The Post-Crisis Macroeconomic Reality

8/10/2019 The Post-Crisis Macroeconomic Reality

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The Post-Crisis Macroeconomic Reality

Wealth Inequality, GDP Stagnation,

Disinflation, and Low Interest Rates

2015 Copyright Tim Fulmer, Ph.D. 1


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Its Not Over Till Its Over

Larry Summers, November 2013

Open question on our situation:

Does the current state of the U.S. and world economy represent

a new normal or a continuation of the 2007-2009 financial

crisis?

In other words: How can we confidently know the financial crisis

is over?

Knowing whether or not the crisis is over is important because it

directly impacts our choice of monetary and fiscal policies.



3/55

Its Over

Most all macroeconomic indicators have vastly

improved over where they stood in 1Q2009.

There is no sense of panic in the financial markets

and broader economy.



4/55

Its Not Over

Key economic growthindicators are significantly

lower than where they were projected to be six

years after the crisis (assuming a full recovery).

The real interest rate remains negative.

The U.S. Federal Reserve balance sheet remains

burdened with $4.4 trillion-worth of bailouts and

quantitative easing.



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Even if there is no definitive answer to the

question of whether or not the financial crisis is

over, can we at least develop a modelthat

describes (or explains) the current state of the

economy?



6/55

A Model of the Current State of the U.S. Economy

High wealth and income inequality

Stagnant GDP growth (0-3%)

Decreased aggregate demand

Low long-term interest rates (0-2%)

Investors reach for yield, drive up

asset values

US Treasuries serve as international

safe haven investment

Increasingly aging population favors

fixed-income investments

Fed uses low-interest rate policies

to stimulate growth

Fiscal policy austerityReduced credit expansion

by financial sector

Increased economic instability 6


7/55

A Cyclical Version of the Same Model

Long-Term IncomeInequality

Low GDP Growth

Low InflationExpectations

PersistentMonetary Easing

Asset ValueBubbles


1

2

3

5

4


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Key Players in the Model


Low GDP Growth

DisinflationaryPressures

(< 2% Inflation)

Persistent

Monetary Easing

(Negative RealInterest Rates)

Asset ValueBubbles

Central Bankers

Workers/Consumers

Investors

Managers

2

1

34


5

Potential for

Liquidity Trap


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Macroeconomic Evidence

Supporting the Cyclical Model



10/55

The macroeconomic evidence supporting the

model is straightforward and uncontroversial.

The controversy lies in the models arrows of

causality, which likely hide critical assumptions.



11/55

Evidence: 1

Source: Elise Gould, Why Americas Workers Need Faster Wage Growth And What We Can Do About It (2014, EPI Briefing Paper)



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Evidence: 1

Source: Fabrizio Perri, Inequalities, Recessions and Recoveries (2013, FRB Minneapolis Annual Report Essay)

The Y Axis represents the ratio of the top 5% of income earners and the median income; market income represents all

income sources (wages, salaries, rents, dividends, interest); disposable income represents market income plus transfer

payments minus tax liabilities.



13/55

Evidence: 2

Source: Steve Keen, End This Depression? Never (published in Business Spectator, 26 November 2013)



14/55

Evidence: 2

Source: Buttonwood, Trends in Low Places (18 November 2014, The Economist)



15/55

Evidence: 2

Borrowed from: Laurence H. Summers, Reflections on the New Secular Stagnation Hypothesis,

in Secular Stagnation: Facts, Causes and Cures (2014, CEPR Press)



16/55

Evidence: 2

Source: The Budget And Economic Outlook 2015 2025, Congressional Budget Office, January 2015



17/55

Evidence: 2


Source: Josh Zumbrun, The U.S. Economy Will Soon See Its Best Years in a Decade, Forecasters Say, Wall Street Journal, 2 Feb. 2015


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Drivers of GDP Stagnation

Shortfalls in Supply:

Slowing productivity growth (technological innovation reverting to itshistorical norm)[1,3,5,6]

Slowing labor force growth (aging population)[1,2,3,4,5]

Shortfalls in Demand:

Reduced middle class purchasing power (increasing income/wealth

inequality)[1,2]

Reduced aggregate purchasing power (transfer of production from high-

wage countries to the low-wage, low-consumption developing world)[2]

Reduced government debt and deficit spending (austerity is

fashionable)[1]

Increased household deleveraging versus consumption[2]Sources: C. [1]Teulings & R. Baldwin, Introduction, in Secular Stagnation: Facts, Causes and Cures (2014, CEPR Press);

[2] Steve Keen, End This Depression? Never (published in Business Spectator, 26 November 2013); [3] Paul Krugman,

Secular Stagnation, Coalmines, Bubbles, and Larry Summers (16 November 2013, The New York Times); [4] No Country

for Young People (22 November 2014, The Economist); [5]James Pethokoukis, Future economic growth will likely be slow

