Secular Stagnation or Bubbles -A Theory to Help Us Understand We have seen that Professor Summers believes that secular stagnation is being caused by too many people wanting to save and not enough people wanting to invest. He says that this is a worldwide phenomenon.
Are their alternative reasons why that we have declining growth and inflation? Paul Krugman - monetary policy is ineffective because of a liquidity trap, but this should be a short run phenomenon Kenneth Rogoff - debt buildups have caused firms and governments to be unwilling to undertake investment (balance sheet repair), but why low real interest rates Robert Gordon - slowing productivity means slowing growth,
but where is the inflation? Ben Bernanke - emerging markets have excess saving propensities and this cannot be accommodated by investment in developed countries Summers doesn't mention it, but Richard Koo also has a complete theory of why there is secular stagnation which also explains the Japanese experience well. It is called balance sheet repair and the problem is what he
calls balance sheet recessions. Some people (like me) think that a series of bubbles in assets caused by loose monetary policy are what are now causing slow growth and even slow inflation. It sounds preposterous that loose money would slow the economy, but (1) Monetary policy around the world is very loose. (2) Interest rates around the world are all falling. (3) Inflation rates are low and often falling.
(4) Growth around the world is very slow compared to 20 years ago. (5) Asset prices have risen substantially. (6) the velocity of money in most countries is falling. These observations are all related. Every country in the world is engaged in creating bubbles to drive their economies forward. But, the bubbles are inducing people to want to save more while the temporary nature of bubbles makes it
risky to undertake long term investment in capital. Summers is right, it is a saving-investment problem, but unlike Summers I see government as causing this catastrophe. Unfortunately, his solution is to make government even bigger. Surely that would be a big mistake To begin to understand this process we might ask -how can we define bubbles? This is quite difficult, unless the bubble has burst. Then, of course, it was obviously a bubble.
Bubbles tend to hide themselves and one can always justify such exaggerated values by saying that the structure of the economy has changed - Rogoff calls this the "This time is different" argument. 1 Here is a recent calculation of the US
Market Capitalization to US Nominal GDP -something we are calling a bubble, B. The Blue uses a stock index, while the Red uses market capitalization - the result is the same.
Bubbles are hidden and therefore appear as regular economic activity. Moreover, they are impossible to identify. Since the economy is always changing we must expect that valuations of assets must likewise always be changing. Ask yourself if there is a property bubble in Taipei. Was the Shanghai market a bubble when it recently almost reached 5000 John Maynard Keynes - "All economic activity is ultimately aimed at consumption"...something he felt was obvious.
Therefore, asset bubbles must be aimed at consumption also...now and in the future. But, true bubbles are valuation of assets which cannot possibly be translated into an equivalent level of consumption of real goods and services ... bubbles are not reasonable. Bubbles are exaggerated mis-estimates of future consumption. When Bubbles form... At least One of Three Things Must Happen
(1) The Bubble Bursts and Trend Asset Values Return to Trend Nominal GDP (Mean Reversion) (2) Output Rises and Trend Nominal GDP Rises to Eliminate the Bubble (Growth Effect) (3) Prices Rise and Trend Nominal GDP Rises to Eliminate the Bubble (Inflation Effect) The real question is whether monetary policy is actually causing the slowdown in
prices and growth by causing secular rise in the demand for money relative to other assets. What is the Demand for Real Money Balances? d M W
d M ( Y,R,Risk,...)W The Equation of Exchange MV = PY Note =
1 = =
1 = =
, & & h ( ) ( ) Thus, bubbles B and increases in the demand for money (i.e. decreases in velocity) will cause monetary policy to become ineffective
and generate low growth and low inflation with low interest rates and high asset prices. Finally, we should tie things together by saying why bubbles are forming and why the demand for money is rising. Why are bubbles forming -- This is the direct consequence of monetary authorities trying to stimulate demand by increasing perceived wealth. It is driving up asset prices but is not having a
noticeable effect on demand. People remain skeptical of the future which is full of uncertainties and potential costs and downsides. (B is increasing) Why is the demand for money rising -- This is because interest rates have been driven to extremely low levels and will probably rise in the future. Also, there are greater transactions on asset markets than before. Finally, there is a strong wealth effect in money demand probably due to risk spreading motives. ( is increasing)
What Should We Be Doing? Summers says we should be letting the government borrow at very low interest rates and undertake useful public investment spending on schools, highways, bridges, airports, etc. But is that fair and can we trust
politicians to use the money wisely? An excellent but controversial book dealing with the problem of secular bubbles and debt is David Stockman's 700 page book The Great Deformation: The Corruption of Capitalism in America
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