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What Market Failures Underlie Our Fears of "Secular Stagnation"?: The Honest Broker for the Week of January 12, 2014

I: The Lesson

The first part of our lesson for today consists of a piece based on his AEA presentation by the terrifyingly brilliant Lawrence Summers: Strategies for sustainable growth: "Last month I argued that the U.S. and global economies may be in a period... in which sluggish growth and output, and employment levels well below potential... coincide... with problematically low real interest rates....

Even with the high degree of slack in the economy and with wage and price inflation slowing, there are signs of eroding credit standards and inflated asset values. If the United States were to enjoy several years of healthy growth under anything like current credit conditions, there is every reason to expect a return to the kind of problems of bubbles and excess lending seen in 2005 to 2007 long before output and employment returned to normal trend growth or inflation picked up again....

Having identified the problem, Summers then writes:

There are, essentially, three approaches:

  1. Emphasize... deep supply-side fundamentals: the skills of the workforce, companies’ capacity for innovation, structural tax reform and ensuring the sustainability of entitlement programs. This is appealing.... But this approach is unlikely to do much in the next five to 10 years....

  2. Lower relevant interest rates and capital costs as much as possible and relying on regulatory policies to ensure financial stability. No doubt the economy is far healthier now than it would have been in the absence of these measures. But a growth strategy that relies on interest rates significantly below growth rates for long periods virtually ensures the emergence of substantial financial bubbles and dangerous buildups in leverage. The idea that regulation can allow the growth benefits of easy credit to come without cost is a chimera. The increases in asset values and increased ability to borrow that stimulate the economy are the proper concern of prudent regulation....

  3. The [approach] that holds the most promise is a commitment to raising the level of demand at any given level of interest rates through policies that restore a situation where reasonable growth and reasonable interest rates can coincide... ending the disastrous trends toward ever less government spending and employment each year and taking advantage of the current period of economic slack to renew and build out our infrastructure. If the federal government had invested more over the past five years, the U.S. debt burden relative to income would be lower: allowing slackening in the economy has hurt its long-run potential. Raising demand also means spurring private spending. Much could be done in the energy sector to unleash private investment toward fossil fuels and renewables... more rapid replacement of coal-fired power plants... mak[ing] sure that a widening trade deficit does not excessively divert demand from the U.S. economy.

And Summers concludes:

Secular stagnation is not inevitable. With the right policy choices, the United States can have both reasonable growth and financial stability. But without a clear diagnosis of our problem and a commitment to structural increases in demand, we will be condemned to oscillating between inadequate growth and unsustainable finance. We can do better.

The second part of our lesson for today is a gloss on and critique of same by the keen-witted Ryan Avent: Secular stagnation: Why is stagnation bubbly?: "Imagine a world, [Summers] said, in which resources are increasingly concentrated in the hands of those with high propensities to save and low propensities to invest: reserve accumulating foreign governments... the very rich.... The real rate of interest that... balances savings and investment [at high employment]... could fall to and remain at very low levels...

The central bank would need to keep its policy rate near zero... asset prices would soar... a dangerous rise in financial instability.... The market-clearing interest rate could fall below zero, leaving the central bank unable to move... and trapping the economy in a prolonged slump. The evidence of our senses, and the judgment of bond markets, appears to strongly support this story....

Summers’ preference would be to close the gap between investment and saving through direct fiscal stimulus... a hefty programme of public investment[:]... if now—with the economy slumping and the government able to borrow at negative real rates—is not the time to fix JFK airport in New York City, when is?... If one runs a large, 5-year fiscal stimulus plan through the Federal Reserve’s basic economic forecasting model, one gets a debt-to-GDP ratio several decades down the road that is lower than in the absence of stimulus, because of the costly nature of a prolonged slump, even if one assumes that production resulting from stimulus is tossed in the ocean and generates zero productivity gains for the economy.

There is another possibility... what I called “the solution that cannot be named”... temporarily raise inflation.... Mr Summers dismissed this possibility. He argued that clearing the market by raising inflation would simply encourage more private investment and reduce saving.... Full employment generated that way would simply lead to increased financial instability: more bubbles. This left me a bit puzzled as to what his story about stagnation actually is....

