Why the heck are interest rates so low?
That's the question former Treasury Secretary Larry Summers and former Federal Reserve Chair Ben Bernanke have been debating in what might be the world's most important, but also most respectful, blog fight. Are rates low because not enough people want to invest or because too many people want to save? The answer tells us why the economy seems stuck and what we can do to un-stuck it.
Now, part of it is that the Federal Reserve has cut short-term rates to zero and bought enough long-term bonds to push their rates down, too. But that's not the real story. After all, it's not like the Fed can keep rates lower than they "should" be without fueling inflation—which there isn't any now. So rates are so low not because that's where the Fed wants them to be, but rather because that's where the economy needs them to be. If it weren't for the fact that rates can't go—well, at least not that far—below zero, they'd probably have fallen even further on their own, and the recovery would have been better. Everything the Fed has done has just been trying to make up for this, to get rates closer to where they would be if they could be negative.
Okay, but why does the economy still need such low rates? Good question. Summers worries it's a new old problem called "secular stagnation." That's the idea that, absent a bubble, the economy will be stuck in a never-ending slump, because inflation-adjusted interest rates can't go low enough to get people to borrow and invest. Economist Alvin Hansen first proposed this in 1938, when it looked like slower population growth would mean slower investment growth—why build new houses or offices if there aren't new people for them?—and make the Depression go on for, well, close enough to forever.
Now the baby boom thankfully proved him wrong, but what if, Summers wonders, their retirement proves him right? Once again, there isn't as much population growth, this time because the Boomers are starting to collect Social Security, and that means there isn't as much demand for new investments. Not only that, but in the internet age, companies don't even need to spend as much as they used to on the investments they do make. Computers, in other words, cost a lot less than factories. Add it all up, and it could be that only way for the economy to get enough investment spending would either be for the government to do it directly or to try to get the private sector to do it by increasing inflation so that real rates come down.
But Bernanke thinks this is overly pessimistic. The U.S. economy looks like it's picking up speed now, and it was going plenty fast in the 1990s even before the tech bubble turned the Pets.com sock puppet into the avatar of irrational exuberance. Besides, it isn't easy to tell a story about why people would need negative real rates to get them to invest. "Almost any investment would be profitable," Bernanke says, if rates were that low for that long, to the point that it would even "pay to level the Rocky Mountains to save the small amount of fuel expended by trains and cars that must currently climb steep grades." That sure doesn't seem like the world we live in. And even if it were—this is the most important part—we could still export our way to health as long as other countries were doing alright.
So why does Bernanke think the economy needs low rates? Well, he doesn't really. Or at least he thinks it won't soon. Now, there are still, he says, "economic headwinds" left over from the crisis that justify low rates today. But rates should rise tomorrow—or maybe six months from now—if the recovery keeps chugging along. "Should" is a funny word, though. If history is any guide, long-term rates probably won't go up that much because of what Bernanke calls the "global saving glut."
Bernanke first talked about this back in 2005, when, as a Fed Governor, he tried to explain the puzzle of long-term rates not rising much despite short-term rates doing so. The answer, Bernanke said, was that after the East Asian Financial Crisis in 1998, emerging markets like China and Saudi Arabia had seen how much trouble they could get into if they didn't build up a war chest of dollars, so they started saving much, much more. Specifically, they took the money they made selling things to the U.S. and put it into U.S. bonds. All that incoming money pushed down long-term rates in the U.S., which, even though it sounds good, actually wasn't, because it also pushed up the dollar and made the trade deficit worse. Things aren't as bad today, but they still aren't good. Sure, Asia's emerging markets aren't hoarding dollars like before, but Germany, as Paul Krugman puts it, is the new China when it comes to turning saving into a vice. So once again, interest rates are down, the dollar is up, and a widening trade deficit is weighing down the recovery.
Even though secular stagnation and the global saving glut are distinct economic stories, it's easy to confuse them since they look the same. Output is below potential and interest rates are low in both, which is just another way of saying that people want to save more than they want to invest. Secular stagnation says it's because there isn't enough demand for investment, while the global saving glut says, yes, it's because there's too much supply of savings. Now why does it matter which it is? Well, as Bernanke points out, different problems have different solutions. Secular stagnation means the economy is broken and the government needs to fix it by giving us more inflation and more infrastructure spending. But the global saving glut means the economy wouldn't need any fixing if governments would stop breaking it by manipulating their currencies down to run bigger and bigger surpluses and amass bigger and bigger piles of dollars.
But enough suspense. Is secular stagnation or the global saving glut to blame for our economic woes? Yes. See, despite the fact that it's hard to imagine a world where real rates aren't negative enough to get people to invest, we can't write off secular stagnation just yet. That's because it's not hard to imagine a world where central banks get stuck in a self-induced paralysis. Just open your eyes. Japan, as Paul Krugman points out, let prices fall so much that its inflation-adjusted rates never fell to zero even though its nominal rates did. So its real rates weren't that much less than the rest of the world's even as its economy fell behind—and, as Brad DeLong reminds us, it did fall behind—which, in turn, meant that its currency never fell enough to be a real escape hatch from its slump. The same has happened to Europe the past few years. Now, it's true that both are doing what they should now—buying bonds, like the Fed did, until inflation goes back up—but both are in such deep holes and have such bad demographics that they're going to be stuck in something that looks an awful lot like secular stagnation for awhile. Maybe not a long a run where we're all dead, but at least one where we're all middle-aged.
And that creates all kinds of problems for us. Europe's slump, for example, means that there's, well, a glut of money leaving the continent looking for better returns abroad, in the process, pushing the dollar up and the euro down. That'd be good news if it was enough to get Europe back to normal anytime soon, but markets don't seem to think it will. If they did, the dollar probably wouldn't be rising as much as it has. So what exactly are we saying here? Well, the easiest way to think about it is this. We used to have a global saving glut caused by other country's policy decisions, but now we have a global saving glut caused by other country's secular stagnation.
If that's right, then it's not going to be enough to browbeat countries that aren't spending a lot into spending more. They can't. Instead, we're going to have to fight the global saving glut by pushing the dollar down—maybe by raising the Fed's inflation target from 2 to 4 percent. The funny thing is that's also the way to fight secular stagnation here at home, so no matter what you think the economy's problem is, this might be the solution. Indeed, back in January 2009, none other than Bernanke himself was surprised that there wasn't "slightly more interest" at the Fed "in moving [inflation] up from our so-called comfort zones, given our recent experience with deflation risk and zero lower bound." It's still surprising that there isn't. The global saving glut hasn't gone away and the fact that interest rates can't go much below zero means there's a risk that with worse policy and worse demographics, we could get dragged down into secular-ish stagnation too.
The real mystery, in other words, is why we're accepting a world where interest rates are staying so low.