Larry Summers, Bubbles, Fiscal and Monetary Policy, and Financial Regulation; The IMF’s Fourteenth Jacques Polak Annual Research Conference Speech

As I have noted previously, Larry Summers delivered an interesting speech at the IMF’s Fourteenth Jacques Polak Annual Research Conference in November. Some commentators have jumped all over the speech, claiming that Summers is advocating that the Federal Reserve create bubbles in order to stop it from falling into recession or worse. (To find such comments, all you need to do is google “Larry Summers bubbles.”)

I was in the audience when Summers delivered his speech, have watched it again online, and have read a transcript of the speech.* What Summers is saying about bubbles is ambiguous. In fact, the word “bubble” appears only once in the speech. This is what Summers said:

“Let me say a little bit more about why I’m led to think in those terms. If you go back and you study the economy prior to the crisis, there is something a little bit odd. Many people believe that monetary policy was too easy. Everybody agrees that there was a vast amount of imprudent lending going on. Almost everybody believes that wealth, as it was experienced by households, was in excess of its reality: too much easy money, too much borrowing, too much wealth. Was there a great boom? Capacity utilization wasn’t under any great pressure. Unemployment wasn’t at any remarkably low level.  Inflation was entirely quiescent. So, somehow, even a great bubble wasn’t enough to produce any excess in aggregate demand.”  

This, however, is Summers' interpretation of what happened prior to the financial crisis. It is not his policy prescription going forward. In fact, he does not offer policy prescriptions but argues that what we need “to think about” is “how we manage an economy in which the zero nominal interest rate is a chronic and systemic inhibitor of economic activity holding our economies below their potential.”

Near the end of his speech is the one statement about asset prices that could be interpreted as Summers’ advocacy of bubble:

“Now, this may all be madness, and I may not have this right at all. But it does seem to me that four years after the successful combating of crisis, since there’s really no evidence of growth that is restoring equilibrium, one has to be concerned about a policy agenda that is doing less with monetary policy than has been done before, doing less with fiscal policy than has been done before, and taking steps whose basic purpose is to cause there to be less lending, borrowing, and inflated asset prices than there were before.”

It is not clear from that how “inflated” asset prices before Summers might want to do something. It is, however, fair to assume that Summers is concerned about a premature cessation of quantitative easing of monetary policy.

With respect to fiscal policy, Summers is pretty clear about what he advocates:

“But imagine a situation where natural and equilibrium interest rates have fallen significantly below zero. Then, conventional macroeconomic thinking leaves us in a very serious problem, because we all seem to agree that whereas you can keep the federal funds rate at a low level forever, it’s much harder to do extraordinary measures beyond that forever; but, the underlying problem may be there forever. It’s much more difficult to say, well, we only needed deficits during the short interval of the crisis if equilibrium interest rates cannot be achieved given the prevailing rate of inflation.”

It is, though, surprising that, even by those inclined to agree with Summers about deficit spending, there has not been much criticism, if any, about another controversial argument Summers made in this speech. Right after the paragraph quoted above, Summers says:

“If this view is correct, most of what might be done under the aegis of preventing a future crisis would be counterproductive, because it would, in one way or another, raise the cost of financial intermediation, and therefore operate to lower the equilibrium interest rate on safe liquid securities.”

It appears that Summers is hinting that, in his view, Dodd-Frank goes too far. Perhaps he is concerned about a Volcker rule that he considers too restraining on banks. The argument that some of what is being done in the regulatory arena could be characterized as closing the barn door after the cows have left or as overkill is not obviously ridiculous even if one is inclined to disagree with it. There were, though, regulatory failures that were clearly an important part of the story of the events leading up to the financial crisis. It is hard to argue against doing something about that, even if one finds fault with particular regulatory initiatives.  

I have criticized Dodd-Frank for not attempting to deal with the regulatory capture issue and not reducing the number of agencies involved in federal regulation. Also, the failure of the regulatory agencies in the years leading up to the financial crisis was more due to a failure to use existing authority rather than due to a lack of authority. For example, it is common to hear the argument that financial derivatives were unregulated prior to Dodd-Frank; however, the bank regulators could have told the banks that certain uses of derivatives constituted an “unsafe and unsound banking practice.”  That they did nothing while major banks were buying credit default swap protection from one source, AIG, was a clear failure. Nevertheless, it is hard to fault the government from trying to rein in excesses in financial markets that pose systemic risks or could result in the taxpayer being on the hook. If Summers made his argument more explicit here, he might find himself in a politically uncomfortable position. Democrats who preferred Janet Yellen over Summers as Fed chair because they felt he might be lax on regulation had a valid concern. (I have previously written about the regulators’ dilemma and regulatory organizational issues.)

Now that Summers is not likely to be appointed to a government position in the near future, I hope he will clarify his thoughts on regulatory issues, as well as resolve the ambiguity of his speech with regard to monetary policy. Even if some of us do not agree with everything he says in this regard, it would certainly be thought provoking. And most of us would probably not disagree with everything.
 