And here Ryan registers both disagreement and a failure to follow the logic of the argument:

We're talking about two very different phenomena! We have the... zero lower bound prevents the central bank from generating adequate demand. And... we have... savings pile up, generating a dangerous hunt for yield.... Why would we think that solving the first problem would exacerbate the second? Mr Summers seems to be arguing that more demand would simply mean more investment, and because we lack sufficient good (private) investment opportunities already (which is why long-term real rates are low) adequate demand just means more foolish investment.... But... are we really arguing that there aren't enough good private investment opportunities in America?...

And he endorses, instead, the inflationista position of Olivier Blanchard:

Olivier Blanchard responded to Mr Summers' take on secular stagnation by arguing that policymakers should target higher inflation to generate adequate demand and then use macroprudential policies to rein in financial instability.... There are many sources of excess saving. Macroprudential policies might very effectively filter out some of them (like inward capital flows from reserve-accumulating foreign governments) while leaving other savings perfectly free to scale up investment and boost the economy....

I whole-heartedly agree with Mr Summers that seizing the opportunity now offered by bond markets to make lots of useful public investments is a win-win-win idea. Probably win-win-win-win. But the evidence strongly suggests that a higher inflation target would in fact make life much easier...

And now let me proceed to my commentary, in which we will see if I can untangle this analytical Gordian knot: What is (are) the underlying market failure(s) here? What would be the first-best solution to compensate for them? What are the possible second-best solutions, and what are the benefits and costs of each?

That is the economist's analytical catechism, and it is--I think--a good one to apply here:

II: The Blanchardist Critique

What I will call the Summersian position seems to me to begin by listing three root factors:

  1. A concentration of wealth--due to earnings from commodity exports and surpluses from pursuing industrial-policy strategies of undervaluing currencies in order to generate the social learning promoted by export-led manufacturing growth--in the hands of sovereign wealth funds and other political actors that seek not to maximize risk-adjusted return but instead some other objective that we can think of as "safety of nominal principal". This is a market failure: they are not properly responding to real economic incentives.

  2. A concentration of wealth--due to other factors making for increasing wealth inequality--that concentrates savings in the hands of the rich who seek not to maximize risk-adjusted return but instead to preserve their principal as they guard against large-scale political risks. This makes the following market failure crucial:

  3. The zero nominal bound on safe interest rates keeps the return on safe savings above its free-market equilibrium price.

And what seems to me the natural response to the Summersian argument's assertion of is then made by IMF Chief Economist Olivier Blanchard. Political actors value not real wealth and risk-adjusted return but rather nominal safety and liquidity? Then you can provide what they want at a lower resource cost by having a higher inflation target--5% per year or so rather than our current target of less than 2% per year. The rich seek safety and are unwilling to bear the risks of enterprise and so the real rate of interest that clears the market for safe bonds is less than zero? Here too the answer is a 5% per year inflation target: that lifts the constraint imposed by the zero nominal lower bound, and allows the market to clear.

Thus, what I will call the Blanchardist position argues, there is no insoluble problem, only a units problem and opportunity that can be easily solved: The problem is that the government has pegged the return on safe assets at a real return of -1% when the free-market equilibrium real return is -3%, and given our institutions a higher inflation target is the best way to release this distortionary price floor. The opportunity is that non-market political actors can be satisfied at lower resource costs under a higher inflation target. Why not do so?

These arguments appear very strong. But they are not convincing to Summers. What else is he thinking besides (1), (2), and (3)? And why?

III: Greenspanite Considerations

One argument--the argument that Paul Volcker, Alan Greenspan, and I believe Ben Bernanke would make--is that a 2% per year inflation target is sustainable over the long run, but that a 5% per year target--even a 3% per year target--is not, or is not easily sustainable. A 5% per year inflation target, this argument I will call Greenspanite goes, demonstrates to investors everywhere that effective price stability is really not high on the central bank's list of priorities. Emergencies and politics will pressure the central bank, and if effective price stability is not the highest priority it will succumb to the temptation to relax its inflation target. Thus a central bank that has been happy with a 5% per year rate of inflation last year will be willing to tolerate a 7% per year rate of inflation next year. Thus if past inflation has been 5% per year, expected inflation will be 7% per year--and the central bank will either watch inflation creep up until it escapes from all control and 1982 is required again to re-anchor expectations again, or the central bank will have to perennially target an unemployment rate higher than the natural rate in order to keep actual inflation at 5% per year below expected inflation at 7% per year, with enormous resulting economic losses.