San Francisco Fed (15 February 2015, American Enterprise Institute); [6]J. Fernald & B. Wang, The Recent Rise

and Fall of Rapid Productivity Growth (9 February 2015, FRBSF Economic Letter)



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Hours Worked and Output Per Hour

(Productivity) are Decreasing or Stagnating


Source: John Fernald and Bing Wang, The Recent Rise and Fall of Rapid Productivity Growth, FRBSF Economic Letter, 9 Feb. 20 15


20/55

Evidence: 3

Source: The Budget And Economic Outlook 2015 2025, Congressional Budget Office, January 2015



21/55

Evidence: 3


Source: Eric Morath, Inflation Well Short of Feds 2% Target, Wall Street Journal, 2 Feb. 2015


22/55

Evidence: 3

Calculated from a model published in: Inflation Expectations, Real Rates, and Risk Premia: Evidence

from Inflation Swaps (Haubrich, Pennacchi, & Ritchken, 2012; Federal Reserve Bank of Cleveland)



23/55

Evidence: 3


Source: The dangers of deflation: the pendulum swings to the pit, The Economist, 25 October 2014

World Inflation Targets


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Drivers of Deflation

Supply-side:

Increasing globalization of market capitalism after fall of Soviet Union[2,3]

The rise of the Internet and other information technology (IT) innovations[3]

A new international monetary system based on a shared commitment by central

bankers to prevent inflation and keep prices stable[3]

Global manufacturing overcapacity flooding markets with a glut of goods[1,2,4]

Falling commodity and oil prices[6]

Demand-side:

Debt-deflation following the bursting of a credit bubble (i.e., following a balance-

sheet recession)[4]

Wage stagnation (job security trumps upward wage pressure)[6]

Other: Excessive quantitative easing (QE) policies worldwide[5]

Sources: [1] M. J. Mandel, The Threat of Deflation (BusinessWeek, 10 November 1997); [2] A. Sullivan, Fear of Falling? Relax,

Global Deflation Might Be Good For You (New York Times, 30 January 1999); [3] C. J. Farrell, Deflation: What Happens When Prices

Fall (2004); [4] B. Bernanke, Deflation: Making Sure It Doesnt Happen Here (Remarks at the National Economists Club,

21 November 2002); [5]A. Evans-Pritchard, The nagging fear that QE itself may be causing deflation (The Telegraph, 4 June 2014);

[6] A.S. Blinder & J. L. Yellen, The Fabulous Decade: Macroeconomic Lessons from the 1990s (2001)



25/55

Evidence: 4

Source: Paul Krugman, Four Observations on Secular Stagnation, in Secular Stagnation: Facts, Causes and Cures (2014, CEPR Press)



26/55

Evidence: 4

Borrowed from: Laurence H. Summers, Reflections on the New Secular Stagnation Hypothesis,

in Secular Stagnation: Facts, Causes and Cures (2014, CEPR Press)



27/55

Evidence: 4

Source: Josh Zumbrun, A Whiff of Secular Stagnation in Budget Forecasts, Wall Street Journal, 3 Feb. 2015



28/55

Evidence: 4

Source: Josh Zumbrun, A Whiff of Secular Stagnation in Budget Forecasts, Wall Street Journal, 3 Feb. 2015



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Drivers of Low Real Interest Rates(i.e., high U.S. bond prices)

Bond investors pessimistic expectations:

Growth of U.S. economy slowing

Growth of world economy (China, Europe, Japan) slowing

U.S./world inflation will remain low

Central bank forward guidance has committed to low long-termnominal interest rates

Central banks maintain accommodative policies (i.e., target lownominal interest rates) to boost employment & GDP numbers

Excess rate of household savings (excess supply of potential loans)

Declining level of business investment (decreased demand forpotential loans)

General excess liquidity in system resulting from QE-type policiesBased on : O. Blanchard, D. Furceri, & A. Pescatori, A prolonged period of low real interest rates?

in Secular Stagnation: Facts, Causes and Cures (2014, CEPR Press);



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The Feds Contribution to Low Real Interest Rates

Borrowed from: N. Michel & S. Moore, Quantitative Easing, the Feds Balance Sheet, and Central Bank Insolvency (2014, Heritage Foundation)



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Persistently Low Real Interest Rates Are Bad

for Multiple Reasons

Low real interest rates undermine monetary policy: if real interest

rates are low during normal times, adverse macroeconomic shocks

may require negative real interest rates to restore full employment

however, negative real interest rates will undermine the

effectiveness of monetary policy in a low inflation environment. Low real and nominal interest rates undermine the financial stability

of the overall economy.

