Bernanke starts by making a very useful point, which is that conventional macroeconomic theory tells us that monetary policy can affect real rates of interest only in the short run. A couple of implications of this are: (i) Leaving aside any effects of quantitative easing (QE), there has been no change in U.S. monetary policy since late 2008, so any nonneutralities of money dissipated long ago. For example, if the Fed had, in late 2008, gone to a fed funds rate range of 1.0%-1.25% instead of 0-0.25%, and stuck with that, real economic activity in April 2015 in the United States under that alternative policy would not be significantly different from what it actually is now. (ii) If you are looking for reasons why the real rate of interest is currently low, you shouldn't be blaming the Fed.
So where does Bernanke look for solutions to the low-real-interest-rate puzzle? He first contemplates Larry Summers's "secular stagnation hypothesis." I discussed secular stagnation in this blog post. There, I argued that there are two types of stagnation that economists like to talk about. The first is growth stagnation, where the argument is typically framed in the context of the standard workhorse growth theory developed by Solow, Cass, Coopmans, etc., many years ago. While growth theory is very useful in helping us understand cross-country growth experience, and to disentangle the factors contributing to economic growth in an individual country, it tells us little about what growth will be in the next 10 years in the United States, for example. Growth theory tells us that a substantial fraction of the growth in per capita income is accounted for by productivity growth, which in turn is driven by growth in the stock of knowledge. If anyone claims to be able to look into the future and see that, you shouldn't take them seriously. Thus, discussion about growth stagnation is just a guessing game.
The second type of stagnation is Keynesian stagnation. That's Larry Summers's version of secular stagnation, which he seems to have first discussed at an IMF conference in November 2013. Summers wasn't acting as the promoter of some well-developed research program. Indeed, the idea seems to have grown in Summers's brain and emerged from his mouth fully-formed. Most of us are longing for the day when this happens to us. No more fighting with editors, referees, colleagues, and various naysayers over our ideas. Just stand up in public, speak, and wait for the adulation. Taylor Swift never had it so good.
Nevertheless, as good scientists, we should flesh out Summers's idea, and check it for consistency and empirical plausibility. Macroeconomists are much better at this than they used to be - say, 50 years ago. So-called microfoundations - essentially, just using the best available theory in a judicious way - is about more than the Lucas critique. We want our models to include economic agents that are recognizably doing the things that real consumers and goods-producing firms do, interacting in ways that will somehow capture the real-world market interactions that we see going on. If the purveyors of particular theories are explicit, we can better understand what they are getting across, and we can check that their conclusions are correct, and that they are taking the right forces into account.
That's not to say that no one has attempted to formally capture what came out of Larry Summers's mouth. Eggertsson and Mehrotra have a paper about secular stagnation, which I wrote about in this blog post. Summers imagines that there exists a persistent inefficiency, reflected in a low real interest rate, that monetary policy can never fix, but which fiscal policy can. There is indeed an inefficiency in the Eggertsson/Mehrotra paper that will persist forever. But in their model it's easy to fix if the government simply provides an outside asset, as is well known for this class of models. I'm not sure this captures what Summers is getting at.
In any case, Summers summarizes what he means by secular stagnation in this reply to Bernanke:
The essence of secular stagnation is a chronic excess of saving over investment. The natural question for an economist to ask is how can such a chronic excess exist in flexible markets? In particular, shouldn’t interest rates adjust to equate saving and investment at full employment? The most obvious answer is that short term interest rates can’t fall below zero (or some bound close to zero) and this inhibits full adjustment.So, suppose we consider a world with certainty - that will capture the long-run phenomena Summers is interested in. Then,
(1) r = R - i,
where r is the real rate of interest, R is the nominal rate of interest, and i is the inflation rate. Summers seems to be saying that, for some reason, the marginal product of capital is low, so the payoff from investing is low, and so the economically efficient real interest rate - what Woodford would call the "natural real rate of interest" or what Bernanke calls the "equilibrium interest rate" - is low. We'll let r* denote the natural real rate of interest. Then, if r* < -i, even with the nominal interest rate at the zero lower bound, the real rate of interest can't fall enough to correct Summers's "chronic excess of saving over investment." You should see where this is going now. You might have thought it odd that Summers mentions "flexible markets," but doesn't breathe a word about the flexibility of prices. How come? You tell me.