This Greenspanite argument is, I think, relatively strong within central banks. I recall one very, very senior monetary policymaker telling me in the late 1990s that Greenspan had in fact pushed the envelope hard in defining a 2% per year inflation target as "effective price stability", and that had been a gutsy loose-money move for someone in his position.

A corollary to this Greenspanite argument is that the government derives seigniorage from being in the liquid-safe-store-of-value business, and that the public derives utility from having the liquid-safe-store-of-value business run by a very patient organization with a very long time horizon. Suppose that the central bank does establish and maintain a 5% per year inflation target. At some point it will strike the investment bank of Schiff Medici Pomponius that it can get into the liquid-safe-store-of-value business as well. They will turn loose their quants to construct the optimal basket of durable, storable commodities to mimic the overall price level; fill containers with those commodities; park the containers along the Hudson, the Thames, in Tokyo Bay, and in Singapore Strait; guard them; set up their own cryptocurrency; announce that they stand ready to buy and sell their cryptocurrency for any other currency at its current commodity value; and so take the seigniorage business away from the 5% per year inflation governments.

They will do so. And as long as Schiff Medici Pomponius remains long-term greedy, the real commodity value of SchiffMediciPomponiusCoin will remain stable. But it will not have the resources to be a proper stabilizing central bank; tying up capital in commodities and containers is a reduction in social wealth; and the containers will actually be full of commodities only as long as Schiff Medici Pomponius remains long-term greedy. When it stops being so, watch out! Thus there is an inverse-Gresham's Law process at work here: short-term good money will drive out less-good money in the medium run, but in the long run the fact that investment banks are likely to have shorter horizons and definitely have less resources than governments will be the cause of enormous trouble.

I have not found anybody else who makes their corollary argument, so I will call it the DeLongian corollary. The question is: where does this corollary--and the original Greenspanite argument--start to apply? It is pretty clear to me that 2% per year is a sustainable inflation rate over the long run. It is pretty clear to me that 10% per year is not. Greenspan, I think, believes that 3% per year is not sustainable. I think it is. I think 5% per year is probably sustainable, but I admit to having little basis for my belief. And I do not think anybody really knows.

This §III, however, has been for the most part a digression. These Greenspanite and DeLongian corollary arguments are, I think, important and weighty. But they do not appear to be the reasons that the Summersian position rejects the Blanchardist proposal for a 5% per year inflation target.

IV: Low Interest Rates and Financial Stability

Let's parse Larry Summers's anticipatory rebuttal to the Blanchardist higher-inflation target proposal. Summers calls, instead, for:

a commitment to... policies that restore a situation where reasonable growth and reasonable interest rates... coincide... ending the disastrous trend towards ever less government spending and employment... taking advantage of the current period of economic slack to renew and build up our infrastructure.... [I]n the energy sector... unleash[ing] private investment on both the fossil fuel and renewable sides.... requir[ing] the more rapid replacement of coal-fired power plants... ensur[ing] that a widening trade deficit does not excessively divert demand from the US economy...

The first best, for the Summersian position, thus seems to involve a very different fiscal policy. The government should be taking advantage of the global savings glut to borrow-and-spend--and, given how low its borrowing costs are and how large is the economic slack produced by too-tight fiscal policy, borrow-and-spend would be an effective way of rebalancing the long-term finances of the government and lowering debt burdens as well. The first best, for the Summersian position, also involves very different environmental regulation: carbon taxes to accelerate the phase-out of coal power and the buildup of first non-carbon energy, second closed-carbon-cycle energy, and third natural gas energy, with its release of the energy from the transformation of four rather than two carbon-hydrogen to carbon-oxygen bonds for each molecule of global warming carbon-dioxide created; and, failing carbon taxes, the regulatory stick to require the investments in energy we would be making if the Pigovian carbon-tax carrot were working properly. And the government should be making sure that non-market wealthholders' demand for dollars does not push U.S. exports and manufacturing production below their first-best levels.

