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?
M  W
d
M   ( Y,R,Risk,... )W
d
The Equation of Exchange
MV = PY
Note ⇒
𝑃𝑌
𝐻𝑒𝑛𝑐𝑒,
𝑃𝑌
𝑉=
𝑀
1
𝑊
⇒ 𝑉=
=
𝑀
𝜃𝐵
𝑊
1
∴ 𝑉=
𝜃𝐵
𝑀
⇒
= 𝑃𝑌
𝜃𝐵
𝑀 ↑ 𝑎𝑛𝑑 𝜃 &𝐵 ↑ 𝑝𝑟𝑜𝑝𝑜𝑟𝑡𝑖𝑜𝑛𝑎𝑙𝑙𝑦
⇒
𝑃 &𝑌 𝑙𝑖𝑡𝑡𝑙𝑒 𝑐ℎ𝑎𝑛𝑔𝑒𝑑
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. (θ 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