Larry Summers gave an IMF speech on Nov 8th where he acknowledged that since the 2008 crisis, the USA has had a “jobless recovery” and that the economy is still floundering well below potential. I’m glad that he is drawing attention to all of that. What I disagree with is his suggestion that we need encouragement of asset bubbles as a way to cope with this reality.
It is as well to note exactly what Larry Summers said:
“Then, conventional macroeconomic thinking leaves us in a very serious problem; because we all seem to agree that, whereas you can keep the Federal funds rate at a low level forever, it’s much harder to do extraordinary measures beyond that forever — but the underlying problem may be there forever. It’s much more difficult to say, well, we only needed deficits during the short interval of the crisis if aggregate demand, if equilibrium interest rates, can’t be achieved given the prevailing rate of inflation.
And most of what would be done under the auspices — if this view is at all correct — would be done under the aegis of preventing a future crisis would be counterproductive, because it would in one way or other raise the cost of financial intermediation, and therefore operate to lower the equilibrium interest rate that was necessary. Now this may all be madness, and I may not have this right at all; but it does seem to me that four years after the successful combating of crisis, with really no evidence of growth that is restoring equilibrium, one has to be concerned about a policy agenda that is doing less with monetary policy than has been done before, doing less with fiscal policy than has been done before, and taking steps whose basic purpose is to cause there to be less lending, borrowing and inflated asset prices than there was before. So my lesson from this crisis is — and my overarching lesson, which I have to say I think the world has under-internalized — is that it is not over until it is over; and that is surely not right now, and cannot be judged relative to the extent of financial panic; and that we may well need, in the years ahead, to think about how we manage an economy in which the zero nominal interest rate is a chronic and systemic inhibitor of economic activity, holding our economies back below their potential.”
Throughout this blog I’ve being trying to explore ideas for a reconstruction of our economic system both to address exactly the “secular stagnation” issue that Larry Summers recognizes AND avoid asset bubble induced financial crises. To me the key is to replace the current tax system with a tax on gross assets.
Furthermore I suspect that asset bubbles actually worsen the underlying root cause of secular stagnation. Over the long term, the only way that bubbles offer relief is by forcing fiscal stimulus in the form of bailouts to clear up the mess after the bubble bursts. As the bubble builds, the private sector appears to be creating prosperity by itself. Once the burst happens, the damage could more than make up for that except government deficits induced by bailouts mitigate the crunch. It may be politically more acceptable to have such “disaster relief” than to have everyday fiscal stimulus but it is exceptionally regressive and wasteful. The private sector becomes distorted into becoming a bailout harvesting machine.
It might be argued that bubbles act as a sort of asset tax in that they cause wealth to be moved out of safety and splurged on malinvestments -creating jobs in the process. People become employed building ghost estates of unwanted houses or making patent applications for pretend biotech innovations or whatever. However I suspect that the people who predominantly get fleeced by such bubbles are minor savers saving for retirement. Retirees who’s pension savings went towards buying insanely overvalued pets.com stock in 2000 are now cutting back consumption as a consequence of having lost those savings. The major players profited not only at the expense of the real economy but also at the expense of all those “dumb money” savers who bought high and sold low. In that way bubbles actually worsen the wealth inequality that is at the root of the whole problem.
Related stuff on the web:
Secular Stagnation, Progress in Economics -JW Mason (link added 27nov2013)
Innovation, Stagnation and Unemployment -Ashwin Parameswaran (link added 30nov2013)
Tapping the Brakes: Are Less Active Markets Safer and Better for the Economy -Stiglitz (link added 21April2014)
appendix (this is an excerpt from the pdf that I started this blog off with)
A zero interest rate policy does not reduce the financial overhead
It is sometimes celebrated that the current ultra-low interest rate regime supposedly reduces the “unearned increment” taken by “rentiers”. Some politicians effuse about the exceptionally low “cost of capital” enabled by the current financial climate. Interest free credit for the financial system means boundless financial leverage. Financial leverage powers the ability of the finance industry to feed off of financial instability and also creates and amplifies such instability.
The current zero-interest rate policy was brought about in Japan to save the Japanese banks after their stock market and real estate price collapse of 1990 and then in the USA and UK after the global asset bubble burst in 2008. Reducing interest rates tends to boost asset prices. Ultra-low interest rates also enable banks to “earn their way out of insolvency” by conducting interest rate arbitrage especially across national boundaries to regions with much higher interest rates. In fact just such a “carry trade” between Japan and the rest of the world provided some of the impetus for the bubble in the lead up to 2008. The impact of zero interest rates runs much deeper than such effects however. Understanding how interest free credit benefits the finance industry requires an understanding of how financial markets extract cash flows via price volatility. Potentially a fluctuating price can be harvested to provide a cash flow. If a security maintains roughly the same price over the long term then that means any 20% drop in price eventually being matched by a 25% rise (4/5×5/4=1), any 50% drop being matched by a 100% rise (1/2×2=1) and any 90% drop being matched by a 1000% rise (1/10×10=1). Obviously, simply holding such a security would provide no benefit as the price would simply bob up and down with no overall gain. However a 50% drop from $100 is a $50 loss whilst a 100% gain from $100 is a $100 gain. The fluctuations in the price are geometric but money is money. The fact that financial holdings can be bought and sold allows that geometric to linear inconsistency to be harvested. Simply periodically rebalancing such a holding against a holding of cash would extract financial gains. Rebalancing across a portfolio of securities with independently fluctuating prices optimises that process.
