No sooner did the world start feeling confident that 2014 had brought the start of a sustained economic recovery than a new fashion in economic literature came to tell us “not so fast”. As is his self-declared habit, it was Paul Krugman who thought of it first, but as he did not go public with it promptly enough, Larry Summers beat him to it and earned the paternity of the discovery. The arguments of the two are similar enough as is their truly American urge to overkill them with a flood of data that hide the main propositions like trees hide the forest.

The main idea of both these economic leaders and their horde of followers in the media and in the faculties is that total demand will prove to be insufficient and prevent output growing by much more than 1 per cent for the next 25-30 years. The forecast is calculated for the United States, but where America leads, the rest of the world will not be far behind, nor for that matter far ahead.

They see several reasons for the insufficiency of demand. One is that population growth will slow down in the countries where productivity used to be high, and will do so especially in the productive age group. In some hitherto productive countries, like Japan, Germany and Italy, population will actually decrease. The second reason is that population will be ageing, the able-bodied having to sustain more and more of the aged. Perhaps worst of all, the participation rate (the proportion of people at work or looking for work) will continue to fall.

These observations call for some opposing remarks that mitigate, though not wholly deny, their validity. The ageing of a given population does not necessarily reduce its productivity. Fewer and fewer jobs in the modern world call for much physical exertion for which the old would be unfit. As life expectancy lengthens, so may the useful life of the old as well as the pleasure many of them take in being active and useful in a job where experience may be more of an asset than physical capacity. The participation rate has been falling in step with unemployment as people became discouraged by the vain search for jobs. As job creation picks up, the participation rate may well return to previous full employment levels. To the extent that it does not, it is surely a sign of an increased preference for leisure, which it would be strange to ascribe to involuntary economic stagnation. Much the same argument may apply to preference-satisfactions that GDP statistics do not catch.

Arguably these elements that deflate demand may just as well be presented as elements that deflate potential supply, i.e. the structural productive capacity of an economy. To the extent that this is the case demand will not be deficient and stagnation need not occur, and will be less probable and milder if it does occur.

The Lower Bound

By far the more important stagnation-creating factor in the arguments of Summers et al. is what they call the “lower bound” of the interest rate. The concept is the new name for what John Maynard Keynes has called the Liquidity Trap which was supposed to prevent the interest rate from falling below a certain positive level, usually held to be 2 per cent. If the lower bound prevents the interest rate from falling low enough the part of investment whose marginal productivity (the rate of profit on capital adjusted for risk) is lower than that will not fall and demand will be insufficient.

When this argument was first formulated, even the safest securities of the shortest maturity yielded a positive interest, though only just. When the short rate went negative, it could be regarded as the custody fee the lender pays the borrower for looking after his funds. However, the negative interest rate has since continued to widen and spread to such a point that even 10-year German federal bonds have a negative yield. In no way could this be interpreted as a custody fee. To add insult to injury, the relevant rate for both lender and borrower was not the nominal rate, but the expected real rate, i.e., the nominal rate plus or minus the change in the price level or the value of the currency during the life of the security. If the nominal rate for 10-year money was -0.2 and the expected rate of inflation 2 per cent, the borrower could be expected to earn 2.2 per cent by the mere act of borrowing and never mind the further percentage of profit which he might expect to earn by investing the borrowed capital. In the face of such numbers it is stressing the language to speak of a “lower bound” of the interest rate due to the fact that central banks cannot set their discount rate below 0 per cent. The very idea of a lower bound as an invincible obstacle to the amount of investment needed for demand to be sufficient, is looking strange. It is implicit in the statement that the currently prevailing negative interest rate is a “lower bound” is the affirmation that if the rate were more negative still, investment would increase. This is very, very, difficult to take seriously.

For an interview with Thomas Piketty, see Thomas Piketty on Inequality and Capital in the 21st Century, an EconTalk podcast episode.

It is ironical that two of the most fashionable economic theories of the day fundamentally contradict each other, yet are being embraced by the same set of fashionable applied economists, Larry Summers and Paul Krugman and their followers. They launched a theory asserting that even a substantially negative real interest rate cannot induce enough investment for aggregate demand to be sufficient. At much the same time Thomas Piketty announced that the rate of return on capital has been substantially higher than the rate of growth of output throughout history and is likely to remain so as a constant typical property of capitalism. He found that the return on capital has typically been positive for 4-5 per cent in America and 6-7 per cent in Europe, while output growth averaged about 1.5 per cent. He also found that our own century is more likely than not to continue to display much the same numbers with a substantial excess of the profit rate over the growth rate. A profit rate higher than the growth rate of the economy replicates an exponential function with unequal exponents. Like the function, it will misbehave and yield an impossible result except perhaps in the short run.

While proclaiming the likelihood of stagnation for at least the next 25-30 years Larry Summers and Paul Krugman accepted the Piketty hypothesis with great admiration and applause, one of them even judging it Nobel material and the other the greatest book of the century. There is, to put it mildly, an impression of self-contradiction. Even a negative real rate of interest is too high, but a fairly high positive rate is agreed to be a constant secular feature of past, present and future capitalism. Perhaps it is left to us readers to choose which side of the contradiction we accept, for it is uncomfortable to try and accept both.

The way out seems to be to recognize that all investment cannot primarily depend on the interest rate. More exactly it cannot primarily depend on interest when it is in one or two exotic regions, either in high inflation or in quasi-deflation. There are several reasons for not assuming under these conditions that the volume of investment will settle at the point where the expected real rate of interest and the marginal product of capital intersect. A minor reason for this is that the expected rate of inflation cannot be inferred from the actual rate and one should not theorise as if it could be. A probably more important reason is that the entrepreneur is more and more heavily influenced by such factors as expected taxation, consumer and environmental protection, a panoply of regulations thought up by well-meaning and security-minded officials, as well as the difficulties and costs of compliance and litigation. He is under gently rising pressure telling him how he must or may conduct his business while also sparing the business of his competitors. Expectations about any of these factors may well have a greater influence on the attractiveness of new investment than the opportunity cost of capital.

One may go further and hazard the broad guess that we have reached a stage where the attractiveness of investment, while still dependant to a limited extend on the expected productivity of capital can be read from a single synthetic variable, namely the overall distribution of income in society as a proxy of government influence on risk and reward.


*Anthony de Jasay is an Anglo-Hungarian economist living in France. He is the author, a.o., of The State (Oxford, 1985), Social Contract, Free Ride (Oxford 1989), Against Politics (London, 1997), and Justice and Its Surroundings (Indianapolis, 2002). His most recent publications include Political Philosophy, Clearly (Indianapolis, 2010) and Political Economy, Concisely (Indianapolis, 2010). His next volume, Economic Sense and Nonsense: Reflections from Europe, 2007-?2012 (a volume in The Collected Papers of Anthony de Jasay), edited and with an introduction by Hartmut Kliemt, is forthcoming from Liberty Fund.

The State is also available online on this website.

For more articles by Anthony de Jasay, see the Archive.