Summers zeroes in on the new normal

Interest rates at zero? Potentially the ‘new normal’, according to economist Larry Summers.

Larry Summers, speaking at an IMF research conference on November 8, had some interesting thoughts on the zero lower bound problem for monetary policy. Summers, whose resume makes for some reading – former chief economist at the World Bank, director of the National Economic Council, and Secretary of the Treasury of the United States – reframed the discussion on the problem of 0 per cent nominal interest rates: a present and persistent problem for the United States, Japan and Europe.

Conventional economic wisdom suggests that the nominal cash rate hitting 0 per cent is a phenomenon reserved for Japan and other countries suffering a recession. The thinking goes that it may be a way of life for the Japanese, but for everyone else it is just a temporary stop on the way to greater economic times.

But this line of thought is changing.

The simple graph below should highlight the problem of a zero lower bound. In the graph, we have an economy where nominal interest rates are at 0 per cent. At this level of interest rates, demand is well below our productive capacity.

The normal response by a central bank to a depressed economy is a rate cut but with interest rates at 0 per cent that is not possible. Consequently, instead of producing G* we are left at the inferior outcome of G¹.

As we know, central banks in Japan, the US, the UK and Europe have responded to this issue via quantitative easing, which is designed to lower long-run interest rates, boost liquidity and create inflation. Rising inflation allows the real interest rate to fall even with nominal rates at 0 per cent. Since the graph above is in nominal terms, increasing inflation causes the demand curve to shift upwards to the right, reducing the divergence between demand and supply.

Summers suggests the zero lower bound problem for monetary policy should be reframed as something that is going to happen over and over again, rather than an unusual byproduct of the global financial crisis. He argues that it has been a feature of the US economy for some time, pointing to the boom prior to the global financial crisis.

“Many people believe that monetary policy was too easy. Everybody agrees that there was a vast amount of imprudent lending going on,” Summers said. “Was there a great boom?”

He says that even a great bubble was not enough to create any real excess in the aggregate economy. Capacity utilisation and unemployment rates placed little pressure on inflation, which remained fairly well contained prior to the crisis.

Expansion phases in the US have increasingly been tied with asset bubbles. The dot-com boom paved the way for the housing boom, and now we face a stock boom. But even with an unprecedented flow of capital into risky assets the US is struggling to generate sustainable growth, employment and inflation.

This suggests the interest rates available to households and businesses remain too high to generate the level of investment required to boost the economy. We know this because the real interest rate is already below zero and it has not been enough to facilitate a significant rise in employment. Summers suggests that we need to "think about how we manage an economy in which the zero nominal interest rate is a chronic and systemic inhibitor of economic activity".

If you accept Summers’ premise, the likes of the Federal Reserve and European Central Bank may eventually need to increase their inflation targets. Rather than targeting inflation of 1-2 per cent, they might lift it to 2-3 per cent or even a little higher. A higher inflation target, if realised, may allow the real interest rate to fall to a level consistent with demand and supply in the broader economy. Changing inflation expectations though is often easier said than done.

Another solution might be the eventual removal of the cash economy so that all purchases are made via plastic. A central bank could set nominal interest rates below zero since it would be impossible for people to hoard their cash. While potentially effective, hopefully this approach never gains popularity.

Getting out of a liquidity trap is one of the great challenges facing central banks. Japan has tried for decades with little success and the likes of the US and especially Europe are facing the prospect of more than a lost decade of economic growth. Summers’ speech at the IMF provides a different perspective on the issue and highlights the boom-bust nature of the US economy over the past twenty years. In my view, it simply reinforces the need for greater research into this issue.