ECONOMICS by Colin TeeseNews Weekly
Mainstream squabbles: much ado about nothing
, May 9, 2015
The exchange between the former chairman of the U.S. Federal Reserve Ben Bernanke and Harvard University economist Lawrence Summers in their attempts to account for why there has been no real recovery from the 2007-08 Global Financial Crisis (GFC) has fascinated mainstream economic circles.
Summers, it will be recalled, has been a leading US mainstream academic economist for decades. He served as 71st US Treasury secretary in the Clinton administration. In that capacity, he was part of the 1999 push led by Alan Greenspan – then chairman of the US Federal Reserve – to persuade President Clinton to deregulate US banks. As a result the Glass-Steagall Act, which had regulated the activities of US banks since the Great Depression, was repealed.
Greenspan and Summers persuaded a gullible President that the financial system and, indeed, the entire economy were functioning so smoothly that regulation had become an impediment to economic growth.
It was a tragically misguided judgment. Many believe, with some justification, that pushing the idea of repealing Glass-Steagall actually ushered in the 2007-08 crisis.
Bernanke’s academic background and, accordingly, his views about matters economic, closely match those of Summers.
In the period before the financial crash of 2007-08, while the boom was in full swing, Bernanke was among those who had proclaimed that the US (and, indeed, the world economy) had entered a kind of “economic nirvana”. Applied economic theory, it was maintained, had so conquered external disruptions to economic harmony that the world now enjoyed the “Great Moderation”.
Good times, it was confidently predicted, were set to last indefinitely into the future.
Unhappily for Bernanke, and those similarly persuaded, the words were barely spoken before boom turned to crash. The so-called Great Moderation was transformed into a full-scale financial bust of such magnitude as to threaten the world economy. Overnight, the Great Moderation became the Great Recession – or, here in Australia, the Global Financial Crisis.
Both Summers and Bernanke, faithful to mainstream economic theory, can be shown to have been monumentally wrong in their judgment of important economic events.
It is a matter of record that dedicated practitioners of mainstream economics have been noteworthy for their inability to anticipate or explain the crash. Which is hardly surprising since they had labelled the boom time as the Great Moderation. Now, seven or eight years on, still unable to advance any plausible explanation of the crash, Bernanke and Summers offer their respective explanations as to why the road to recovery has proved so rocky.
Both associate the slow recovery with the fact of enduringly low interest rates. Bernanke is more optimistic than Summers about the pace of recovery, though that is a minor difference between them.
Fundamentally both men advance markedly different reasons to account for the persistence of low interest rates; nor do they agree on the best means of dealing with them.
They are, however, in basic agreement that investment in new capacity is necessary to stimulate growth, the aim being what they call “bringing investment into balance with full employment”.
Summers advances the idea of “secular stagnation” to explain why interest rates have remained low. Secular stagnation is not a new idea: US economist Alvin Hansen first expressed it in 1938.
Hansen argued that quite specific engines drove real economic growth – notably rapidly expanding population and technological advances. He suggested that, since these were no longer present in the measure necessary to sustain growth levels appropriate to rising standards of living, we had entered a period of secular stagnation.
Summers concluded that Hansen was essentially correct, though perhaps premature as to timing. In Summers’ view the fact of secular stagnation was hidden from view first by the onset of World War II, second by the impact of pent-up domestic demand after the war, and finally from the 1980s until the crash, by consumers with falling incomes borrowing to maintain former levels of consumption.
None of those artificial growth drivers, Summers argues, are still available. In that new circumstance, he believes it is no longer possible to manage the economy by manipulating interest rates (down to offset slow economic growth, up to take spending out of an overheated economy). The new reality is that economic management to maximise growth will have to rely on government injecting money into the economy.
Summers makes a persuasive case for new government spending, say, on infrastructure; particularly for the US. With the benefit of low interest rates, the returns will easily outweigh the outlays.
