The Problem is Policy Not a Secular Decline in the Real Interest Rate

Larry Summers’ recent talk on what ails the US economy  at the November 8 IMF conference is getting a lot of attention. I first heard Larry present his argument at the October 1 Brookings-Hoover conference organized by Martin Baily and me, and it got a lot of attention at that conference too.

Here are the basic elements of the Summers argument:

  • In the years before the crisis and recession, easy money and related regulatory policies should have shown up in demand pressures, rising inflation, and boom-like conditions.  But the economy failed to overheat and there was significant slack.
  • In the years since the crisis and recession, the recovery should have been quite strong, once the panic was halted.  But the recovery has been very weak. Employment as percentage of the working age population has not increased and the gap between real GDP and potential GDP has not closed. 
  • A decade long secular decline in the equilibrium real interest rate explains both the lack of demand pressures before the crisis and the slow growth since the crisis.  This decline in the equilibrium real interest rate offset any positive demand effects of the low interest rate policy before the crisis. And, with the zero interest rate bound, the low equilibrium interest rate leaves the economy weak even with the current monetary policy.

The first point is inconsistent with some important facts.  Inflation was not steady or falling during the easy money period from 2003-2005. It was rising. During the years from 2003 to 2005, when Fed’s interest rate was too low, the inflation rate for the GDP price index doubled from 1.7% to 3.4% per year.  On top of that there was an extraordinary inflation and boom in the housing market as demand for homes skyrocketed and home price inflation took off, exacerbated by the low interest rate and regulatory policy. Finally, the unemployment rate got as low as 4.4% well below the natural rate, not a sign of slack.

I completely agree with Larry’s second point that the recovery has been weak. I have been writing about this weakness on since the so-called recovery began. The book by Lee Ohanian and me published last year shows the distressing picture of the employment to population ratio on the cover. But the factual problem with Larry’s first point sheds doubt on the whole “low equilibrium real interest rate” explanation.

Fortunately, another explanation fits the facts. I summarized this explanation in my presentation at the Brooking-Hoover conference at which I was on the panel with Larry Summers as well as Sheila Bair and Kevin Warsh. The explanation is detailed in my 2012 book First Principles.  In my view, deviations from good economic policy have been responsible for the very poor performance over the past decade. Such policy deviations created a boom-bust cycle, and were a significant factor in the crisis and slow recovery.

Examples include the Fed’s low interest rate policy in 2003-2005 and the lax enforcement of financial regulations—both deviations from rules-based policies that had worked in the past.  These were largely responsible for the boom and the high level of risk taking, which ended in the bust in 2007 and 2008.  Other more recent examples are the hundreds of new complex regulations under Dodd-Frank, the vast government interventions related to the new health care law, the temporary stimulus packages such as cash for clunkers which failed to sustain growth, the exploding federal debt that raises questions about how it will be stopped, and a highly discretionary monetary policy that has generated distortions and uncertainty.

In sum, the view that “policy is the problem” stands up quite well compared to the view that “a secular decline in the equilibrium real interest rate is the problem.”

This entry was posted in Slow Recovery. Bookmark the permalink.