Bernanke and Summers debate about secular stagnation as American and EU monetary policies diverge, testing their hypotheses.
Former Chair of the Federal Reserve Ben Bernanke is finally speaking out on the economic issues he was politically unable to when in office. In his new blog at the Brookings Institution, he has already targeted US Senators, Germany, and Lawrence Summers.
Never one to shy away from a debate, Summers engaged Bernanke and the two discussed one of the most crucial questions of the post-Financial Crisis economy: are interest rates so low because of secular stagnation?
The differences in their arguments are nuanced, but their policy prescriptions are entirely different. Summers’s secular stagnation theory requires government stimulus, while Bernanke’s requires currency appreciation and time.
There are much broader implications of the debate and the issue at hand than just those two prescriptions, especially as it relates to the bond market and diverging central bank policies.
Secular stagnation and the demand for investment
Bernanke’s blog post cast serious doubt on the idea that Lawrence Summers brought back into the mainstream economic debate last year: secular stagnation. Secular stagnation is the idea that interest rates are unusually low—and will remain unusually low for an extended period of time—because changing demographics and capital needs of businesses have led to a dearth of demand for investment.
Summers has adapted the idea, which was originally presented to describe interest rates during the Great Depression, to an analogous situation today. With fewer young people and more retirees, the scale is tipped towards an overabundance of savings.
On top of that, Summers’s version of the theory holds that new businesses in developed countries need significantly less capital today because instead of building factories filled with machinery, they are designing software in a small office.
All together, these changes mean there is more savings than need for investment and interest rates will remain low until the balance is shifted. Bernanke’s conclusion is the same, but refuses to agree that it is because demand for investment is too low. After all, if the cost of taking out massive loans was essentially zero, businesses and governments could find myriad projects that would be profitable.
Instead, Bernanke posits that the supply of investment—or savings—is too high. Countries like Germany are not spending enough, leading to lackluster economic growth across Europe and North America because of the interconnectedness of financial markets.
Closely tied to the Summers-Bernanke debate, but not brought up in either’s case, is an increasing concern in financial markets over bond liquidity—or more fittingly, bond illiquidity. Over the last year, trading bonds, especially high-yield corporate bonds, has become difficult.
Interest in the issue first piqued last fall when oil prices collapsed and concern over the health of energy companies’ balance sheets spread into the rest of the corporate bond market. Now, as the Federal Reserve gets closer to raising interest rates, concern over another collapse in the bond market is rising.
At the center of the concern for many is that new capital requirements in the Dodd-Frank Act and Volcker Rule make it more difficult for major banks and bond dealers to hold bonds. Traditionally, these institutions have held onto bonds during sell-offs in order to prevent a rapid fall in prices, but according to the Bureau of International Settlements (BIS), market makers are no longer doing so.
These banks and dealers are not doing so as a result of a combination of their unwillingness and new regulation. In the market makers’ absence, it is possible that prices will fall into a downward spiral and pose a threat to the larger financial system.
These liquidity worries are more about market structure than about the particulars of the Bernanke-Summers debate. But within the question at hand, bond illiquidity poses a larger problem under Bernanke’s too-much-supply thesis.
In a bond sell-off in an illiquid market, having fewer bonds in the market (as a result of too-little-demand for investment) will stabilize prices faster—mimicking what market makers used to do. In Bernanke’s theory, the lack of market maker bids is a second downward pressure on prices and possible catalyst for a run on bonds and bond funds.
On the other hand, Global Risk Insights analysis concluded last summer that austerity on the past of state and local governments in the US has dramatically decreased supply of municipal bonds. In the language of the Summers-Bernanke debate, this is an example of Summers’ too little demand for investment story.
Even if state and local governments began issuing municipal bonds at historical levels again, which to date they have not, the markets would feel a crunch until the debt from the past few years reaches maturity. Summers’s solution to secular stagnation, more simulative government spending, would be able to address this problem.
If this does not happen, yields on municipal bonds will remain depressed for some time as prices remain high, putting investors in a position of accepting lower returns or pushing into more risky assets.
Diverging central bank policies
The biggest test for Bernanke’s argument against secular stagnation will unfold during the rest of 2015 across North America and Europe. Bernanke’s case is based on relative currency movements—which already is happening, and will continue to happen, across developed markets.
The US, Canada, and UK are nearing decisions to raise interest rates, while the euro will depreciate during Eurozone’s new quantitative easing scheme.
If Bernanke is right, rates in North America and Canada will rise as expected—and not repeat the strange sticky behavior he spoke about in 2005—as investors settle in after nine years of reaching for yield. In Europe, the extraordinarily low rates offered by the ECB will finally test whether there is enough demand for investment in the Eurozone.
If events do not go as planned—and especially if Europe does not rebound over the next 18 months—then Summers’s story will be more convincing than Bernanke’s rebuttal. At that point, however, matters will be much more serious as Europe’s economy will have been in retreat for nearly a decade under the precise policies that Summers has railed against.