Larry Summers on the risk of bubbles and excess leverage

by on January 6, 2014 at 12:40 am in Economics | Permalink

He explains it very well in a single paragraph:

The second strategy, which has dominated U.S. policy in recent years, is lowering relevant interest rates and capital costs as much as possible and relying on regulatory policies to ensure financial stability. No doubt the economy is far healthier now than it would have been in the absence of these measures. But a growth strategy that relies on interest rates significantly below growth rates for long periods virtually ensures the emergence of substantial financial bubbles and dangerous buildups in leverage. The idea that regulation can allow the growth benefits of easy credit to come without cost is a chimera. The increases in asset values and increased ability to borrow that stimulate the economy are the proper concern of prudent regulation.

Note that “build-ups in leverage” will do enough of the work of the argument if you are allergic to citation of “bubbles.”

Age Of Doubt January 6, 2014 at 1:19 am

Are we really worried about bubbles right now? It’s a bit like saying: “We better not wear jackets in the middle of January. The temperature might suddenly shoot up to 80 degrees, then we’ll be mildly uncomfortable and we’ll need to take our jackets off.” It seems the risk is low and the consequence is manageable.

Yancey Ward January 6, 2014 at 10:26 am

The funny thing is I read comments like yours both 6 and 13 years earlier.

Michael January 7, 2014 at 4:39 pm

We weren’t facing a liquidity trap and anemic job growth 6 or 13 years ago.

AoD is right–the consequences of worrying about bubbles right now are negligible. We need a mechanism to allocate capital more efficiently and a mechanism to allow more people to enjoy prosperity.

Alex K. January 6, 2014 at 10:36 am

“Are we really worried about bubbles right now?”

Larry Summers thinks that “the real interest rate” (who the hell uses this concept almost a century after Sraffa’s paper on the multiplicity of real rates of interest ?) that is compatible with full employment is negative. So he worries that money interest rate that is compatible with inducing real investment is very low, low enough to induce bubbles.

I don’t find this position very coherent. For instance, Summers clearly believes that stimulating aggregate demand will lead to “healthy” grow. But wait a second. What the hell happened to “the negative real interest rate?” Apparently, the government spending money makes “the negative real interest rate” positive. If this is true, then why can’t private investors make “the negative real interest rate” positive too? This does not make much sense, unless you dismiss all bullshit about “the negative real interest rate,” which is the same as dismissing Summers’s position.

You could imagine that Summers is talking about multiple equilibria: the current equilibrium, which has a lattice of capital that is compatible with large unemployment; and a possible equilibrium, which has a lattice of capital that is compatible with low to vanishing unemployment. The government, in its wisdom, will use fiscal policy to move us to the new and improved lattice of capital, with low unemployment. This at least would be a logically coherent position.

While logically coherent, this still does not make much economic sense. In this story, the only reason that investors do not use their funds to invest in real capital assets –assets that are compatible to the low unemployment capital lattice– is that they do not know what that lattice looks like. How, then, does the government know in what capital assets to invest?

If the government invests in bridges to nowhere, and the investors know that it invests in bridges to nowhere, then there is no stimulative effect of the government investment: investors will reasonably assume that the wasted investment will be paid with future taxes (I am ignoring here expectations of inflation, because you could get those with purely monetary policy). If the government invests wisely, in assets that are compatible with the low unemployment lattice of capital, and the investors know it, then the government investment is indeed stimulative. But this only puts the emphasis on what is wrong with this multiple equilibria argument: if the government knows in what assets to invest, why don’t the investors know where to invest?

In practice, this argument, as simple as it is, is already more sophisticated than criminally simplistic macroeconomic models allow for. In the illegitimately aggregated macroeconomic models, one can not even express the point that whether the investment is stimulative or not depends on whether the government invests in good (compatible with the low unemployment capital lattice) or bad assets. In practice then, governments guided by such aggregated models will not even worry about bad investments, let alone know what the good investments are.