Rebalancing between financial holdings bids up the prices of whatever is cheap and bids down the prices of whatever is expensive. Such trading moderates the price fluctuations that it depends upon. However, such ‘liquidity providing’ speculation is accompanied by extensive ‘liquidity taking’ speculation that amplifies price fluctuations. If a trader envisions that prices are due to rise (or fall) then she can take advantage of such anticipated price changes. In an idealised market where no participant had ‘an edge’ such ‘liquidity taking’ speculation would not make sense -the market as a whole would have already priced in any predictable price movement. However in the real world, market-moving levels of finance are controlled by traders who do have ‘an edge’ over the market as a whole. Liquidity panics occur when traders risk losing everything due to the market moving against their leveraged positions. Consequently, increases in the volume of trading activity typically increase rather than decrease price volatility.
Security trading is a zero sum game. For every participant who buys low and sells high someone else has to have sold to them and bought from them. Certain financial securities are firmly linked to the real economy. Commodity futures set the prices for essentials such as crude oil, grains and industrial metals. Producers and processors of such commodities have real world considerations when they decide whether to sell or buy. The real economy provides the “chump” who ends up buying high or selling low so as to provide the trading gains for financiers. Previously, the borrowing cost for the funds used for trading limited such financial extraction. Interest free credit removes that constraint.
The dream of “popular capitalism” was for everyone to own stocks and align with capitalistic interests to benefit from corporate profitability and efficiency. Various government schemes endeavoured to induce households to buy stocks. However a shift in the capital structure of many companies allows much of the potential benefits to slip past “mom and pop” type stock holders. In principle, the stock market provides a mechanism for distributing corporate profits amongst the shareholders. However, companies can decide to take on debt such that much of the cash flow services the debt instead of going to profits. Low interest rates favour such corporate leverage. Corporate debt is encouraged by the current severe taxes on corporate profits. Debt servicing costs are fixed ahead of time whilst the corporate cash flow varies according to the varying fortunes of the company. Once a fixed block of cash flow is pledged to creditors, any variation becomes proportionately much more dramatic for the remaining profits. The consequence is amplified share price volatility. Management payment in the form of stock options especially encourages a capital structure orientated towards inducing share price volatility.
A highly indebted company needs to nimbly keep the debt burden serviceable by either paying off debt if tough times are envisioned or expanding the debt and buying back stock when times are good. In effect the company itself acts as “the chump” using profits for share buybacks and aquisitions -bidding up oscillations in its own share price. Those shareholders who know what they are doing are able to harvest that volatility by buying and selling at opportune times. The benefits entirely pass by the other shareholders who simply hold the stock as the price bobs up and down. All of the gains pass on through to be captured by those who trade astutely. Some shareholdings last for less than a second in an effort to harvest wiggles in the price on a microsecond timescale.
When financial leverage goes wrong, the assets bought on credit may fall in value to become worth less than the money owed. Historically, bankruptcy laws were extremely harsh on debtors and so financial leverage was feared. Without limited liability laws, company owners were personally on the hook for every debt. Nowadays, however, debts can be taken on such that there is an amplification of any gain (which is pocketed) or an amplification of any loss (which becomes un-payable and so is apologized for). The bank bailouts since 2008 have taken this asymmetry to another dimension. The government stepped in and said that it would pay for all of the losses so that none would be suffered by the creditors (predominately also banks and financial institutions in a reciprocal web of lending). Richard Bookstaber summarised the strategy ,
“Innovative products are used to create return distributions that give a high likelihood of having positive returns at the expense of having a higher risk of catastrophic returns. Strategies that lead to a ‘make a little, make a little, make a little, …, lose a lot’ pattern of returns. If things go well for a while, the ‘lose a lot’ not yet being realized, the strategy gets levered up to become ‘make a lot, make a lot, make a lot,…, lose more than everything’, and viola, at some point the taxpayer is left holding the bag.”
Currently, high finance is an extremely complex business. It requires a colossal technological and human effort. The most advanced and expensive computers are dedicated to high frequency trading (HFT). The best and brightest are educated at elite universities to prepare them for the intense battle of mathematical genius that financial trading has become. Traders pay exorbitant rents so as to have their computers next to those of the major exchanges to avoid even the slightest time delay. A private fibre optic cable has been laid directly between New York and Chicago so as to gain a microsecond advantage for comparisons between the futures and stock markets. It is easy to become beguiled by the sheer complexity and effort of it all. People marvel at superlative feats of human endeavour and the financial markets are the Great Pyramids of our time. That is not to say that it is not counter-productive and essentially moronic.
The vast sums skimmed off from the economy by the vastly expensive finance system could mostly be avoided if money used for financial leverage had a cost such as would be the case under an asset tax system. The useful functions of price discovery and exchange would be better served by pedestrianized financial markets in which all participants interacted on a level playing field. Advanced computers would be rendered pointless if transactions were conducted with a time resolution of minutes rather than microseconds. Such a time buffer would end the vastly expensive arms race in computer technology between elite traders. The current ultra-low-latency trading environment often provides a perfectly continuous price variation down to a microsecond resolution. That much applauded attribute is only of any relevance for ultra-low-latency traders in their quest to out manoeuvre other participants. Whilst advanced technology normally creates such (superfluous) pricing precision it occasionally runs amok creating gross mispricing events such as the “flash crash” of May 2010 and the Knight Capital fiasco of August 2012. A genuinely efficient financial market is one that allows prices to be formed that genuinely reflect supply and demand and does so at minimal cost. Excessive opportunities to “make money” from trading are an indication of a dysfunctional market. However, the current market structure is entirely a concoction for just that purpose. The failure of current financial markets to serve their original purpose is apparent from withdrawals. Farmers are now making less use of futures to hedge their prospective crop yields. There has been a transfer of stock ownership from households and pension funds to financial institutions.