Dear Larry,

Notes on Larry Summers's Interest rates are at inconceivable levels, and we must confront what that means


Larry, you are thinking inside the box.

The U.S. 10- and 30-year interest rates on Wednesday reached all-time lows of 1.32 percent and 2.10 percent...
Such rates would have seemed inconceivable a decade ago ...
[E]xtraordinarily low rates reflect both sub-target expected inflation even over long horizons and very low real interest rates...
Remarkably, the market does not now expect a full Fed tightening until early 2019. This is despite all the Fed speeches expressing optimism about the economy and a desire to normalize interest rates...

There is a growing sense that the world is demand-short — that the real interest rates necessary to equate investment and saving at full employment are very low and often may be unattainable ...

First of all, Larry, you are explaining "demand-short" in terms of interest rates. Don't do that. It gets you to interest rates too soon. Actually, you skipped the explanation altogether and went straight to your conclusion that the interest rates we need are unattainably low.

Let's say you're right. Then the question is: Why? Why are rates so low? And how did rates get that way? In other words, Larry, we still need an explanation. (And then, maybe it is not the need for low rates that is the problem. Maybe it is the thing that created the need for low rates that is the problem. See how that works?)

The situation is different now. Not like before the crisis. The situation is different, but your thinking is no different. You are still relying on concepts and short cuts that you used back in 1991 when you were wrong about the 4.5% mortgage rate being an "antique". In truth, Larry, there is no remedy except to throw over the axiom of parallels and to work out a non-Euclidean geometry, if you get my drift.

Second: Are you relying on loanable funds theory? Sounds like it. Savings and investment are not made equal by interest rates. They are made equal by accounting convention.

And then, Larry, and then you look at the world around you, you describe what you see, and you call it "the result" of the conclusion that you jumped to.

Look what you wrote, Larry:

There is a growing sense that the world is demand-short — that the real interest rates necessary to equate investment and saving at full employment are very low and often may be unattainable given the bounds on nominal interest rate reductions. The result is very low long-term real rates, sluggish growth expectations, concerns about the ability even over the fairly long term to get inflation to average 2 percent, and a sense that the Fed and the world’s major central banks will not be able to normalize financial conditions in the foreseeable future.

 

So. Having fitted the post-crisis world to your pre-crisis economics, and having identified the problem by proclamation, you now move on and consider solutions.

Having the right worldview is essential if there is to be a chance of making the right decisions.

Good point, Larry. I agree with that.

Here are the necessary adjustments:

First, with differences between countries, neutral real interest rates are likely close to zero going forward... There is no good reason to think given sluggish investment expectations that the neutral rate will rise to be significantly positive in the foreseeable future... Substantial continued reductions in Fed estimates of the real neutral rate lie ahead.

Larry, you are doing it again. Starting with low interest rates. Fact is, interest rates in the U.S. have been drifting down hill since 1981. Maybe we should think about that. Maybe we should think about why that. Don't start with interest rates being low at the moment. That's what you thought about your parents' mortgage rate. Think instead about why rates went down for 34 years.

Maybe there is more to it than just interest rates. Get my drift, Larry? Having the right worldview is essential. Without it, you end up saying things like "Substantial continued reductions in Fed estimates of the real neutral rate lie ahead."

They've been lowering rates for 34 years, Larry, and now they've reached the zero bound. The only interest rate left for them to lower is their estimate of the real neutral rate. You're not telling me anything useful, Larry. Anyway, you got to your conclusion by jumping.

Second, as counterintuitive as it is to central bankers who came of age when the inflation of the 1970s defined the central banking challenge, our problem today is insufficient inflation.

No, Larry. Our problem is not insufficient inflation.

Third, in a world where interest rates over horizons of more than a generation are far lower than even pessimistic projections of growth, traditional thinking about debt sustainability needs to be discarded. In the U.S., the U.K., the Euro area and Japan, the real cost of even 30-year debt will be negative or negligible if inflation targets are achieved. Indeed, the conditions Brad DeLong and I set out in 2012 for expansionary fiscal policy to pay for itself are much more easily satisfied today than they were at that time.

Thinking inside the box, Larry. The Keynesian box. Keynes said deficit spending, so Larry Summers says deficit spending. Get out of the box, Larry. Think for yourself. We've had 80 years of deficit spending in the public and private sectors. Maybe it is time for something else. Get out of the box.

Want a hint? I'll give you a hint. What happens when you have 80 years of deficit spending in the public and private sectors? You accumulate a lot of debt, that's what happens Larry. (HINT: Maybe the problem is too much debt.)

Anyhow, why are you still talking about public debt? Everybody knows Keynes said increase the public debt. You say that is the solution again, now. Other people say public debt was the problem then, and is the problem now. Nobody says fuckall about private debt. Get out of the box, Larry. This isn't 1936. The facts are different.

When events change, I change my mind. What do you do?

Fourth, the traditional suite of structural policies to promote flexibility are not especially likely to be successful in the current environment, though some structural policy approaches such as removal of restrictions on investment are still desirable. Indeed, in the presence of chronic excess supply, structural reform has the risk of spurring disinflation rather than contributing to a necessary increase in inflation. There is, in fact, a case for strengthening entitlement benefits so as to promote current demand.

IS, Larry. The traditional suite of policies IS not likely to be successful. If you're going to say it, Larry, at least get the grammar right.

Larry, Larry, Larry. First you say "some structural policy approaches such as removal of restrictions on investment are still desirable." Then you say "in the presence of chronic excess supply, structural reform has the risk of spurring disinflation". I know, when the facts change you have to change your mind. But you changed your mind mid-paragraph. The facts didn't have time to change.

And then, oh my: You say "There is, in fact, a case for strengthening entitlement benefits so as to promote current demand."

You're a case, Larry. You get things we need mixed up with policies we should put in place. Instead of doing something about income inequality, you would increase entitlements "to promote current demand". Have you forgotten what an economy is? Do you not know how an economy works?

And that brings us to your concluding paragraph:

There is much more to be said about policy going forward. But treatments without accurate diagnoses have little chance of success. We need to begin with a much clearer diagnosis of our current malaise than policymakers have today. The level of interest rates provides a very strong clue.

I absolutely agree that an accurate diagnosis is required. That's why I'm writing to you today, Larry. But that thing about interest rates, you have to re-think that.

You said it yourself: Interest rates are inconceivably low, and we must figure out what it means.

Here, let me lay it out for you Larry.

Interest rates are at record lows, and still going lower. You told me as much. The Fed wants to "normalize" rates -- wants to get rates back to normal. But markets don't expect a hint of normal till at least 2019.

Of course, if there is any hint of inflation, or any hint of vigor in the economy, rates will rise and cap off the vigor right away. Meanwhile, it's all downhill. You told me so.

We need to get interest costs down to get economic growth so that we can raise interest rates and undermine that growth. This is your plan for the economy. What's to understand?

Larry, you crack me up. All this focus on interest rates. And no focus at all on the number of dollars on which interest must be paid. You guys cut interest rates, as low as they can go. Now you're trying silly stuff with negative rates -- an act of desperation, to be sure. But you pay no attention to the accumulation of debt. It's the accumulation of debt that created the need for low rates.

Cut debt in half, Larry, and you cut interest costs in half. What's to understand?