The debate on secular stagnation goes on

Lawrence H. Summers

Joseph Stiglitz, noted economist Roger Farmer, and I are now and have long been in agreement on what are probably the most important points. The “New Keynesian” paradigm that sees business cycles as arising from temporary rigidities in wages and prices is insufficient to account for events like the Great Depression and the Great Recession. Too little was done in the aftermath of the financial crisis a decade ago to stimulate aggregate demand. A more equal income distribution operates to increase aggregate demand. Substantially stronger financial regulation than was in place before 2008 needs to be adopted to minimize the risks of future crises.

I continue to have disagreements with Stiglitz on the record of policy advice, and with both Stiglitz and Farmer on some points of theory regarding secular stagnation.

Starting with the policy record, Stiglitz is right to assert that economists should not be expected to agree on issues of political feasibility. They should, however, be able to agree on what texts say. The New York Times commentary that Stiglitz proudly cites calls for a stimulus of “at least US$600 billion to US$1 trillion over two years.” The Obama administration called for and received stimulus totaling some US$800 billion, a figure well within Stiglitz’s range, despite being politically constrained by the necessity of Congressional approval. So I’m not sure what he is claiming.

Stiglitz asserts that the study Fannie Mae hired him to write in 2002 said only that its lending practices at that time were safe. That is not how I read it. It speaks to ten-year default probabilities of less than one in 500,000; notes that even if the analysis is off by an order of magnitude, any risks to government are very modest; and appeals to the regulatory system in place at the time to minimize that their model missed risks. He makes arguments against the Congressional Budget Office, the Department of the Treasury, and the Federal Reserve, all of which had suggested — based on the same information available to Stiglitz when he wrote his paper — that implicit guarantees to Fannie Mae were potentially costly.

I am not sure what point Joe is making with respect to derivatives. I was clear in my article to which he is responding that I wish we had not supported the 2000 legislation. But I also noted that there is no reason to think that, in the absence of the legislation, the Commodity Futures Trading Commission under the Bush administration would have asserted new authority over derivatives and pointed to the legal certainty problem that career lawyers thought was important to address.

What about secular stagnation theory? Stiglitz and I agree that Alvin Hansen’s prediction was not borne out after World War II because of a combination of expansionary policy and structural changes in the economy. This was my point five years ago in renewing the idea of secular stagnation — to suggest that the economy as it was in 2013 required some combination of fiscal expansion and structural change to sustain full employment.

Structural factors

My discussions of secular stagnation have all emphasized a variety of structural factors, including inequality, high profit shares, changes in relative prices, and global saving patterns. Where does Stiglitz disagree?

Farmer, in his thoughtful commentary (published in Shanghai Daily on September 13 ­— editor’s note), argues that models of the type he has pioneered in recent years are the right way to think about chronically excessive unemployment and that, with the right microfoundations, one can conclude that fiscal policies are ineffective. I think his modeling approach may well prove very fruitful, and I wish I understood it better. But, for now, I find the empirical evidence, international comparisons, time-series studies, and studies of local variation within the US compelling in suggesting that fiscal policy works. I do think, however, that Farmer’s views on the use of monetary policy to stabilize asset prices deserve serious consideration.

Finally, I hope Stiglitz will respond positively to my repeated suggestions that we debate these matters in person at Columbia or Harvard or some other suitable venue. We can all agree that the stakes in a better understanding of the lessons of macroeconomic history, and in avoiding future events like those of the last decade, are very high.

Lawrence H. Summers was US Secretary of the Treasury (1999-2001), Director of the US National Economic Council (2009-2010), and President of Harvard University (2001-2006), where he is currently University Professor.Copyright: Project Syndicate, 2018. www.project-syndicate.org

Joseph E. Stiglitz

As Larry Summers rightly points out, the term “secular stagnation” became popular as World War II was drawing to a close. Alvin Hansen (and many others) worried that, without the stimulation provided by the war, the economy would return to recession or depression. There was, it seemed, a fundamental malady.

But it didn’t happen. How did Hansen and others get it so wrong?