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* The video of the entire panel session during which Larry Summers gave his speech can be found here. It is the last video of the research conference. The video quality is better than what can be found on YouTube.  An unofficial, but it seems to me to be accurate, transcript of the speech can be found here. Summers has posted a “lightly edited” version of the speech on his blog. The major edit is the elimination of his calling “stupid” what “people in Chicago and Minnesota” might write in his hypothetical scenario.  

Observations on Increasing the Fed’s Inflation Target

The U.S. economy is currently growing sluggishly and has too much unemployment. No one thinks this is a good thing. Indeed, at the IMF research conference last month, many economists expressed particular concern about the high youth unemployment rate in the U.S. and elsewhere and the negative implications of this for society.

They are right to be concerned. The question is what should be done.

One answer is given by two economists of different political stripes. They are Paul Krugman and Ken Rogoff. Krugman is clearly a liberal; he even uses that word in the title of his widely read New York Times blog – “The Conscience of a Liberal.” Rogoff’s politics are somewhat less clear; I heard him say at a seminar arranged as part of the program of the World Bank/IMF annual meetings in October that he was not political, just a scholar. However, he was an adviser to the John McCain presidential campaign in 2008.

Even though they have had disagreements, they both advocate that central banks in the current situation target a higher inflation rate than the current two percent. (For example, see here and here.)

The principal argument of some economists advocating a higher inflation target is that it is a way to achieve a negative real rate of interest (the nominal interest rate is lower than the inflation rate), given that the Fed cannot lower nominal interest rates below zero. They believe that a negative real interest rate is necessary to achieve full employment. Another reason, though this seems to be less explicitly argued, is that inflation encourages current consumption (and discourages savings). Consumers have an incentive to buy now before prices increase. The resulting increase in consumption stimulates the economy.

There are a few problems with these arguments. First, in the current period, the Federal Reserve does not seem capable of increasing inflation. It has increased its balance sheet and, hence, the monetary base to an unprecedented degree. This has not, though, translated into rapid growth of the money supply and the current inflation rate, as measured by the CPI, is less than 2 percent. (I have commented on this here, here, and here.) There is, though, concern about possible bubbles in stocks and bonds and in housing prices.

Second, assuming that the Fed could eventually produce four percent or higher inflation, the economists making the case for this seem to assume that there would not be a political reaction reflecting heightened concern among the public about the future value of their savings and their ability to generate earnings that keep up with inflation.¹ In this regard, it is interesting to note that in July 1971, the CPI had risen by 4.4 percent year over year. The next month, President Richard Nixon announced wage and price controls (as well as severing the last remaining link of the dollar to gold).

The public would be right to be concerned about inflation. Monetary policy is a blunt instrument, and it is doubtful that the Fed would be able to achieve a narrow target on the inflation rate for a substantial period of time. Higher inflation also can feed upon itself, as the aftermath of the Nixon’s Administration’s experiment with wage and price controls demonstrates. If this happens, ultimately the Fed would have to slam on the brakes and generate a recession, as Paul Volcker did when he was Fed chairman. Targeting inflation is not the same as targeting a short-term interest rate, such as the fed funds rate (the rate at which banks lend to each other on an unsecured basis). Inflation is only observable with a lag, and it takes some analysis and judgment to discern whether a higher or lower than expected monthly number is due to a temporary aberration or is indicative of something more permanent.

Finally, using fiscal policy is preferable and more likely to be effective than monetary policy to stimulate the economy in a prolonged period of sluggish growth (or worse). When the Fed increases the monetary base, it does not directly add to demand. If the money is lent out by the banks, the borrowers will spend or invest it. But what if the banks sit on a huge amount of excess reserves, as they are doing now? Then nothing much happens to the real economy except for whatever stimulatory effect there is from the increase in the prices of the assets the Fed has bought (Treasury notes and bonds and mortgage backed securities).

On the other hand, if the government spends money, this directly adds to demand. In this regard, there is a strong argument that the federal government should be investing in improving infrastructure, both because infrastructure, such as highways, bridges, public transportation systems, and water and sewer systems, need to be improved and because such projects will put people to work. Krugman and Rogoff agree on this, as does Martin Feldstein, who disagrees with the other two on monetary policy. Also, if the federal government finances this by increased borrowing rather than taxes, it can borrow very cheaply since interest rates are too low. The cost in inflation-adjusted terms may even be negative, if inflation turns out to be higher than the nominal rate at which Treasury borrowed.²

The rejoinder to this argument is that it is not currently politically possible to increase government expenditures in any significant way. That is true, which is why the Fed feels it has no choice but to follow an aggressive monetary policy. Janet Yellen apparently believes that regulatory tools can be used to contain any bubbles that may develop because of this before they cause too many problems. I hope she is right, but I understand why the Fed needs to run this risk when fiscal policy has been contractionary. It is a troubling fact that the current economic distress and uncertainty have given rise to a populism of the right that believes that shrinking government in the current situation will solve economic problems rather than prolong them. It is also troubling that there is a dearth of skilled and knowledgeable politicians who can lead the public to understand the right solutions. Instead, we have a faction of the Republican Party riding the Tea Party wave for opportunistic reasons, though it is doubtful that they will reap the political benefits they hope.