But, the Summersian position appears to go, fiscal policy is very wrong: government purchases and government investment are too low, environmental regulation is too hesitant and insufficient, and U.S. trade policy does not properly compensate for the distortionary harm inflicted on U.S. export and import-competing manufacturing by the market failure of so much global wealth being controlled by political actors. We should, therefore, move immediately to the first-best fiscal policy. Were we to do so, we would find that we had a much stronger economy, a lower prospective long-term debt burden, and no requirement to raise the inflation target in order to clear the market at the first-best price of the real return on safe 98766debt.

OK. That makes a lot of sense. I am 100% behind this aspect of the Summersian position...

But we are not going to get there, absent the complete destruction of Republican legislative power, plus the recognition by both the Rubin wing of the Democratic Party that now is the time to spend more, and the recognition by the Very Serious People who have been the debt-scold caucus that they have been barking up the wrong tree, plus the conversion of Obama to the belief that in his attachment to the debt-scold caucus he has served America poorly. We are not getting there. So, the Blanchardists would argue, isn't a higher inflation target then the second-best? Given fiscal dysfunction, isn't that the best we can do?

And the Summersian position still says: "No". Summers somewhat elliptically writes against:

the... strategy... [of] lowering relevant interest rates and capital costs as much as possible, and relying on regulatory policies to assure financial stability.... A strategy that relies on interest rates significantly below growth rates for long periods of time virtually guarantees the emergence of substantial bubbles and dangerous build-ups in leverage. The idea that regulation can allow the growth benefits of easy credit to come without the costs is a chimera. It is precisely the increases in asset values and increased ability to borrow that stimulate the economy that are the proper concern of prudential regulation...

The argument seems to be thus: Yes, we could have a higher inflation target and so lower real rates on safe bet well below zero, and with a constant risk premium thus lower required yields on real assets low enough and boost real asset prices high enough to induce enough private investment and private consumption to get us to full employment. But we also need to guard against bubbles and financial instability. And macroprudential regulation works by putting barriers in the way of the wrong people holding risky investments and thus works by raising the spread between the real safe rate of return and the required risky yield. What we do to stimulate investment via a higher inflation target at the zero nominal bound we undo by macroprudential regulation that raises spreads, and thus leaves the required real yield where it was: too high to induce enough private investment (and consumption) to get us to properly full employment.

The Blanchardist response to this is well-put by Ryan Avent:

There are many sources of excess saving. Macroprudential policies might very effectively filter out some of them (like inward capital flows from reserve-accumulating foreign governments) while leaving other savings perfectly free to scale up investment and boost the economy.... Lots of useful public investments is a win-win-win.... But the evidence strongly suggests that a higher inflation target would in fact make life much easier...

How much wiggle room there is in fact to boost private investment without triggering private financial instability by give us via lowering real safe interest rates below zero while taking away the macro prudential regulation that pushes unworthy risk bearers out of the market is a complicated and understudied question. I cannot deal with it here. What I do want to do is make explicit the underlying Summersian argument: the required real yield on private investments low enough to induce enough investment to balance savings at full employment is too low a yield to properly discourage bubbles and overleverage. The argument appears to be:

  1. There are "worthy" private risky investment projects and "unworthy" ones.
  2. "Worthy" risky investment projects have a relatively low elasticity of supply with respect to the required real yield.
  3. "Unworthy" ones have a high elasticity of supply.
  4. When safe real interest rates get too low savers who should not be bearing risk do so by reaching for yield--they stop checking whether investment projects are "worthy" or "unworthy", and so sell unhedged puts in the hope that everything will come out all right.

This is what provokes Ryan's despairing plea that:

are we really arguing that there aren't enough good private investment opportunities in America?

Yes. We are.

