The Crises – United States nearing the End Game

by Jörgen Eriksson on November 20, 2013

On November 8, the International Monetary Fund held the annual research conference on the state of the world. The theme this year was Crises: Yesterday and Today, about innovative research on a wide range of issues on crises and to facilitate the exchange of views among researchers and policymakers.

Larry SummersThe last speaker of the conference was Larry Summers, an American economist and former chief economist of the World Bank and Treasury Secretary of the United States. Earlier this year he was expected to become the successor of Ben Bernanke as the Chairman of the Federal Reserve Bank, although he declined to candidate for this post.

Larry Summers made a brilliant speech about the state of the American economy at the IMF conference. He said that the role of the Federal Reserve Bank (or any Central Bank in a market economy), most of the time, is pretty simple. Its main job is to set the federal funds interest rate, which ripples out and raises or lowers other rates on everything from mortgages to credit cards to business loans.  Media tend to refer to the Fed as raising or lowering “the interest rate” rather than just the funds rate to reflect its wider influence on the whole economy.

If the Fed wants to know what interest rate we should have at a given time, it can just plug the unemployment rate and the inflation rate into an macro economic equation, which will show what the fed funds rate should be for the economy to recover and regain growth. In theory this could not be easier.

The problem is that when inflation is low and unemployment is high, the interest rate that equation spits out is sometimes below zero, it is negative.

However in reality the Central Bank can not have negative interest rates. That would mean peoples’ bank accounts would start losing value over time, and then of course everyone would immediately withdraw their money from the banks. If that were to happen, everyone would just start doing transactions in cash, which does not decay over time. So what the Fed can do, and does do, is promise to keep interest rates at 0 (zero) for a very long time. The hope is that doing that has similar effects to having negative rates, and will get the economy back to normal, where we can have positive rates again.

But that approach only works if, when times are good, the interest rate we want is positive. For most of history to date that has been true. But Summers argues that it could be that the rate we want, the rate given by the equation on how to get new growth, is negative. If that is true, then keeping rates at zero indefinitely will not get us where we need to be. We need to take much more drastic action.

economic stagnationThis is hthe situation that Japan has been through since the early 1990s with a stagnating economy combined with negative inflation. What happened to Japan during the past 25 years is a cautionary tale. Since 1995, that nation’s economy has shrunk, while the Nikkei stock market index until recently stood around 10.000, or about 70 percent below its high of more than 20 years ago. Only in 2013 the Japanese economy seems to have started recovery.

Ever since the American housing bubble burst in 2008, economists have made comparisons between Japan and the United States, and also with the recent situation in Brazil. In all three cases, an easy monetary policy helped feed asset bubbles in stocks and real estate while the absence of inflation hid the danger. As the crises developed, the countries became caught in a liquidity trap, in which government infusions of money into the economy failed to lower interest rates.

Due to the adoption of the twisted logic that now welcomes inflation, early warning signs are likely to either be ignored or praised. Inflation is a lagging indicator, which compounds the recognition problem. In United States the “political paralysis of a US government which is divided and President Barack Obama unable to get cooperation from the Congress, the outcome seems inevitable. Another one of the worlds smartest economists, Paul Krugman, summarizes the consequences in this article. He concludes “What Larry did at the IMF wasn’t just give an interesting speech. He laid down what amounts to a very radical manifesto. And I very much fear that he may be right.

Below is a video of Lawrence Summers speech, well worth watching.

Larry Summers at IMF Economic Forum, Nov. 8

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