Low real interest rates increase the cost of new household

borrowing under deflationary conditions

Low real interest rates increase the financial burden of current

household debt under deflationary conditionsSources: C. Teulings & R. Baldwin, Introduction, in Secular Stagnation: Facts, Causes and Cures (2014, CEPR Press);

B. Bernanke, Deflation: Making Sure It Doesnt Happen Here, remarks at the National Economists Club, 21 November 2002



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Evidence: 5

Source: Screenshot from Yahoo! Finance (01 December 2014, 6:19 am EST)



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How Did the Model Look Before

the Crisis?



34/55

The model looked much the same prior to the

crisis, with one fundamentally important

difference: commercial credit bubbles (6).



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The Great Moderation: 1985 - 2007


Strong GDPGrowth Despite

Low Wages

PeriodicInflationaryPressures

Periodic MonetaryTightening

Asset ValuesSteadily Rise

Central BankersWorkers/Consumers

Investors/

Financial Markets

Managers

Cheap Credit,

Lax Loan Standards

Commercial Banks

6



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Fulmers Hypothesis: During the Great

Moderation, aggregate purchasing power

derived from the credit bubbles masked the

low-growth effects of long-term income/wealthinequality, which became visible only after the

credit bubbles burst.



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The Financial Crisis: 2007 - 2009


GDP GrowthSeverely Slows

StrongDisinflationary

Pressures

Interest Rates HitZero-Lower Bound

(ZLB)

Asset ValueBubble

Central BankersWorkers/Consumers

Investors/

Financial Markets

Managers

Credit Bubble

Bursts

Commercial Banks


Households Replace

Spending with Deleveraging

Central Bank Adopts Aggressive

Policy to Stimulate Demand

Investors Stay in Cash

Or Buy Paper Assets

Managers Reluctant

to Hire & Increase Wages

Central Bank Lacks

Credible Means of Increasing

Inflation ExpectationsLiquidity Trap


38/55

A Liquidity Trap Drives and Is Driven By

Deflation


Source: Paul Krugman, Fear of a Quagmire? New York Times, 24 May 2003

What if the economy is in such a deep malaise that pushing interest

rates all the way to zero isn't enough to get the economy back to full

employment? Then you're in a liquidity trap: additional cash pumped

into the economy -- added liquidity -- sits idle, because there's no

point in lending money out if you don't receive any reward.Andmonetary policy loses its effectiveness.

Once an economy is caught in such a trap, it's likely to slide into

deflation -- and nasty things begin to happen. Falling prices induce

people to postpone their purchases in the expectation that prices willfall further, depressing demand today.


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A Liquidity Trap Is a Central Bank

Credibility Problem

We normally say that an increase in the money supply leads to an

equal proportional increase in the price level But thats not actually

right. What a model with all the is dotted and ts crossed actually says

is that the CPI doubles if you double the current money supply and

all future expected money supplies.

[But]once you realize that central banks may not be able to move

expectations about future money supplies, it becomes a real

possibility that the economy will be in a liquidity trap: if interest rates

are near zero, money printed now just gets hoarded, and monetarypolicy has no traction on the real economy.


Source: Paul Krugman, Macro policy in a liquidity trap (wonkish), New York Times, 15 November 2008


40/55

A Liquidity Trap May Be Masked by

Credit Bubbles

Without all that increase in household debt [during the Great

Moderation: 1985 - 2007], interest rates would presumably have

to have been considerably lowermaybe negative. In other

words, you can argue that our economy has been trying to get

into the liquidity trap for a number of years, and that it onlyavoided the trap for a while thanks to successive [credit]

bubbles.


Source: Paul Krugman, Secular Stagnation, Coalmines, Bubbles, and Larry Summers, New York Times, 16 November 2013


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An Entrenched Liquidity Trap Is Called

Secular Stagnation

Secular stagnation is the proposition that periods like the last

five-plus years, when even zero policy interest rates arent

enough to restore full employment, are going to be much more

common in the future than in the past that the liquidity trap is

becoming the new normal.


Source: Paul Krugman, Three Charts on Secular Stagnation, New York Times, 7 May 2014


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Secular Stagnation Is a Demand-Side

Phenomenon: Krugman

Secular stagnation is the claim that underlying changes in the

economy, such as slowing growth in the working-age population,

have made episodes like the past five years in Europe and the

US, and the last 20 years in Japan, likely to happen often. That is,

we will often find ourselves facing persistent shortfalls of

demand, which cant be overcome even with near-zero interest

rates. But if we have a persistent shortfall in demand, what

we need is measures to boost spending higher inflation,

maybe sustained spending on public works (and less concernabout debt because interest rates will be low for a long time).


Source: Paul Krugman, What Secular Stagnation Isnt, New York Times, 27 October 2014


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Secular Stagnation Is a Demand-Side

Phenomenon: Summers

Secular stagnation in my version, like that of Alvin Hansen, the

economist who coined the term in the 1930s, has emphasized

the difficulty of maintaining sufficient demand to permit

normal levels of output. But with a high propensity to save, a

lowpropensity to invest and low inflation, this has been

impossible.


