Larry Summers: We need bubbles

Has losing out to Janet Yellen in the race to be the next head of the US Federal Reserve turned Larry Summers into a pessimist, or simply freed him to speak his mind even more than he usually does?

The notoriously blunt former Treasury secretary raised eyebrows when he told an IMF conference earlier this month that the US economy may be undergoing a “secular stagnation” similar to Japan’s experience over the past two decades.

Given Summers has previously made statements such as “We remain totally unlike Japan”, this indicated that he has undergone a major shift in his views.

Summers expanded on this by stating that, with hindsight, “there’s something a little bit odd” about the economy prior to the financial crisis. While monetary policy appeared easy, lending was highly imprudent and asset prices were inflated, there was little sign that the economy was overheating.

“Capacity utilisation wasn’t under any great pressure. Unemployment wasn’t under any remarkably low level. Inflation was entirely quiescent. Somehow, even a great bubble wasn’t enough to produce any excess in aggregate demand.”

One possible explanation is that “the short-term real interest rate that was consistent with full employment had fallen to negative two or negative three per cent sometime in the middle of the last decade”.

In short, the economy was already weak before the crisis and only monetary policy that was too loose to constrain asset prices enabled it to keep ticking along at an acceptable pace.

The implication was summed up punchily by Paul Krugman: “Summers’ answer is that we may be an economy that needs bubbles just to achieve near full employment”.

While Summers did not make any specific proposals on how to tackle this situation, he left no doubt that he sees promoting growth as more important than any risks that bubbles may bring.

It seems likely that many policymakers who lack Summers’ ability to speak freely feel the same, implying no end in sight for easy-money policies.

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