Like some modern-day secular stagnation advocates, there were deep flaws in the underlying micro- and macroeconomic analysis — most importantly, in the analysis of the causes of the Great Depression itself.

As Bruce Greenwald and I (with our co-authors) have argued, high growth in agricultural productivity drove down crop prices in the first three years of the Depression alone. Incomes in the country’s major economic sector plummeted by around half. The crisis in agriculture led to a decrease in demand for urban goods and thus to an economy-wide downturn.

WWII, however, provided more than just a fiscal stimulus; it brought about a structural transformation, as the war effort moved large numbers of people from rural areas to urban centers and retrained them with the skills needed for a manufacturing economy, a process which continued with the GI bill. Moreover, the way the war was funded left households with strong balance sheets and pent-up demand once peace returned.

An analogous structural transformation, this time not from agriculture to manufacturing, but from manufacturing-led growth to services-led growth, compounded by the need to adjust to globalization, marked the economy in the years before the 2008 crisis. But this time, mismanagement of the financial sector had loaded huge debts onto households. This time, unlike the end of the WWII, there was cause for worry.

As Summers well knows, I published a widely cited commentary in The New York Times on November 29, 2008, entitled “A US$1 Trillion Answer.” In it, I called for a much stronger stimulus package than the one President Barack Obama eventually proposed. And that was in November.

By January and February 2009, it was clear that the downturn was greater and a larger stimulus was needed. In that Times commentary, and later more extensively in my book “Freefall,” I pointed out that the size of the stimulus that was needed would depend both on its design and economic conditions. If the banks couldn’t be induced to restore lending, or if states cut back their own spending, more would be required.

Indeed, I publicly advocated linking stimulus spending to such contingencies — creating an automatic stabilizer. As it turned out, the banks weren’t forced to expand lending to small and medium-size businesses; they cut it drastically. States, too, slashed spending. Obviously, an even larger stimulus in dollar terms would be needed if it was poorly designed, with large parts frittered away in less cost-effective tax cuts, which is what happened.

It should be clear, though, that there is nothing natural or inevitable about secular stagnation in the level of aggregate demand at zero interest rates. In 2008, demand was also depressed by the huge increases in inequality that had occurred over the preceding quarter-century. Mismanaged globalization and financialization, as well as tax cuts for the rich were major causes of accelerating concentration of income and wealth.

Aggregate demand

Inadequate financial regulation left Americans vulnerable to predatory banking behavior and saddled with enormous debts. There were thus other ways of increasing aggregate demand besides fiscal stimulus: doing more to induce lending, to help homeowners, to restructure mortgage debt, and to redress existing inequalities.

Policies are always conceived and enacted under uncertainty. But some things are more predictable than others. As Summers again knows full well, when Peter Orszag, the head of the Office of Management and Budget at the beginning of Obama’s first administration, and I analyzed the risks of mortgage lender Fannie Mae in 2002, we said that its lending practices at that time were safe. We did not say that no matter what it did, there was no risk.

And what Fannie Mae did later in the decade mattered very much. It changed its lending practices to resemble more closely those of the private sector, with predictable consequences.

But what was predictable and predicted was the manner in which under-regulated derivatives could inflame the crisis. The Financial Crisis Inquiry Commission put the blame squarely on the derivatives market as one of the three central factors driving the events of late 2008 and 2009. Earlier in President Bill Clinton’s administration, we had discussed the dangers of these fast-multiplying and risky financial products. They should have been reined in, but the Commodity Futures Modernization Act of 2000 prevented the regulation of derivatives.

There is no reason economists should agree about what is politically possible. What they can and should agree about is what would have happened if …

Here are the essentials: We would have had a stronger recovery if we had had a bigger and better-designed stimulus. We would have had stronger aggregate demand if we had done more to address inequality, and if we had not pursued policies that increased it. And we would have had a more stable financial sector if we had regulated it better.

These are the lessons that we should keep in mind as we prepare for the next economic downturn.

Joseph E. Stiglitz is the winner of the 2001 Nobel Memorial Prize in Economic Sciences. Copyright: Project Syndicate, 2018. www.project-syndicate.org