Bernanke and Poole on Secular Stagnation
By David Henderson
Note: The reason for my dearth of blog posts lately is the troubles I’ve had with my 6-year-old Mac. I now have a new one and all is well. Fingers crossed.
Does the U.S. economy face secular stagnation? I am skeptical, and the sources of my skepticism go beyond the fact that the U.S. economy looks to be well on the way to full employment today. First, as I pointed out as a participant on the IMF panel at which Larry first raised the secular stagnation argument, at real interest rates persistently as low as minus 2 percent it’s hard to imagine that there would be a permanent dearth of profitable investment projects. As Larry’s uncle Paul Samuelson taught me in graduate school at MIT, if the real interest rate were expected to be negative indefinitely, almost any investment is profitable. For example, at a negative (or even zero) interest rate, it would pay to level the Rocky Mountains to save even the small amount of fuel expended by trains and cars that currently must climb steep grades. It’s therefore questionable that the economy’s equilibrium real rate can really be negative for an extended period. (I concede that there are some counterarguments to this point; for example, because of credit risk or uncertainty, firms and households may have to pay positive interest rates to borrow even if the real return to safe assets is negative. Also, Eggertson and Mehrotra (2014) offers a model for how credit constraints can lead to persistent negative returns. Whether these counterarguments are quantitatively plausible remains to be seen.)
This is my favorite paragraph from Ben Bernanke’s blog post “Why are interest rates so low, part 2: Secular stagnation,” March 31, 2015. Bernanke is a clear writer, which is refreshing.
I heard my own version of “Uncle Paul’s” example from Sam Peltzman, who had heard it from Martin Bailey. Another person who had heard it from Bailey is Bill Poole. Poole writes:
A convincing counterargument [to the secular stagnation argument] was presented in a 1962 textbook by Martin J. Bailey, with whom I studied at the University of Chicago. Bailey argued that investment spending would not reach a limit at a zero rate of interest because there are some investments that have an annual return that continues in perpetuity. If an investment has an infinite life, then the present value of the project can be made as large as you please by making the interest rate as low as you please. Mathematically, as the discount factor on future returns goes to zero the present value becomes indefinitely large. The lower the rate of interest the greater the number of investments there would be with present value above their capital cost and the total size of these investments would be easily large enough to bring the economy to full employment.
Bailey used the example, and had estimates of the cost, of creating new farmland by filling shallow coastal areas in the Gulf of Mexico. The newly created land would have a return in agricultural output that would continue indefinitely.
Another example discussed by Bailey is leveling the Midwest. This argument always yielded a few smiles from the class. However, anyone who lives in the hugely productive farm areas of the Midwest knows that the land is not perfectly flat. Water collects in the lower spots, damaging agricultural productivity. At finite cost, a farmer can strip off topsoil, level the land, and put the topsoil back. The increase in output continues indefinitely. At a low enough interest rate, the value of the investment exceeds its cost. Bailey had other examples of investments that would create a long string of returns and that, at a low enough interest rate, would be worth doing.
I don’t quote this just to show that the point was well known. Poole goes on to make a point that Bernanke doesn’t mention: insecure property rights. Poole writes:
As I speak, the yield on the inflation-protected Treasury bond is about zero at the 10-year maturity and slightly below 1 percent on the 30-year maturity. Yet, I have not observed a rush to fill in the Gulf of Mexico or level the Midwest. Why?
For Bailey’s argument to work, environmental permits have to allow the investment in the first place. And, the relevant return is on an after-tax basis. Will future tax law permit such an investment to earn enough to cover its capital cost?
I am convinced that the issue in the United States today is not that business is shortsighted and unwilling to take risk. Consider the enormous investment, and risk, Boeing assumed when it launched the 787 Dreamliner project. The exact timing does not matter for my argument, but a quick Internet search suggests that Boeing went public with the project in early 2003. Although the plane is currently about 3 years late to market, when Boeing decided to proceed it must have had a planning horizon of at least five years to bring the first model into service. Boeing expected the 787 to yield a stream of extra returns over many years; discounting those returns back to the decision date, Boeing must have thought the project had a present value above its enormous cost.
This sort of long-horizon investment is frequent in U.S. history. We do not see more such investment now because of uncertainty over the tax and regulatory environment. Martin Bailey, writing before establishment of the Environmental Protection Agency, could not have foreseen that creating new agricultural land in the Gulf of Mexico would have been impossible, and that plans to level sections of the Midwest might have been held up for years and years. And given the unsustainable federal budget situation, returns from risky projects might never be realized because they would be taxed away.
Interestingly, Larry Summers, whom Bernanke let guest blog on secular stagnation, and who, with me, was a colleague of Bill Poole at the Council of Economic Advisers, does hint at some of Bill Poole’s point, writing:
Ben grudgingly acknowledges that there are many theoretical mechanisms that could give rise to zero rates. To name a few: credit markets do not work perfectly, property rights are not secure over infinite horizons, property taxes that are explicit or implicit, liquidity service yields on debt, and investors with finite horizons.