Mr Summers identifies three broad solutions to the problem. One is to do nothing, or not much anyway, on the demand side. This is not a particularly attractive solution, as it implies a very long slump in which incomes are lower than they need to be, unemployment is higher, and the economy's potential is eroding. Another is to raise inflation expectations in order to reduce real, or inflation-adjusted, interest rates until demand is where we'd like it to be. This policy is not without its downsides, says Mr Summers. In an interview with Ezra Klein, he noted:
First, there are the questions of just how productive will be the investments that are not attractive at a negative real rate but only become attractive at a more negative real rate, and how much incremental investment will be stimulated. Most observers think quantitative easing has run into diminishing returns.The last option to address stagnation is to have the government soak up excess savings and boost demand through deficit-financed public investment.
Second, there is the question of financial stability. As Fed governor Jeremy Stein, among many others, has pointed out, lower real and nominal rates achieved either through quantitative easing or forward guidance raise the risk of bubbles as investors increase their risk-taking and the attractiveness of leverage is increased...
Third, there are fairness issues. A strategy of driving down discount rates to inflate asset values benefits those who hold assets — very disproportionately the wealthy.
The third option is quite clearly Mr Summers' preferred course of action. And it is a very attractive option. It is a rare rich country that doesn't have a list of infrastructure needs that could justifiably be addressed in the best of times. Pulling those off the shelf and taking them on amid rock-bottom interest rates and weak demand is a no-brainer. Unfortunately, governments are discinclined to seize these opportunities. That makes it very important to sort out the relative attractiveness of alternative solutions to stagnation.
In my previous writing on the subject, however, I wasn't clear on where Mr Summers stood. On January 6th, I wrote:
[T]o sum up what appears to be his view: a world of adequate demand supported by public investment is preferable to a world of inadequate demand, which is preferable to a world of adequate demand supported by private investment.Mr Summers' interview with Mr Klein suggested that this preference ordering might be wrong. He noted there that "[doing] nothing and wait[ing] for supply to fall back to demand through hysteresis effects" is the worst strategy.
Mr Summers wrote to point this out to me and elaborated on his comments. In fact, Mr Summers reckons that while fiscal policy is the first best means to address stagnation, using higher inflation to reduce real interest rates and boost private demand is a clear second best, preferable to the status quo (and certainly to doing nothing at all).
My sense is that Mr Summers reckons the inflation strategy is not as easy to deploy successfully as I make it out to be. QE purchases focused on safe assets might have an ambiguous effect on the economy: boosting asset prices through portfolio balance effects but limiting lending growth by sucking up the supply of good collateral. And as Brad DeLong notes, high inflation could conceivably undermine the safe-asset status of some government securities. Meanwhile, central banks might not be comfortable mustering the bluster to convince markets that higher inflation is ahead. And if they did, increases in long nominal rates could create their own financial difficulties.
So there we are. I'm not convinced of the seriousness of some of these challenges. A fiscal stimulus that succeeded in creating adequate demand would also generate big increases in long-run nominal rates, for instance. If higher inflation primarily works as a solution to stagnation because it redistributes purchasing power from savers to spenders, then financial stability concerns are almost certainly overstated. I think we make a mistake in worrying about the technical difficulty of using either fiscal or monetary policy to whip stagnation.
But I should also acknowledge a weakness in my own argument. I often return to higher inflation as a strategy because something like Mr Summers' five-year programme of deficit-financed public investment looks politically unachievable to me. Higher inflation, by contrast, is something the technocratic Fed could deliver without the support of a divided Congress.
But I've also written that central banks don't generally propel economies out of slumps like these without significant political pressure being applied. It was elected governments that pushed the monetary changes that got Britain and America out of the Depression, and it was an elected government that shook the Bank of Japan out of its long paralysis. One suspects that, however economies choose to get out of stagnation, the impetus to make the escape will be political.