Or, perhaps, we are arguing that there aren't enough good relatively safe private investment opportunities in America. Or, perhaps, we are arguing that there has been a large-scale systematic failure to mobilize the economy's risk-bearing capacity so that when additional risky private investment opportunities are launched the risks are carried by intermediaries that really should not be carrying them.

The argument seems to be that there are people who should be holding risky assets, that there are people who should be holding safe assets, and that lowering the real return to safe assets induces people who really should not be holding risky assets to go and try to hold them.

V: Second-Best: Raising the Inflation Target? Housing Finance as a Tool of Macroeconomic Stabilization Policy?

If we adopt the Summersian perspective, the first-best for this set of issues is clearly expansionary fiscal policy. There are a bunch of financial intermediaries that have (or ought to have) low risk tolerance. Hence they ought to be holding safe assets. The government can create those safe assets. The government has infrastructure and other investments it can fund with the money earned by selling those safe assets. There are unutilized resources about because wages and prices do not fall when aggregate demand is low. The fact that we have an economy with lots of nominal debt contracts means that we do not want to see wages and prices fall faster than they do because that generates universal bankruptcy. Thus given the market failures--financial intermediaries that shouldn't be holding risky assets, savers who cannot properly monitor what the financial intermediaries are doing, wage and price rigidity, and principal-agent problems that lead to nominal debt contracts which cause deflation to lead to universal bankruptcy--borrow-and-spend by the government is first-best when the economy hits the zero nominal lower bound, or perhaps constrained first-best.

But what if the government cannot adopt borrow-and-spend to restore us to full employment because of political dysfunction? What then is the second best?

Some (e.g., Mankiw and Weinzerl (2012)) say that inflation is not just the second-best but the first-best--drop the real return on safe assets well below zero and so induce financial intermediaries to fund enough risky long-term private investment projects in order to get us back to full employment. From the Summersian perspective, this Weinzerlist solution is not a good road to walk. The fundamental problem is that too little risky investment is being financed because the fundamental risk tolerance is not there to finance it. Dropping the safe interest rate below zero pushes the safe interest rate below what is in some sense its fundamental value and so provides incentives to (a) overinvest in long-duration safe private assets that do not yield returns commensurate with their social resource cost, and (b) induce financial intermediaries to play heads-we-win-tails-you-lose with the money of their clients of low risk tolerance--a game that in its limits less to froth, bubbles, and Ponzi schemes. Dropping the safe interest rate below zero and promising to keep it there may still be second best: these distortions from too-loose monetary policy do create Harberger triangles but we currently have a huge Okun gap, and it takes a heap of Harberger triangles to fill an Okun gap. And the argument that their truly are large risks from (a) lengthening the duration of the capital stock beyond its first-best and from (b) having financial intermediaries reach for risky yield have not been nailed down to my satisfaction.

But might there be a better way?

Look at what has happened to residential investment as a share of potential output:

FRED Graph St Louis Fed 4

When I look at this graph, I find it very hard to escape the conclusion that the big bad thing going on in the third millennium is not the excess construction of the mid-2000s housing bubble--a sum of 7.5% points of annual GDP--or the working-off of that 7.5% points of GDP worth of excess construction, but rather the additional--so far--but rather the additional 20% points of annual GDP of residences not built since 2007 because of the financial crisis, resulting depression, and breaking of housing finance. Fixing whatever is keeping housing finance and thus housing construction broken would then be job #1, and so using the FHFA and the GSEs as tools of macroeconomic policy might well be superior to raising expected inflation and so trying to goose financial intermediaries that should not be funding risky and long-duration assets into doing so. (This question is, of course, complicated by the fact that housing is one of the longest-duration assets we have.)

(And at this point I should note that it was back in... July 2008... that Larry Summers and I and others had a few talks about how if the situation went south we might very well want to have a head of what became FHFA willing to aggressively use the agency as an instrument for macroeconomic stabilization. And yet Barack Obama never took even the initial steps to set up the pool table so that this might be done should it become necessary, as I think it has been very much necessary over the past four years.)

