On "On Falling Neutral Real Rates, Fiscal Policy, and the Risk of Secular Stagnation:
I have been thinking about this by Łukasz Rachel and Lawrence H. Summers this week: On Falling Neutral Real Rates, Fiscal Policy, and the Risk of Secular Stagnation.
It says an awful lot of true things. The average "neutral" 10-year safe real interest rate consistent with full employment in the Global North does look like it has fallen from 4% per year in the 1990s to -0.5% per year today. That does pose a huge problem for central banks that seek to use monetary policy s as the principal depression-fighting tool: a small negative shock that reduces this rate by only a little bit more would drive an economy into territory where the central bank cannot do its job. During this period of decline, increased government debts have put perhaps 2%-points of upward pressure on the neutral rate: the actual decline has been 6.5%-points.
But I find myself uncertain on what conclusions to draw from their paper. They focus on only one of what I think are three key interest-profit-discount rates in play here:
There is the (short or long) real safe interest rate on the securities of governments that issue reserve currencies and thus possess exorbitant privilege. This is down to today's -0.5% from 3% 20 years ago and 4.5% 40 years ago.
There is the long-term real risky discount rate at which the cash flows accruing to owners of capital are discounted in the market—the expected return on financial investments in stocks. This is at to 5% today, up from 4% 20 years ago, down from 12% 40 years ago, and down from 6% 50 years ago.
There is the societal profit rate earned by new investments in physical or intellectual capital. This is ??? to today's ???, from ??? 20 years ago and from ??? 40 years ago.
This third social profit rate is in some sense the fundamental opportunity-benefit-of-investment ground out by the real economy of production and distribution on top of which the financial superstructure is built.
The second is the quotient of profit flows over the market value stock, and takes the societal profit rate returns to society's capital and adds to them the amount of monopoly rents captured by enterprises, subtracts from them labor rents and spillover benefits, both organizational and technological, that are not captured by those who undertake the actions that generate those spillovers, and then values those cash flows at the long-term risky discount rate.
The first of safe interest rate is the second minus the liquidity and safety terms that lower the required rate of return on safe assets.
Łukasz Rachel and Lawrence H. Summers focus on rate (1): the (short or long) real interest rate on the safe securities of governments that issue reserve currencies and thus possess exorbitant privilege. The problem is that the wedge between this (1) safe interest rate and the risky discount rate (2)—the rate at which risky cash flows are discounted—is worse than poorly understood by economists: it is not understood at all.
Economic and finance professors continue to attempt to understand this large equity return premium as somehow reflecting some market-maker somewhere's attitude toward risk. They fail. They will continue to fail.
The gap between the risky discount rate and the safe interest rate is 5.5%-points today, was 1%-point 20 years ago, was 7.5% 40 years ago, and was 4% 50 years ago. Most of the time since the development of stock markets that were more than grifter cons for insiders 150 years ago, this gap has been vastly in excess of any rational assessment of the extra risk born from investing in a diversified portfolio of stocks rather than in safe government bonds. But sometimes—1998, when the risk associated with investments in stocks was not low but was unusually high—it is not.
What else can this be, economic and finance professors ask, but the attitude toward risk of the market-maker who posts the prices? People can invest in diversified stock portfolios: doing so requires neither expertise nor information but simply a chimpanzee at the keyboard picking from a list. People can invest in bonds. The only difference between the portfolios is risk. And this margin must be in equilibrium, right?
The market-maker at the stock-bonds margin, whoever that may be, is sometimes prone to episodes of irrational exuberance in which they greatly overestimate the likely returns from diversified stock portfolios. And the market-maker at the stock-bonds margin, whoever that may be, is usually greatly averse to risky equities in a manner no rational von Neumann-Morgenstern with any not-insane utility function would ever be.
My guess is that the risky discount rate is driven by greed and fear—fears of depression and political collapse on the one hand, and greed for the benefits of economic and technological growth as well. And my guess is that modeling these as anything more than herd episodes of irrational exuberance and irrational pessimism is a fool's game. My guess is that any form of arbitrage between the risky discount rate and the safe interest rate fails because the typical market-maker, whoever that may be, does not understand that you need 50 stocks to be diversified, focuses their attention on 10 often-correlated stocks that they know, and so does face unacceptable existential risk were they to leverage their portfolio toward equities.
If you accept these guesses, then you will be tempted by the following narrative to account for the past 20 years' moves in the equity return premium:
- The end of dot-com irrational exuberance that drives the equity premium up from 1998-2002 with no effect on the *safe interest rate.
- The financial side of the China shock 2002-2008 that greatly increases the demand worldwide for safe assets. Political risks in emerging markets and economic risks of stalling emerging-market growth greatly increased demand for safe assets like U.S. Treasuries: it seems sensible to hold U.S. Treasuries for that portion of your portfolio which will be the only thing left if the balloon goes up and you have to flee your country in the Learjet, or in a rubber boat. This drives the equity premium up further.
- The financial crisis's destruction of confidence that any organization besides Global North governments is or will be in the business of providing AAA assets eliminated AAA and near-AAA private close substitutes for Treasuries. This drives the equity premium up still further.
The natural conclusion I am tempted to draw—which Łukasz Rachel and Lawrence H. Summers do not—is
- The world economy today desperately wants to hold its wealth in claims on Global North sovereigns with exorbitant privilege issuing reserve currencies.