Summers's secular stagnation world appears to be one where the prices are sticky forever. He doesn't say as much, but I don't know how else he gets this to work. It seems to me that, in equation (1), i should be adjusting in the long run so that r* = R - i, no matter how the central bank sets R, if we think of this as, for example, a Wooford-type world. Further, in terms of conventional asset pricing, again in a world with certainty, we can write the real interest rate (approximately), as:
(2) r(t) = b + ag(t+1),
where r(t) is the real interest rate at time t, b is the subjective rate of time preference, a is the coefficient of relative risk aversion (assumed to be constant), and g(t+1) is the growth rate in consumption between this period and next period. It's hard to know for sure (as, again, Summers has not been explicit), but it seems that the effect he is discussing above is a level effect - the stagnation has to do with the level of output, not its growth rate. This translates in equation (2) into no effect on g(t+1), so in order to have a low real rate of interest, something else has to give. Some New Keynesians are fond of capturing real rate shocks as an increase in the discount factor, or a decrease in b in equation (2). This is hardly satisfactory, though. We're supposed that think that the economy will stagnate due to a contagious attack of patience? Maybe Summers thinks that (2) is not a good place to start in pricing assets? If so, he should tell us.
So, we're left wondering what Summers really has in mind, or if he's even thought about these problems. Why don't the prices adjust? What's the source of the low real natural rate?
Bernanke doesn't like Summers's secular stagnation ideas, but for the wrong reasons, I think. First, he gets a bit tangled up in interest rate logic:
The Fed cannot reduce market (nominal) interest rates below zero, and consequently—assuming it maintains its current 2 percent target for inflation—cannot reduce real interest rates (the market interest rate less inflation) below minus 2 percent.As Summers points out, assuming that a central bank can maintain a 2% inflation target at the zero lower bound - particularly over an extended period of time - is a big leap. Indeed, if we add a time dimension to equation (1),
(3) r(t) = R(t) - i(t),
then (2) and (3) imply that, at the zero lower bound,
(4) i(t) = -b - ag(t+1)
So, conventional asset pricing theory tells us that, if monetary policy is irrelevant for the growth rate in consumption in the long run, then a central bank will have a hard time hitting an inflation target of 2% at the zero lower bound in the long run, unless there is a large enough sustained decrease in consumption. But, you might say, while many central banks in the world are indeed missing their inflation targets on the low side while at the zero lower bound - or even lower - we haven't yet seen sustained deflations, particularly in the United States. Even Japan, with about 20 years at the zero lower bound, experienced an average inflation rate of about zero over that period.
Now, note that, essentially by definition, the right-hand side of equation (4) is the real interest rate. If we're puzzled why we're not seeing deflation at the zero lower bound, we should also be puzzled by the low real interest rate. And, if we can figure out why the real interest rate is low, we also have a potential explanation for why inflation is higher than the conventional theory tells us it should be.
Here's another issue on which Bernanke seems confused. In the chart in this post, he shows us a real interest rate - the yield on 5-year TIPS. That's a security issued by the Treasury, of course. But when he starts taking issue with Summers, he's discussing the rate of return on investment - the marginal product of capital, in most macro models I know about. Maybe Bernanke is thinking that rates of return on all assets move together, and any differences in those rates of return are due to risk, but I don't think that's correct. For example, in this paper by Gomme, Ravikumar, and Rupert, the after-tax rate of return on business capital is measured. Their notion of capital is standard, but excludes residential capital and consumer durables. Basically, this is the average product of capital, which is proportional to the marginal product of capital with a Cobb-Douglas production function. On page 269 of their paper, they show a time series of their rate of return measure. The average is 5.16% for the period 1954-2008, and the rate of return is fairly smooth - bounded for the most part by 4% and 6%. But the real rate of return on short-term government debt (that's the ex post real rate) has much more variability, as can be seen in the following chart.