To the extent that it really is policy uncertainty about (a) the future of the macroeconomy and (b) the future of the GSEs and thus where long-run housing risk will lie over the next generation that is depressing the risk tolerance of the private market, fixing that market failure looks to be better than pushing safe real rates below zero. (It might even be better than borrow-and-spend.(

And look at what has happened to government purchases:

FRED Graph St Louis Fed 4

When I look at this graph, I see:

  • No change under Reagan and the "read my lips: no new taxes" incarnation of George H.W. Bush.
  • A steep decline in government purchases as a share of the economy in order to get our fiscal house in order under the Foley-Mitchell-(HW) Bush 1990 and Clinton-Foley-Mitchell 1993 deficit reduction agreements.
  • Rough stabilization of the government-purchases share of potential GDP in Clinton's second term and throughout George W Bush's presidency.
  • A small fiscal stimulus bump of 0.5% of GDP when the Lesser Depression hits as federal spending outweighs state and local austerity.
  • The 2%-point plus of annual GDP collapse in government purchases since 2009.

It's not just that we have not been expanding government purchases as a share of the economy to get close to the first best: we have been contracting them fiercely. That cannot be good.

VI: Quantitative Easing

But what if (a) we cannot attain the (constrained) first best via public-sector borrow-and-spend or (b) rebalancing housing finance, and (c) cannot attain the second best via a higher inflation target that at the zero lower bound pushes safe real interest rates strongly negative, but must (d) resort to quantitative easing to lower the spread between safe and risky interest rates, and so induce more private risky investment that way?

There is a meme in the literature that such quantitative easing policies act, like pushing the safe interest rate below zero, to increase risks by inducing financial intermediaries that have no fundamental business investing in risky assets to do so. And to the extent that quantitative easing works by raising future expected inflation, this point is as strong as the Summersian point that there are indeed risks in inducing financial intermediaries that shouldn't be reaching for risky yield to do so--however strong that point turns out to be.

But to the extent that quantitative easing works by shrinking the spread between safe and risky interest rates by having the Federal Reserve take risk off of the deficient risk-tolerance private market and put it on taxpayers? I don't think that argument holds much water. As I wrote before:


In the financial market there is a demand for risk-bearing capacity by firms and others who want to borrow but who cannot guarantee that they will be able to repay. The higher is the price of risk--the greater the risk premium interest rate spread over short-term Treasuries they must pay--the less they will borrow.

In the financial market there is also a supply of risk-bearing capacity by savers and financial intermediaries who want to lend, and are willing to accept and bear some risk in return from getting more than the short-term Treasury rate. The higher is the price of risk----the greater the risk premium interest rate spread over short-term Treasuries they must pay--the more they will be willing to lend.

When the Federal Reserve undertakes quantitative easing, it enters the market and takes some risk off the table, buying up some of the risky assets issued by the U.S. government and its tame mortgage GSEs and selling safe assets in exchange. The demand curve for risk-bearing capacity seen by the private market thus shifts inward, to the left: a bunch of risky Treasuries and GSEs are no longer out there, as the government is no longer in the business of soaking-up as much of the private-sector's risk-bearing capacity:


And this leftward shift in the net demand to the rest of the market for risk-bearing capacity causes the price of risk to fall, and the quantity of risk-bearing capacity supplied to fall as well. Yes, financial intermediaries that had held Treasuries and thus carried duration risk take some of the cash they received by selling their risky long-term Treasuries to the Fed and go out and buy other risky stuff. But the net effect of quantitative easing is to leave investors and financial intermediaries holding less risky portfolios because they are supplying less risk-bearing capacity.

How do we know that they are holding not more but less risky portfolios? We know because we know that supply curves slope up, and if they were holding more risky portfolios in total--supplying more risk-bearing capacity to the market--the price of risk would have not fallen but risen, and interest rate risk spreads would be not lower but higher, wouldn't they?

So when the intelligent and thoughtful Mark Dow tweets:

I, too, think risks [of QE] overstated, but they're non-zero. Main ones r credit leverage buildup…

I am at a loss. As long as supply curves slope up, QE does not increase but reduces the leverage of private-sector financial asset holders.