- A well-functioning economy creates things of value.
- The Global North sovereigns with exorbitant privilege issuing reserve currencies can create a lot of value. They should do so: governments should run up their debts until they satisfy demand with an equity return premium at a value we think is sensible and "normal".
What should governments do with the money they raise from issuing more debt? The natural answer is "everything that promises a social return": Global-warming research, global-warming control, infrastructure, education, beefing-up the Social Security trust fund and investing int in equities: The world wants risk borne—desperately. The private sector does not mobilize society's potential risk-bearing capacity. Global North sovereigns with exorbitant privilege issuing reserve currencies can mobilize their societies' risk-bearing bearing capacity. They should do so.
Łukasz Rachel and Lawrence H. Summers: On Falling Neutral Real Rates, Fiscal Policy, and the Risk of Secular Stagnation: "Simple calculations using observed estimates of the impact of deficits on interest rates suggest that the increase from 18% to 68% in the public debt-to-GDP ratio of the advanced economies should ceteris paribus have raised real rates by between 1.5 and 2%-points over the last four decades. This effect is quantitatively important but is a presumptive underestimate of the impact of fiscal policy changes given the rise in pay-as-you-go government pensions and other social insurance programs. This analysis leads to the conclusion that the fall in real long-term interest rate observed in the data masks an even more dramatic decline in the equilibrium “private sector” real rate...
...Building on... Gertler (1999)... life-cycle behavior... heterogeneity in marginal propensities to consume and differences in the implicit discount rates across agents mean that Ricardian Equivalence... does not hold... making the effects of a range of government policies on real rates non-trivial.... Simulations suggest that shifts in these policies pushed equilibrium real rates up by over 3.2%-points between the early 1970s and today....
Bewley-Huggett-Aiyagari... idiosyncratic risks and precautionary behavior... degree of income uncertainty matches the risks estimated from the data on individual household incomes... rising government debt accounts for around 1.5%-points... upwards pressure on the neutral real interest rate....
Private sector forces dragging down on interest rates are more powerful than previously anticipated, and that on average across the business cycle, equilibration of private-sector saving and private-sector investment may indeed require very low real rate of interest in advanced economies for years to come.... The developed world is at risk of mirroring the experience of Japan, whereby the very low equilibrium rate of interest appears to be a semi-permanent feature of the economic landscape....
Current real rates appear to be quite well predicted by pre-financial crisis trends. We believe that the these trends are best analyzed in terms of changes in saving and investment propensities or equivalently in terms of trends in desired wealth holdings by consumers and desired capital accumulation by producers. While factors involving liquidity, scarcity and risk no doubt bear on levels of real interest rates we find it highly implausible that they are the main factor accounting for trend movements. The movements are too large and too pervasive across assets and the fluctuations in spreads are too small and lacking in trend for these factors to account for the observed trends in the data....
The neutral real rate would have declined substantially more over the last generation but for increases in government debt and expansions in social insurance programs.... The specific magnitudes are very uncertain, but open-economy aspects and the possibility suggested by our analysis–that budget deficits emerge in response to excesses of private saving over private investment–lead us to think that we are more likely to understate than overstate the extent of fiscal support for real interest rates in recent years.... But for major increases in deficits debt and social insurance neutral real rates in the industrial world would be significantly negative by as much as several hundred basis points....
The private economy is prone to being caught in an underemployment equilibrium if real interest rates cannot fall far below zero. Full employment in recent years has been achieved where it has been achieved either through large budget deficits as in the United States or Japan or large trade surpluses as in Germany. It is worth considering that in the United States during the period prior to the financial crisis, negative real short term interest rates, a huge housing bubble, erosion of credit standards and expansionary fiscal policy were only sufficient to achieve moderate growth. Adequate growth in Europe was only maintained through what in retrospect appears to have been clearly unsustainable lending to the periphery....
It has to be acknowledged that the US economy appears to be slowing to below potential growth despite projected primary deficits that will lead even on very favorable interest rate assumptions to steadily growing debt–to-GDP ratios that will ultimately set historical records. There is no guarantee that deficits sufficient to maintain positive neutral real rates will be associated with sustainable debt trajectories. Indeed, the Japanese experience suggests that this may not be the case....
Monetary policies that induce significantly negative real rates.. might be achieved through setting negative nominal rates, raising or adjusting inflation targets... or using unconventional monetary policies such as quantitative easing.... There is a range of concerns about the possible toxic effects of low rates, including suggestions that they make bubbles and over-leveraging more likely as they encourage risk taking, that they may lead to misallocation of capital by reducing loan payment levels and required rates of return, reinforce monopoly power....
A final possibility is structural measures that reduce saving or promote investment. Clearly regulatory policies that encourage investment without sacrificing vital social objectives are desirable. The extent to which these are available is very much open to question....
If secular stagnation is avoided in the years ahead it will not be be because it is somehow impossible in a free market economy, but instead because of policy choices. Our conclusions thus underscore the urgent priority for governments to find new sustainable ways of promoting investment to absorb the large supply of private savings and to devise novel long-term strategies to rekindle private demand...
#finance #highlighted #macro #publicfinance #fiscalpolicy