Source: Lawrence Summers, Bold Reform Is the Only Answer to Secular Stagnation, The Financial Times, 7 September 2014


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Evidence: 6

Borrowed from: D. Alpert, R. Hockett, & N. Roubini, The Way Forward (2011, New America Foundation)



45/55

How Can We Boost GDP Growth?



46/55

If it isnt socially or politically feasible to flatten

wealth and income inequality through harsh

redistributive policies, what other options exist

to boost purchasing power and spur GDPgrowth?



47/55

Suggested Policies for Spurring GDP Growth

Supply -side structural strategies: Educate and improve the skills of the workforce

Improve companies capacity for innovation

Implement structural tax reforms

Bolster entitlement programs

Demand-side (Keynesian) strategies:

Continue to lower nominal interest rates (standard monetary

policy)

Temporarily raise the inflation target to lower real interest rates[2]

Increase public investment in infrastructure (fiscal policy)[1]



48/55

Suggested Policies for Spurring GDP Growth (Contd)

Other approaches: Recognize that the growth era is over and seek to maintain a

steady-state economy[3]

Commit to higher inflation and simultaneously intervene in the

foreign-exchange markets to devalue the dollar[4]

Sources: [1]Larry Summers, Strategies for Sustainable Growth (5 January 2014, The Washington Post); [2] Why is Stagnation

Bubbly? (6 January 2014, The Economist);[3] Herman Daly, The Negative Natural Interest Rate and Uneconomic Growth (17

January 2014, The Daly News and blog entry on triplepundit.com); [4] Purchasing Power Disparity (14 January 2014, The Economist);

Glut Busters (15 May 2014, The Economist) [5]



49/55

Conclusion

Its not over.



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Appendix



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Larry Summers Speech at the IMF Economic Forum (8 November 2013)

Observation #1:

Economy four years after the crisis:

While panic was averted, the share of adults working today is basically the same as it was four years ago, and GDP has fallenfurther behind 2009 potential.

Observation #2:

Economy prior to the crisis:

There was too much easy money, too much borrowing, too much wealth, yet inflation was entirely quiescent. Thus, somehow

even a great [credit] bubble wasnt enough to produce any excess in aggregate demand .

Explanation that might fit both observations (Summers hypothesis):

The short-term real interest rate consistent with full employment had fallen to -2 or -3% sometime in the middle of the last

decade. In that case, even with artificial stimulus to demand from financial imprudence, you would not see excess demand.

Moreover, even with a resumption of normal credit conditions, you would have difficulty getting back to full employment.

Policy Challenge Going Forward:

While its been demonstrated that monetary policy can contain panics when the interest rate is at zero; and while its also been

demonstrated presumptively that monetary policy can affect a range of asset prices to support demand when the interest rate is

zeroit may be a very difficult situation when natural and equilibrium interest rates have fallen significantly below zero

because it becomes much more difficult to make long-term use of extraordinary [monetary policy] measures.

Final Lesson:

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 activities, holding our economies back below their potential.



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Policies for Combating Deflation


H th F d l R C P t


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How the Federal Reserve Can Prevent

Deflation

During normal times, do not try to pushinflation to zerorather, a maintain a bufferzone of perhaps 1 -3% per year.

Use supervisory and regulatory powers toensure banks are well capitalized and thefinancial markets are functioning smoothly.

When inflation is already low, actpreemptively and aggressively to furtherlower interest rates.


Source: B. Bernanke, Deflation: Making Sure It Doesnt Happen Here, remarks at the National Economists Club, 21 November 2002

H th F d l R C C


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How the Federal Reserve Can Cure

Deflation

Print money & distribute [very unlikely].

Purchase short-term U.S. Treasury securities (traditional open-

market operations)

Make large-scale asset purchases (LSAPs) (quantitative easing (QE))

Long-term U.S. Treasury securities

U.S. agency-backed securities

Purchase foreign government debt

Offer low- or zero-interest-rate loans to banks, with a range of

private assets deemed eligible as collateral. Intervene on currency markets to depreciate the U.S. dollar

[unlikely since it contradicts U.S. Treasury policy].


Source: B. Bernanke, Deflation: Making Sure It Doesnt Happen Here, remarks at the National Economists Club, 21 November 2002;

N. Michel & S. Moore, Quantitative Easing, The Feds Balance Sheet, and Central Bank Insolvency (Heritage Foundation, 14 August 2014)


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How Fiscal Policy Can Cure Deflation

A broad-based tax cut

Increase government spendingSource: B. Bernanke, Deflation: Making Sure It Doesnt Happen Here, remarks at the National Economists Club, 21 November 2002

Documents

The Post-Crisis Macroeconomic Reality