And when the intelligent and thoughtful Mark Dow tweets:

I, too, think risks overstated, but they're non-zero. Main ones r… outsized int'l capital flows

I am again at a loss. Yes, the Federal Reserve has taken some domestic risky assets off the table. Yes, U.S. financial intermediaries and savers will respond by buying foreign assets to so deploy some of their now-undeployed risk bearing capacity. Yes, they will now bear some exchange-rate risk. But, once again, the fact that QE pushes interest rate spreads down is very powerful evidence that these capital flows are not "outsized"--that the extra exchange-rate risk U.S. financial intermediaries have now taken onto their books is less than the duration risk that QE took off of their books.

At least, that is the case as long as the supply curve for risk-bearing capacity slopes up, like a good supply curve should.

Perhaps those who claim that there are big risks to quantitative easing regroup. Perhaps they claim that financial intermediaries are perverted, and that the lower is the price of risk the greater is the amount of risk-bearing capacity they supply to the market because they lose their jobs if they don't make at least three cents on every dollar of assets in a normal year in which risk chickens come home to roost.

In that counterfactual world, the supply-and-demand graph would look like this:


And in that counterfactual world, the Federal Reserve's adoption of quantitative easing policies triggered an enormous expansion of the quantity of risk-bearing capacity demanded by firms and households and a huge private-sector lending boom as firms issued enormous tranches of risky bonds and as firms and households took out risky loans. In that counterfactual world, employment in bond underwriting tripled as $85 billion a month in QE was more-than-offset by an extra $120 billion a month in private-sector bond issues. In that counterfactual world, we saw a rapid recovery of housing construction and a thorough equipment investment boom as far across the U.S. as they eye could see.

That didn't happen.

So what are the risks of QE?

It really seems to be this:

  • Commercial banks traditionally accept deposits, put the deposits in long-term Treasuries, rely on the law of large numbers and on deposit insurance to allow them to always hold their long-term Treasuries to maturity, and so have a riskless and profitable business model.
  • When commercial banks cannot do this, they find some way to gamble with government-insured deposits.
  • ????
  • LOSS!!

But this is not a source of systemic risk: because the deposits they may be gambling with are government insured by the FDIC, no run on the banking system or the shadow banking system occurs when risks come due. It would be embarrassing, yes. And the proper response to thinking that commercial banks are running undue risks with government-insured money is to send in the bank examiners--not to undertake policies that raise unemployment.

So put me with Ryan Avent, who tweets:

[The] risk [is that] of not being considered a [very] serious person by peers [unless you claim to greatly fear the risks of quantitative easing]

VII: Conclusion

This ends my rambling and unsatisfactory tour of my current thinking on the issues around what has come to be known as Secular Stagnation II...

If you asked me to rank the policies that we should pursue at this point in time, I would say that my tour through these arguments--Summersian, Blanchardist, Greenspanite, the DeLongian corollary, Aventist, Weinzerlist, and so forth--has led me to think that we should, in this order:

  1. Do no harm: reverse immediately the post-2009 fall in government purchases as a share of potential GDP.
  2. Do good: take advantage of the global glut of savings seeking safety to have the U.S. government fulfill market demand for safe assets, and use the funds to invest in the highest social return expenditures open to the government.
  3. In addition and perhaps as an even better alternative than all-in on (2), have Mel Watt's FHFA end policy uncertainty about housing finance and rebalance the construction sector to fill in our current 20%-point of annual GDP housing capital deficit.
  4. Do not taper the Federal Reserve's asset purchases: QE appears to me to have advantages vis-a-vis forward guidance of extraordinary monetary ease in terms of whether it creates outsized risks.
  5. Extend promises that interest rates will remain zero and that the Federal Reserve will not panic when inflation rises above 2% per year until the economy has reattained full employment.

And if any of these turns out to be politically-blocked, move on to the second.

But--and let me stress this--my thoughts on this entire set of issues are tentative, half-formed, subject to error, and revision. As, indeed, are everyone's. That is why I have called the positions "Summersian, Blanchardist, Greenspanite, the DeLongian corollary, Aventist, Weinzerlist, and so forth"--for every economist involved in the serious side of this debate understands that their positions are tentative. And everyone serious is ready to revise their views and mark their beliefs to market as more evidence comes in.

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