Larry Summers shocked everyone recently with his speculations on the links between growth and bubbles. some people slightly agree, others do not. For example, Clive Crook disagrees with the premise we need bubbles for the economy to work properly.
I have been thinking about the link between bubbles and growth for nearly 3 years. Back in my Traders Crucible days, Nick Rowe wrote a post on bubbles which really caught my attention. He pointed out an old paper by Paul Samuelson gave some insight into the reason the (completely wrong) Intertemporal Government Constraint might not hold.
“There is something economists have known since 1958 that we don’t talk about much, except in private, like in economics journals that nobody else reads. It’s a bit too weird.
There are two sorts of world. In a normal world, the equilibrium rate of interest is above the growth rate of the economy. In a weird world, the equilibrium rate of interest is below the growth rate of the economy. What’s weird about a weird world is that it needs a bubble, a Ponzi scheme, a chain-letter swindle, for the economy to work well.
Maybe the world we live in is a weird world. And it needs a bubble to work well. And the economy keeps trying to create a bubble. And when it succeeds the economy does work well. But bubbles are unstable and eventually burst. Then it works badly again. Until the next bubble.”
I have been publicly silent on this idea for a while, but this does not mean I’ve stopped thinking about the relationships between g (the real rate of growth) and r (the rate on interest on publicly held government debt) and another r (the natural rate of interest).
I do not believe in an economy wide natural rate of interest. It does not seem to be observable in real time, or even easy to determine it’s general level years after the fact.
(Aside on the natural rate of interest: Here are more problems with the NRoI. The inputs to determine the “natural rate” are hard to measure. The NRoI suffers from ex-ante, ex-post problems. The NRoI doesn’t meet basic criteria for effective real time guidance. The economy is ergodic, so what use is a NRoI? It also seems mis-specified in that it targets an low quality economic equilibrium of stable prices. The Investment/Savings aggregation problems. Aggregating a yield curve into a single interest rate is nonsense. NRoI implies lending, which implies borrowers and lenders, and borrowers and lenders are not uniform at all. The NRoI highly dependent on institutional structure. I have some writings on this which will come out over the next few weeks. There are more…)
But for now, just forget the problems with the NRoI. Take the NRoI model at face value, like Larry Summers does. What does this mean in the context of the Paul Samuelson world? Do we live in this weird world, where g is higher than r (the natural rate of interest)? More specifically, do individual economic sectors (such as real estate) live in this weird world?
Yes we do. We currently live in a world where growth is higher than the natural rate of interest. Everyone who thinks there is a natural rate of interest believes the NRoI is negative right now. Miles Kimball, Brad Delong, Paul Krugman – nearly any economist who abides by the NRoI model believes the NRoI is negative.
The economy needs a bubble in order to function properly when g > r.
They also believe g, our real rate of growth, is positive today and has been positive over the last several years. The rate g might be low, but it’s well above zero, probably somewhere around 2-3%. Technology is advancing at some non-zero rate, which *must* force growth to be higher than zero. In any case, real GDP has been growing.
These circumstances put the U.S. economy into Paul Samuelson’s world where we can get a free lunch, as long as we have a bubble. We get extra growth at no cost of inflation. Our lives are better off with the bubble.
My take on this is the economy demands bubbles when r <g. That’s right – demands bubbles. If the bubble is not met, it will try and find a way to create this bubble. (See real estate, stock market, S&L, Emerging Markets) Artificially constraining the bubble forces unnecessary misery on people, and causes involuntary unemployment and unused capacity, which is bad because it causes an economic incentive for war.
How large does our “bubble” need to be for the economy to function properly? This should be an empirical question.
What does a “bubble” mean? I have a post on this, but bubbles and money are closely related. Bubbles can only happen within the structure of a money creation process. Nick talks about this in his post:
“Samuelson called the chain letter “money”. But it could be an unfunded government pension plan. Or gold could serve the same purpose, even if gold were intrinsically useless except as a store of value. Whatever it is, it’s a bubble, that has a market value in excess of any intrinsic value.
But if the marginal return on capital, after an allowance for risk, is less than the growth rate of the economy, it still needs a bubble. A chain letter, or bubble, can grow forever at the growth rate of the economy, as long as people believe in it and don’t break the chain. And it can pay a rate of interest equal to the growth rate. So people save partly in real capital, and partly in the bubble, and both pay the same risk-adjusted rate of return, equal to the growth rate. (The marginal rate of return on capital rises as the capital stock falls when people hold less capital and more bubble.)
Land may also alleviate the problem, in the same way that capital does. But land is different from capital because they aren’t making it any more. That means that land may also serve as the bubble asset, with the price of land made up of a fundamental component equal to the present value of expected rents, plus a bubble component, with the bubble component growing at the growth rate of the economy and yielding capital gains. And house price bubbles are really just bubbles in the price of the land on which the house sits, because the house itself is just reproducible capital.
Governments can create the bubble, with a national debt they never pay the interest on, but just rollover from one year to the next. A Ponzi scheme. If spending and tax revenues grow at the growth rate of the economy, and that growth rate is above the rate of interest, they can do this forever. The long run government budget constraint just doesn’t add up, literally.”
This isn’t an easy topic at all. This gets right to the heart of our economic system. It’s easy to make mistakes, and I don’t claim to have anything close to an understanding of how this works. Remember, I do not think the NRoI is something that exists economy wide, but is something which is rather sector/geographically specific.
Yet, with the discussion kicked off by Larry Summers.
- r is impacted by our institutional structure. We can change this with our monetary, fiscal, credit, and foreign sector setup. We could live in bubble land forever if we wanted.
- g isn’t entirely outside our control either…
- if r and g are sector specific, then some sectors will demand bubble or anti-bubbles (where the sector wants to destroy money). This should be extremely confusing to the “economy”.
- While r is impossible to sum
- This adds some color to the observation deflation incentivizes war. Deflation/Depression attempts to force g down to r, rather than bringing r up to g. People don’t like this
- It seems like we’ve lived in bubble land since we abandoned Bretton Woods and Functional Finance in 1973. If we take the estimates of the NRoI at face value, there is a decent chance we are in bubble land for much of the time.
- If the NRoI is negative today, then the demand for a bubble must be very large today. The spread between NRoI and real growth is very, very high – possibly as high as 5%
- When r < g, we demand a bubble. If r < g for more than a few years, we need a bubble.
P.S. Businesses Hire when they are swamped with demand.
Update: Slackwire has been thumping around this same area. His post is a must-read in context of the comments by everyone below.