This is where the danger of fiscal stimulus is: an economy with lots of “stimulative” bridges to nowhere is an economy with a large debt that can still have low growth and high unemployment. Of course, the idiots that are unable to think about the economy except in aggregated models will blame such a situation on “the negative real interest rate” and on “insufficient aggregate demand.”

msgkings January 6, 2014 at 12:55 pm

Aren’t there good assets that the government has the scale and time horizon and lack of profit motive to invest in? Not bridges to nowhere but infrastructure projects like electricity grids, LNG export terminals, nuclear power plants, etc? It seems there are some projects that, while good, require more than the private sector can reasonably be expected to muster…

Alex K. January 6, 2014 at 1:33 pm

“Not bridges to nowhere but infrastructure projects like electricity grids, LNG export terminals, nuclear power plants, etc? ”

Yes, but those projects can be justified on their own terms, without appeals to stimulus.

So if the argument is: “Look, the government is going to repair those roads anyway, we might as well repair them now, while we can borrow at very low interest rates” then that is actually a good argument. This type of argument is correct without even mentioning aggregate demand, except as a marginal benefit.

On the other hand, the argument for investing in speculative or dubious projects (like high speed trains in a low density country) has a crucial need for appeals to their “stimulative” benefits.

Willitts January 6, 2014 at 3:29 pm

No, those projects are desirable in their own right based on the remaining useful life of existing infrastructure AND current interest rates.

Many projects become admissible when interest rates are lower. Reducing interest rates bring many projects forward in time; however, that comes at the cost of future projects, value losses from temporal inefficiencies, and removal of existing useful life from the notional balance sheet.

Alex K. January 6, 2014 at 4:16 pm

“No, those projects are desirable in their own right based on the remaining useful life of existing infrastructure AND current interest rates.”

I’m not sure what your disagreement is. The point is that there is something wrong with the money interest rates, hence that the government can take advantage of that.

The rest of your claims look like coming from equilibrium thinking, but the whole point of my thought experiment was to illuminate what the government can or can not do to shift the economy from one equilibrium to another.

derek January 6, 2014 at 10:47 am

I love this when people say that the risk is low. Do you think that the Federal Reserve has the credibility to take another 5 trillion onto their balance sheets, that they could pull the late 2008-2009 money generation and market manipulation that they did? Does the Treasury have the ability to maintain $1.5 trillion deficits for three or four years running, again?

Do you think that the US consumers can take another 30-40% hit on their net worth? Do you think that businesses, who are doing quite well on their balance sheets right now can handle an equivalent decrease in demand this time without massive shrinking of their operations?

We just went through a correction brought on by a bubble collapsing. You want us to go through that again?

Alex K. January 6, 2014 at 11:07 am

“I love this when people say that the risk is low. Do you think that the Federal Reserve has the credibility to take another 5 trillion onto their balance sheets, that they could pull the late 2008-2009 money generation and market manipulation that they did? ”

I don’t know if you’re replying to me or not (I say there’s about 25% chance that you are).

If so, then I should point out that when I attack the Larry Summers secular stagnation thesis (plus some other forms of Keynsianism) I do so without necessarily disagreeing that easy credit conditions can induce bubbles. In fact, I kind of agree with this claim, partly because easy credit conditions make the market selection mechanisms weaker while at the same time increasing leverage — so it is likely that easy credit induces bad investments that can fail in a way that drags other investments into failure.
(Where I have reservations is that in a crisis there is a deflationary spiral, so easy monetary policy can help in stopping the spiral.)

But again, that’s not the part of the Summers argument that I am criticizing.

Willitts January 6, 2014 at 1:57 am

Yes and no.

The time of emerging from a recession is exactly when you want to borrow money and take prudent risks. It is the smart money buying when prices are low.

Most of the growth in house prices thus far have been investment purchases, and stock market index growth adequately represents opportunities for risk as well as low yields elsewhere.

What Summers means is that artificial stimulus causes overabundance of such risk taking and, hence, a reduction in prudential lending and investment.

That there are bubbles forming is almost beyond dispute. The question is where.

mkt January 6, 2014 at 2:15 am

Bitcoin? ;)

As an aside, I don’t like how Summers contributes to the use of “chimera” as a metaphor for “imaginary object”. For two reasons: chimeras actually do exist (it’s a biological term). And chimeras are a more powerful metaphor for (possibly mythological) conjoined objects, rather than generic mythological objects.