Bernanke disagrees. He accepts that persistently low interest rates are the issue, but turns his face firmly against the idea of government spending. And he dismisses the notion that secular stagnation explains low interest rates. The real problem is a “savings glut” induced by a collapse of interest rates. At prevailing rates those with savings would rather save than lend for investment. The absence of new investment makes it impossible to establish the necessary balance between investment and full employment. Interest rates must rise to the levels needed to encourage savers back into the investment market and thus end the savings glut.
Obviously, both Bernanke and Summers, as mainstreamers, believe that the problem of unemployment can only be solved by new investment. In other words, they believe investment is dependent upon the level of interest rates.
Australia’s Steve Keen, an economist outside the mainstream, says they are both fixated on interest rates, and on the proposition that savings drive investment. Which is consistent with what they learned and subsequently taught at university.
Because of that fixation, Summers and Bernanke begin their analysis from the wrong point. If, indeed, savings fund investment, then certainly low interest rates are at the heart of the problem. But savings are not the source of investment funds. That can be said with confidence on no lesser authority than the Bank of England.
At the beginning of 2014, the Bank’s Quarterly Review examined this proposition. Basic economic textbooks were wrong, the bank claimed, when they advanced the so-called “Loanable Funds” theory (which maintains that private banks fund their loan portfolios with depositors’ money). In fact, 95 per cent of private banks’ lending is not funded that way. Rather they create loan money “out of thin air”. Effectively, these loans can, and if necessary, will be, supported by central bank advances.
Assuming the Bank of England knows what it is talking about, it follows that Bernanke certainly, and to a lesser extent Summers, are mistaken. Since bank lending is not sourced from bank deposits, then whatever savers think about current interest rates cannot be the bottleneck to lending for investment. Private banks are as well able as in the past to fund investment. So why are they not doing so?
First, banks for now prefer to fund more profitable house mortgage borrowers; and second, whatever Bernanke and Summers believe, interest rates are not the decisive trigger for businesses to invest in new productive capacity; regardless of the level of interest rates, businesses will not invest in new productive capacity unless they judge that the market will absorb the additional output of goods or services created by new investment.
Right now, slow demand is discouraging business investment in new productive capacity. The demand is not there because consumers are no longer able to borrow to buy more; they are busy paying down debt already accumulated.
Summers and Bernanke apparently believe that appropriate levels of investment “balance at full employment”. Steve Keen rejects these view – and draws upon data to demonstrate an almost perfect correlation between rising unemployment and falling private debt in over-indebted economies.
When consumers and businesses reduce debt, demand falls and unemployment rises in parallel. New investment certainly creates additional employment opportunities, but only rising aggregate demand can persuade businesses to invest in additional output.
A decline in aggregate demand, and therefore growth and employment, is inevitable in an economy overburdened with household and business debt. The path back to sustainable growth entails writing off the excess debt.
Wolfgang Münchau, writing in London’s Financial Times, takes the debt issue further. What holds for private debt also is true for governments holding excessive amounts of debt in a foreign currency.
The Greek government has borrowed from both the International Monetary Fund (IMF) and the European Central Bank (ECB), so as to keep servicing loans obtained from banks outside Greece. To attribute responsibility for Greece’s debt plight to either irresponsible lending or imprudent borrowing is to miss the point.
The reality is that the Greek economy cannot generate the surpluses needed to repay advances from the IMF or the ECB.
The only viable resolution of the problem is for Greece to default on both the IMF and the ECB borrowings. Certainly that will be necessary before any measures can be taken to resurrect the Greek economy. And that, in important respects, is closely connected to ensuring the future viability of the euro.
Mainstreamers believe that after a shock such as the GFC, economies always return to their previous equilibrium. Trouble is, as Bernanke and Summers both demonstrate – though each has his own view as to why – this time there has been no return to previous equilibrium.
Münchau draws the obvious conclusion: mainstream theories cannot deal with current realities. For that reason, he also believes that the equilibrium theory will be overturned, though most likely resulting from pressures imposed on the economics profession from outside.
It is hard to disagree with him.
Colin Teese is a former deputy secretary of the Department of Trade.