Here's The Scary Possibility That The US Might Need Permanent Bubbles In Order To Grow

Over the past couple of decades, strong economic growth has consistently been spurred on by bubbles – the tech bubble in the 90s, the housing bubble more recently. In his speech at the IMF on November 8, Larry Summers brings up an important question: Is a bubble a prerequisite for economic growth?

“I don’t think it was thought fiscal policy was conspicuously austere in the period prior to 2007 and 2008,” he said. “And I think it’s hard to construct a counterfactual for the period — 2003 to 2007 — with no bubbles and reasonably rapid growth, since the bubbles are now seen as having been the cause of a significant fraction of the growth that there was.”

The idea that the only way for the economy to have robust growth is through a bubble is scary. If true, that means that anytime the economy is doing well, we should expect a crash soon after when the bubble pops.

Paul Krugman pointed out the fundamental problem in a smart blog post yesterday which riffed on Summers:

[H]ow can you reconcile repeated bubbles with an economy showing no sign of inflationary pressures? Summers’s answer is that we may be an economy that needs bubbles just to achieve something near full employment — that in the absence of bubbles the economy has a negative natural rate of interest. And this hasn’t just been true since the 2008 financial crisis; it has arguably been true, although perhaps with increasing severity, since the 1980s.

[W]ith all that household borrowing, you might have expected the period 1985-2007 to be one of strong inflationary pressure, high interest rates, or both. In fact, you see neither — this was the era of the Great Moderation, a time of low inflation and generally low interest rates. Without all that increase in household debt, interest rates would presumably have to have been considerably lower — maybe negative. In other words, you can argue that our economy has been trying to get into the liquidity trap for a number of years, and that it only avoided the trap for a while thanks to successive bubbles.

As Krugman notes, inflation has been low for a number of years despite significantly increased debt for US households. Economic theory would normally predict that this would lead to higher inflation. More consumption leads to higher wages and prices. But that hasn’t happened. Where has all of this excess money gone then? Summers and Krugman both hypothesize that the answer is bubbles.

Since the housing bubble burst, the Fed has used monetary stimulus to attempt to push the economy back towards full employment. The problem with this is that when nominal interst rates fall to zero, the Fed has limited tools at its disposal. Right now, it’s using quantitative easing to lower long-term rates and forward guidance to credibly convince the market that rates will stay low for an extended period of time. Both policies are meant to incentivise businesses to invest and spur on economic growth.

Nevertheless, the recovery has still been weak and inflation low, indicating that Fed policy is still too tight. What Summers and Krugman are both questioning is whether this is a new phenomenon. If bubbles have been the driver of economic growth during the past 30 years, than it stands to reason that those bubbles kept investment artificially high. That leads to a higher natural rate of interest, masking the underlying problem of the zero lower bound.

The best way to understand this is to use one of Krugman’s favourite models: the IS-LM framework. This model predicts that the natural interest rate will occur at the equilibrium between desired savings and investment. Here’s it in graph form (explanation below):

This graph shows where the desired savings (LM curve) equals desired investment (IS curve). Under normal conditions, that equilibrium point brings about full employment. However, right now is not normal. The Great Recession caused a massive shift back in investment as demand plummeted and businesses hoarded crash. In fact, the IS curve shifted so far back that the equilibrium point would fall below zero if nominal rates could go negative:

As Krugman shows in that graph, the LM curve flattens out at zero, because if it interest rates were to go below zero, people would simply horde cash. The Fed can’t push the nominal interest rate below zero. That’s the liquidity trap were currently in. Thus, the point we’re currently at is not an equilibrium and has not returned us to full employment. Slowly, investment is returning as demand recovers, but progress has been slow since we’re not at the equilibrium.

The interest rates on the graph are short-term ones, which the Fed controls through the money supply. It also can have an effect on long-term rates. Since hitting the zero lower bound after the recession, the Fed has used indirect means such as purchasing Treasuries and mortgage-backed securities to drive down long-term rates as well and attempt to return to equilibrium. We’re not there yet.

The larger question though is whether that second graph is a recent development. If bubbles led to artificially high investment, then it’s very possible that absent them, the natural rate of interest may have been negative the entire time. This jibes with the lack of inflation we’ve seen for the past few decades as well.

If that’s the case, the scary part is whether we can have robust economic growth without a bubble or does persistently bumping up against the zero lower bound prevent that? The good news is that we can break free of that bound. The Fed could allow for greater inflation, lowering real interest rates and bringing the economy back into equilibrium. Another method would be to move to a cashless society where people cannot hoard money and thus the Fed can cut nominal rates below zero. All of these tools are intended to break free of that bound. This would spur greater investment and bring back full employment.

However, we aren’t becoming a cashless society anytime soon and the Fed’s institutional structure has limited how loose it can make its policy. That means that we could be stuck at zero, struggling to regain full employment. Krugman speculates that decreased labour force participation and slower population growth will only exacerbate this problem, leading to lower demand and thus reduced investment. If the Fed cannot get the desired rate of savings and investment to reach a natural equilibrium point, then Summers may be right. Bubbles may be necessary for robust economic growth. That’s a scary possibility.

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