Douglas Knight January 6, 2014 at 12:30 pm

Yes! Down with these new-fangled uses that are only eight hundred years old! Why do we need a different language than Homer?

Willitts January 6, 2014 at 3:33 pm

His point is that using metaphors dismisses alternative viewpoints without actually having to refute them.

Economics, finance, and public policy would be greatly enhanced if we were to ban metaphors, analogies, buzz words and rhetorical flourishes.

Careless January 7, 2014 at 10:31 am

Regardless of the age, it’s a bad usage. There are many fictional monsters that are not also used to suggest a different phenomenon. Retire chimera.

dirk January 6, 2014 at 2:09 am

Time for some serious fiscal policy. Monetary policy is out of bullets.

white radical blogger January 6, 2014 at 3:37 am

the run up in asset values was deliberate. The housing prices are the linchpin of the banking industry. The banks owned mortgage derivatives that tumbled in value in 2009, making the big banks effectively insolvent. In order to make them solvent again, the price of housing had to be driven up. Thus the low interest rates, which drove housing values up by creating corporate buyers, and also the lenders did not want to loan to most individual homeowners at the current low rates, especially since they knew that rates would go back up fairly soon. Restricted supply of home loans == low supply of homes.

Thus supply was tightened. Corporate buyers snapped up the available supply, and supply was restricted. Price went up, and the banks owning the mortgage derivatives became solvent again.

That is one reason they will continue to cram mass immigration down our throat and why deportations will probably continue to decrease. The USA financial structure is in large part based on driving up home prices. It’s a livestock operation, and in many ways a ponzi scheme, one dependent on increasing population via mass immigration.

msgkings January 6, 2014 at 12:56 pm

The rising home values helped a lot of homeowners too, not just the banks.

VTProf January 6, 2014 at 8:47 am

Great, Tyler is coming around to favor fiscal stimulus. Because that’s Larry’s point: low interest rates and fiscal stimulus are complements, and low rates w/out stimulus is more likely to drive bubbles than growth. Good to see Tyler rethinking his views :)

Bill January 6, 2014 at 9:34 am

+1 Notice that Tyler did not mention what Summers first choice was.

Tyler Cowen January 6, 2014 at 9:46 am

Personally, I favor monetary policy working through inflation rate and/or ngdp targeting rather than doing so much with interest rates. At our current margin, “recovery” is the indicated strategy in order.

Z January 6, 2014 at 10:14 am

Global capitalism cannot exist without near zero borrowing costs for the global capitalists. Summers surely knows this. The question is whether it is sustainable. If the answer is no, then what?

rayward January 6, 2014 at 1:39 pm

All too often economists take refuge in their theorems and equations when simply opening their eyes would provide them the enlightenment they are missing (but not necessarily seeking). My interpretation of Summers’s op/ed is that we need a larger public sector, not the public sector that is a checkbook (transfer payments) but the public sector that constitutes an investment for future growth (such as the infrastructure he mentions in the op/ed). Most have assumed that Summers is suggesting an increase in government borrowing and spending for its economic stimulus, but he doesn’t mention government borrowing specifically. Again, my interpretation is that the increase in the public sector can be funded with either borrowing or with selective tax increases, as long as the funds are invested. The public sector in the US is small compared to that in other industrial countries, much small if defense spending isn’t included. It doesn’t require a visit to western Europe to appreciate the enormous difference in public investment here and there.

Floccina January 6, 2014 at 4:49 pm

Transportation is under 4% of the Fed budget, could you productively spend double that?

Dave January 6, 2014 at 1:52 pm

“But a growth strategy that relies on interest rates significantly below growth rates for long periods virtually ensures the emergence of substantial financial bubbles and dangerous buildups in leverage.”

Aha! So Larry Summers is Austrian…

Floccina January 6, 2014 at 4:47 pm

So is the idea to expand the supply of money enough to keep interest rates up?

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