This article by Larry Summers argues that it will be difficult to achieve a full employment economy in the industrial world along with financial stability. He claims that the basic assumptions of classical macro theories, as well as the new Keynesian theories, have proven to be inadequate. Both of these theories assume that flexible prices will enable the economy to arrive at a full employment equilibrium over time. Interest rates have dropped about as far as they can and a further decline in wages and prices leads us into a deflationary spiral that is difficult reverse. Moreover, the IMF and the CBO continue to lower their forecasts of the level of potential GDP. This calls to question the assumption that output will rise the trend line that existed prior the Great Recession. That is, we may be in for an extended period of lower economic growth than we have anticipated. Summers reviews the data that support his hypothesis and he considers possible solutions to the problems that he views in the global economy. He concludes that normal monetary policy cannot produce a full employment economy without creating the kind of financial instability that led to the financial crisis. In fact, the collapse of the financial system may have been predictable in hindsight. Unsustainable credit risks had masked the difficulty of sustaining adequate economic growth.
In the US, the economy looked pretty good between 2003 and 2007, leading up to the financial crisis. Low interest rates were an important factor in achieving a reasonable growth rate. However, low interest rates encouraged investors to take on greater risk to increase the yields on their investments. The banking system obliged by extending credit to high risk borrowers. That led to a real estate boom that eventually collapsed and produced the Great Recession. Summers extends this analysis even further into the past. He argues that unsustainable credit growth had been fueling the economy for the last 20 years in the US. That leads Summer into an analysis of the factors in the economy that required unsustainable credit support to maintain full employment. That is, the forces that were reducing potential output without support from credit expansion. In doing so, he turns Say's law, which holds that supply creates its own demand, on its head. He concludes that falling demand leads to falling supply.
To support his hypothesis he shows that there has been a steady and substantial decline in real interest rates since 1985. They reached a trough in 2011 where the real interest fell to fell to zero. The implication is that the full employment real interest rate may be much lower than it has been in the past. Therefore, monetary policy will have difficulty maintaining full employment and production at potential GDP without increasing the risk of financial instability. Increased inflation would lower the real interest rate but that does not lower the risk of financial instability.
If monetary policy has reached its limits, fiscal policy, along with a reduction in income inequality that redistributes income to households with a higher propensity to consume, is the only solution available that does not increase the risk of financial instability.
Summer's analysis is receiving more attention within the economics profession and among policy makers. It will be strongly resisted, however, because it flies in the face of a dominant ideology, and it would reverse the policies that have been promoted by those who have benefited the most from the current arrangement in the US and in England. Reagan and Thatcher are alive and well in both countries. The mid term elections are likely to increase the political power of the party that worships at the Reagan alter and the party of Thatcher controls the UK economy.
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