What to make of this? Long ago, when people were interested in the equity premium puzzle, Mehra and Prescott showed that it was hard to reconcile standard asset pricing theory with observed returns on government debt and equities. Given empirical evidence on risk aversion, and the observed degree of aggregate risk from the time series, standard asset pricing predicts a much smaller risk premium than what we observe. Another way to think about this is that safe rates of interest in frictionless models are much higher than they are in practice. Indeed, in the conclusion to their paper, Mehra and Prescott suggest that people start looking at the frictions:
This is not the only example of some asset receiving a lower return than that implied by Arrow-Debreu general equilibrium theory. Currency, for example, is dominated by Treasury bills with positive nominal yields yet sizable amounts of currency are held.And:
The fact that certain types of contracts may be non-enforceable is one reason for the non-existence of markets that would otherwise arise to share risk. Similarly, entering into contracts with as yet unborn generations is not feasible. Such non-Arrow-Debreu competitive equilibrium models may rationalize the large equity risk premium that has characterized the behavior of the U.S. economy over the last ninety years.Of course, most of the asset pricing literature didn't follow Mehra and Prescott's suggestions, but instead stuck to Arrow-Debreu pricing. I think they were missing something, and in the current context, Mehra and Prescott's suggestions are quite useful.
Take currency for starters. Bernanke gives an example of why negative real interest rates don't make sense. Basically, with a very small real interest rate, the present value of a small per-period payoff could be huge, making all kinds of seemingly ludicrous investment projects have positive net present value. But, of course, the real rate of return on currency is typically negative, and has been known to be quite large in absolute value. Why do people hold this asset if its rate of return is low - indeed lower, as Mehra and Prescott point out, than Treasury bills, which have essentially identical risk properties? We could say that the difference in the rates of return on money and T-bills reflects a liquidity premium - currency is more useful in exchange than are T-bills. So, extending the idea, why couldn't government debt bear a liquidity premium relative to other assets - capital for example? Government debt is indeed useful in exchange, in the sense that it is useful in credit contracts, as collateral - particularly in repo markets. This has to do with the non-enforceable contracts that Mehra and Prescott mentioned. Then, instead of equation (2), we can determine the real interest rate as:
(5) r(t) = b + ag(t+1) - l(t),,
where l(t) is a liquidity premium. The more liquid the asset, the higher is l(t), and the lower the real interest rate. Of course, equation (5) is a just a piece of a model. Has anyone written down fully-articulated general equilibrium models that determine such liquidity premia? You bet. Here are some:
That work isn't coming out of nowhere, of course. It's part of a broader research program involving other people - new monetarists, actually - and building on the work of many others. You can read about that in the papers. What the models show is that l(t) is an endogenous object, that depends in general on monetary policy, fiscal policy, and what is going on in credit markets.
Once we have the liquidity premium to work with, we have a potential explanation for why the real interest rate is so low - the liquidity premium is unusually high. Why would that be? We don't have to look too far to find the reasons. The financial crisis effectively destroyed part of the stock of eligible collateral, as did sovereign debt problems in parts of the world. U.S. government debt then became relatively scarce, and its price went up. Further, note that, at the zero lower bound,
(4) i(t) = -b - ag(t+1) + l(t),
so a higher liquidity premium on government debt also implies that we will tend to see higher inflation at the zero lower bound. In the models in the papers I refer to above, the real interest rate can be low due to suboptimal fiscal policy. If that suboptimal policy persists forever, the real interest rate can be low forever, and there is an inefficiency, reflected in low output, consumption, and employment. Looks a lot like what Summers would call secular stagnation. But it's a financial problem - there's insufficient government debt outstanding, not an insufficiency of government spending on goods and services. Faced with suboptimal fiscal policy, monetary policy matters in unusual ways - it's permanently non-neutral, and a severe shortage of government debt can mean that the central bank wants to be off the zero lower bound.
So, I think it would do Ben Bernanke good to get out more. Stop hanging out with big shots like Larry Summers, and make the acquaintance of some young macroeconomists, and other assorted riff-raff.