Commenting on the recent spat between Larry Summers and Ben Bernanke over secular stagnation, Greg Ip from the WSJ wrote that Bernanke has the theory while Summers has the evidence. In fact, Bernanke has neither.
According to Bernanke, secular stagnation, which occurs when the interest rate required for full employment is permanently negative, cannot exist. Since all investments generate a positive return, Bernanke argues, interest rates can never stay negative, because the private sector, lured by massive profits, will borrow ad infinitum and prevent rates from turning red. The result is that full employment is always achievable with positive rates.
Alas, this argument is wrong on so many levels.
Let’s start with the ludicrous notion that all investments are profitable. To prove his point, Bernanke uses the unfortunate example of levelling the Rocky Mountains. If we razed the Rockies to the ground, he explains, drivers would save on fuel costs. So even if an obscene amount of resources are squandered on this grandiose plan, the investment would be profitable.
Is this theoretically true? Well, if we put on our sci-fi blinders, ignore the environmental costs, and pretend that investment returns are pre-ordained, then yes, Bernanke is correct. After an enormous upfront cost, the investment would yield a positive return each year in the form of reduced fuel use. And since the Rockies won’t magically re-sprout, no further expense is required.
Bernanke’s logic crumbles — and crumbles fast — when he extrapolates from his mountain example to all investments. In other words, Bernanke stipulates that because his geo-engineering project is profitable, then all investments must be profitable.
Yes, you read the above sentence correctly. Bernanke has just claimed that all investments are profitable, a statement which is hard to reconcile with the man who lifted the world out of the economic abyss.
Anyone who has spent a mere hour in the real world can figure out why this is not the case, so I won’t waste time explaining how an investment can be unprofitable even with rock bottom rates. Here’s a hint though: not all investments last forever, and not all investments incur zero running costs. (All right, all right: for the ivory tower-bound among you, imagine a business that generates $95 in annual sales for every $100 in expenses, and then think about the conditions under which an investor might finance it.)
Okay, so leg one of Bernanke’s argument — all investments are profitable — is pure bunk. But for kicks and giggles, let’s pretend that he’s right. Let’s assume for a moment that all investments do generate a positive return. Does this mean that interest rates can never stay negative for long?
The answer, again, is no.
For some baffling reason, Bernanke ignores the possibility that there simply aren’t enough investment opportunities to absorb all savings at full employment. What if the economy wants to save $1000 at a 0% interest rate, but there are only $500 in investment opportunities? Whether these investments are profitable or unprofitable is beside the point. What’s important is that there aren’t enough of them. We need six mountains to raze, but there are only three.
Without sufficient investment opportunities, the only way to avoid a pernicious and prolonged depression is for desired savings to fall from $1000 to $500. And the only way this can happen is if interest rates fall permanently into negative territory.
There is another common argument that Bernanke — thankfully — does not make to support his no-negative-rate theory. This is the idea, often heard in Austrian circles, that no sane person values a dollar tomorrow over a dollar today. The epic morons at the Mises Institute recently posted on Zero Hedge arguing this very point. If interest rates turn negative, the reasoning goes, then the savings rate will plummet to zero, since everyone would rather spend their hard-earned money today than watch it slowly bleed value over time.
My advice to them is the same I would give to Bernanke in regards to his Rocky Mountain analogy: you need to get out more. In the real world, people might stomach negative rates for all sorts of reasons, and in Germany and Switzerland, they already are. The obvious example is a future pensioner who wants to save money for his retirement. Another is a corporation whose shareholders might value the safety of a large cash hoard and are willing to pay to maintain it. In both cases, negative rates are possible.
Not kowtowing to the Austrians can be viewed as Bernanke’s fig leaf. But the reputational damage has already been done. Here is a man who is justly credited with saving the US from a second Great Depression, a man whose words are pored over and accepted as true, announcing to the world that secular stagnation cannot exist. Even if he ends up being right, he should be more cautious. Such unequivocal pronouncements can stifle policy debate before it has even begun.
Secular stagnation may or may not afflict the US, but it is possible. A student of Japan like Helicopter Ben should know better.