We currently live in a world where growth is higher than the natural rate of interest. Everyone who thinks there is a natural rate of interest believes the NRoI is negative right now. Miles Kimball, Brad Delong, Paul Krugman – nearly any economist who abides by the NRoI model believes the NRoI is negative.
The economy needs a bubble in order to function properly when g > r.
They also believe g, our real rate of growth, is positive today and has been positive over the last several years. The rate g might be low, but it’s well above zero, probably somewhere around 2-3%. Technology is advancing at some non-zero rate, which *must* force growth to be higher than zero. In any case, real GDP has been growing.
These circumstances put the U.S. economy into Paul Samuelson’s world where we can get a free lunch, as long as we have a bubble. We get extra growth at no cost of inflation. Our lives are better off with the bubble.
My take on this is the economy demands bubbles when r <g. That’s right – demands bubbles. If the bubble is not met, it will try and find a way to create this bubble. (See real estate, stock market, S&L, Emerging Markets) Artificially constraining the bubble forces unnecessary misery on people, and causes involuntary unemployment and unused capacity, which is bad because it causes an economic incentive for war.
We now know 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 you can in fact say the same about the later years of the Reagan expansion, which was driven at that point by runaway thrift institutions and a large bubble in commercial real estate.
So you might be tempted to say that monetary policy has consistently been too loose. After all, haven’t low interest rates been encouraging repeated bubbles?
But as Larry emphasizes, there’s a big problem with the claim that monetary policy has been too loose: where’s the inflation? Where has the overheated economy been visible?
So how can you reconcile repeated bubbles with an economy showing no sign of inflationary pressures? Summers’s answer is that we may be an economy that needs bubbles just to achieve something near full employment – that in the absence of bubbles the economy has a negative natural rate of interest. And this hasn’t just been true since the 2008 financial crisis; it has arguably been true, although perhaps with increasing severity, since the 1980s.
Are we in a great stagnation? What might be causing it? Krugman:
Think of it this way: during the period 1960-85, when the U.S. economy seemed able to achieve full employment without bubbles, our labor force grew an average 2.1 percent annually. In part this reflected the maturing of the baby boomers, in part the move of women into the labor force.
This growth made sustaining investment fairly easy: the business of providing Americans with new houses, new offices, and so on easily absorbed a fairly high fraction of GDP.
Now look forward. The Census projects that the population aged 18 to 64 will grow at an annual rate of only 0.2 percent between 2015 and 2025. Unless labor force participation not only stops declining but starts rising rapidly again, this means a slower-growth economy, and thanks to the accelerator effect, lower investment demand.
By the way, in a Samuelson consumption-loan model, the natural rate of interest equals the rate of population growth. Reality is a lot more complicated than that, but I don’t think it’s foolish to guess that the decline in population growth has reduced the natural real rate of interest by something like an equal amount (and to note that Japan’s shrinking working-age population is probably a major factor in its secular stagnation.)
There may be other factors – a Bob Gordonesque decline in innovation, etc.. The point is that it’s not hard to think of reasons why the liquidity trap could be a lot more persistent than anyone currently wants to admit.
I've written here before about what type of economy a country needs in a world of shrinking populations. If we are to avoid what Japan has gone through since 1991, we may need to shift to a model where you earn a negative interest rate on savings. That's right, any money you might leave in the bank might actually shrink.
Encouraging spending/investing instead of saving and trying to drive and sustain inflation may sound crazy, but many are arguing persuasively that it might be what we need to avoid stagnation.
Nick Rowe provides a more straightforward description of the need for a bubble given our demographic trends.
Each cohort of people lives for two periods. The population, and everything else, stays the same. When young they work and produce goods. When old they cannot work and cannot produce goods. So they want to save when young so they can consume when old.
If no goods can be stored, they cannot save, and the old starve. They would like to lend when young, even at very negative interest rates, but there is nobody willing to borrow from them. The next cohort, who could pay them back, haven't been born yet.
A chain letter swindle solves the problem. Each old person sends a letter to one young person, saying "Please give me half your goods, and then you can send this same letter to one young person when you are old". Each young person now saves half the goods he produces, by buying one letter. And he sells the letter when he is old for the same amount of goods. The rate of interest is now zero, as is the growth rate of the economy.
Every cohort is now better off than without the chain letter, because they don't starve when old. But the first cohort to invent the chain letter swindle is much better off, because they consume all their production when young, plus half a young person's production when old. And if any cohort breaks the chain, the preceding cohort is much worse off, because they consume half their production when young, and nothing when old.
Samuelson called the chain letter "money". But it could be an unfunded government pension plan. Or gold could serve the same purpose, even if gold were intrinsically useless except as a store of value. Whatever it is, it's a bubble, that has a market value in excess of any intrinsic value.
The value of the bubble would be equal to half the GDP per period. So, if the "period" is about 20 years (if retired people live for about 20 years), the bubble would need to be worth about 10 years of GDP. That's a very big bubble to make the economy work well. It could be bigger still if people wanted to save for emergencies, or for their kids, as well as for retirement.
Introducing capital alleviates the problem, but may not always solve it. Without capital, the natural rate of interest in the model is minus 100% per period, because the produced goods rot before the next period. Investing in real capital can have a positive rate of return, and so can raise the natural rate of interest above zero. If the marginal return on capital, in equilibrium, is greater than the growth rate, then the world returns to normal. People will save by investing in real capital, and the economy doesn't need a bubble. But if the marginal return on capital, after an allowance for risk, is less than the growth rate of the economy, it still needs a bubble. A chain letter, or bubble, can grow forever at the growth rate of the economy, as long as people believe in it and don't break the chain. And it can pay a rate of interest equal to the growth rate. So people save partly in real capital, and partly in the bubble, and both pay the same risk-adjusted rate of return, equal to the growth rate. (The marginal rate of return on capital rises as the capital stock falls when people hold less capital and more bubble.)
Take a subset of the economy I'm particularly invested in, the technology industry, and ask yourself about past Internet bubbles. Many people have a visceral disgust when they believe they are living in the midst of another technology bubble, but as long as the bubble persists, the money and investment flows freely, people start companies and employ other people, the wages are recirculated into the economy, and on par life is better for more people on an absolute basis if not a relative one.
Maybe the tech industry mirrors the economy at large in its need for a persistent bubble. On the bright side, this latest bubble in tech, if you believe we are living through one, brought back the always entertaining Valleywag, so perhaps everyone is united in benefitting from the bubble, whether they are living inside it or throwing stones at it from the outside.