While I think the Fed has no good options other than following its current course, announcing an inflation target of 4 percent would be a mistake. The risks of doing that are, I believe, higher than Krugman and Rogoff appreciate. In any case, it is doubtful that it is politically possible. While the Fed is an independent agency and insulated from the political winds of the moment, it cannot totally ignore political reality.

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1. When I worked at Treasury, I was heavily involved in the discussions about and the development of Treasury inflation-indexed bonds (Treasury Inflation-Protected Securities or “TIPS”). One of the arguments made for Treasury issuing inflation-indexed bonds is that this would facilitate the private sector’s creation of other inflation-indexed products, such as inflation-indexed annuities or mortgages. There has not been much interest in other inflation-indexed products, except for mutual funds that invest in TIPS and, sometimes, physical commodities. Note, though, that, if there were greater use of inflation-indexed products, these instruments could have served to mitigate to a degree people’s fear of inflation, but at the same time they would also have acted to limit inflation’s ability to stimulate the economy.

 

2. Treasury does not match particular security issuances with particular expenditures. Therefore, as a practical matter, it is not possible to determine the borrowing costs for any particular expenditure without making some assumptions.

 

A Brief Note on “Printing Money” and the Monetary Base, M2, and Inflation

When it comes to monetary policy, the media is fixated on the Fed’s “printing money”* and the timing of any tapering of “quantitative easing.” Critics of the Fed assert that the Fed’s quantitative easing policies will lead to inflation. The simple argument is that the Fed’s policies will lead to too much money chasing too few goods, which will result in price increases.

In order to evaluate this argument, it is useful to remind ourselves of some basic facts. It is true that the Fed through its quantitative easing policies – purchasing Treasury notes and bonds and mortgage-backed securities – has been vastly increasing the size of its balance sheet to an unprecedented degree. This has resulted in a large increase in bank reserves and the monetary base (currency in circulation and balances of depository institutions held at Federal Reserve Banks). It has not, though, resulted in an unprecedented increase in the money supply. M2, which is a commonly used measure of the money supply, consists of currency held by the public, transaction deposits at depository institutions, savings deposits, time deposits of less than $100,000, and retail money market fund shares. (See here for the Fed’s description of these aggregates and links to monetary data.) Note that bank reserves, including excess reserves, are not included in M2.

What is important to note is that the relationship of changes in the monetary base, which the Fed controls, and changes in M2 has been completely transformed since the financial crisis. The monetary base also currently has no relationship to inflation as measured by the CPI. This graph shows on a monthly basis beginning in 2000 percentage changes from a year ago of M2, the monetary base, and the CPI.

 

 

Before claiming that Fed policy is leading to inflation, critics need to analyze the change in the relationship between the Fed’s expansion of its balance sheet and the growth rate of M2. They also need to examine the current lack of relationship between the monetary base and inflation.

What seems more plausible is that monetary policy has not been as effective as desired at stimulating the economy. There also is little effect of quantitative easing on increasing the growth rate of the money supply. There is a case to be made, though, that the quantitative easing policies have served to lower long-term interest rates, particularly on Treasuries and mortgage-backed securities, but to an unknown degree. This has perhaps fueled increases in stock market and housing prices, but it has not resulted in an increase in prices of consumer goods. There is reason to be concerned about asset bubbles at the current time, but the danger (or benefit) of inflation seems remote.

Some economists, such as Paul Krugman and Ken Rogoff, advocate Fed policies leading to an increase in inflation as a way to get the economy growing. Higher inflation can produce negative real interest rates, which some view as necessary to get the economy to full employment. At the moment, it would seem that the Fed would have to be much more aggressive than is currently feasible politically or practically to get the inflation rate at some economists’ preferred target of four percent. Of course, it may become possible at a later time, though it is subject to debate whether this would be good policy. At the moment, the greatest risk to the economy from current Fed policy is asset bubbles which inevitably deflate. The Fed’s greatest challenges are deciding how to meet its legislatively mandated goals of “stable prices” and “maximum employment” in a period when fiscal policy is far from helpful in stimulating the economy, when and how to phase out its quantitative easing policies, and how to avoid dangerous asset bubbles.    

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* The phrase “printing money” is misleading shorthand for what the Fed does. I prefer to call it “creating money.” The Treasury Department through its Bureau of Engraving and Printing prints money. The Federal Reserve pays the Treasury for the printing costs. How much the Federal Reserve orders of Federal Reserve notes is largely determined by the public’s demand for physical currency. Coins are minted by the Treasury’s Bureau of the Mint and sold at face value to the Fed. The difference between the face value of the coins and the cost to the Treasury of producing the coin enters into government accounts as a means of financing, i.e., it is not an outlay or a receipt and does not serve to increase or reduce the reported budget deficit. This is called seigniorage. In minting pennies and nickels, this seigniorage is a negative number.