Paul Krugman explains the implications of the speech given by Larry Summers at the IMF conference. Summers pointed out the US economy has been driven by bubbles for a couple of decades. Some have blamed low interest rates for the bubbles. But if low interest rates were the problem we would have expected inflation and rising interest rates during the bubbles, but that did not happen. He argues that negative interest rates (nominal rate minus inflation) may be the new normal. That is, we need negative real interest rates to have a full-employment economy.
Summers argues that the new normal rate of interest may be negative because there is not enough investment to absorb our savings. He then suggests that our low rate of investment is caused by secular stagnation in the economy. There are lots of possible causes of secular stagnation but our demographics are not favorable for investment. Our population, and the size of our labor force is not growing fast enough to create the demand that would stimulate investment. Without the doubling of household debt since 1980, which fueled our bubbles, we would not have had full employment economies prior to the financial crisis.
If Summers is correct in his analysis, and we have a problem of secular stagnation, we are focusing on the wrong problems in Washington. For example, we tend to view savings as virtue and we believe that debt is a sin. Our problem today is that our savings exceed the demand for investment. Many of our politicians tell us that we should be worried about inflation. But if negative real interest rates are the new normal we may need more inflation to achieve a full employment economy. The focus on deficit reduction is also counterproductive. We need more spending and less savings in a stagnant economy. Furthermore, the cost of debt service is very low when real interest rates are negative.
Summers' speech created quite a stir at the IMF conference. If he is correct, and secular stagnation is our problem, it will take quite an effort to reshape our thinking about how to deal with our economy. Japan has been in a similar situation for two decades and it has been difficult for policymakers to deal with the reality of secular stagnation.