on interest rates. Surely, their argument also applies in reverse: doesn’t the end of a period of significant fiscal consolidation mean stronger growth ahead? Why apocalypse now, just when allegedly devastating fiscal austerity is about to abate?
In sum, Summers and Krugman may have overstated their argument. There has been some structural damage to the economy and policy makers have added to that damage by helping delay the cyclical recovery. However, this is a very odd time to argue for secular stagnation. Quite to the contrary, with structural repair and fading fiscal headwinds, there is a good case for stronger growth next year. The economy doesn’t need to be shocked out of its zombie state, he will look a lot better if we just stop punching him.
Source: Bank of America Merrill Lynch
