Yesterday, Nayarana Kocherlakota, the president of the Minneapolis Federal Reserve Bank, gave a speech in which he said that the Fed "will only be able to achieve its congressionally mandated objectives by following policies that result in signs of financial market instability." I noted that this was also the Fed's approach in the 2000s -- and we all know how that worked out. Central bankers should spend more time coming up with new ideas instead of retreading ones that have already been discredited by experience.
One intriguing idea was buried in the middle of Kocherlakota's speech. He implied that a credible promise to make entitlement programs like Social Security and Medicare more generous in the future could lead to a faster economic recovery today. If you take Kocherlakota's reasoning seriously, this would obviate the need for a prolonged period of low real interest rates and the associated bubble-bust cycles.
According to Kocherlakota, real interest rates need to be "unusually low for a considerable period of time" because the demand for "safe assets" has increased even as the supply of genuinely safe assets has collapsed. There are many ways to think about this problem. I have written about some of them, as have many others. The obvious solution is for governments that can create safe assets to issue more of them until the demand has been satisfied. Instead, as Frances Coppola aptly noted earlier today, many countries have been pursuing the opposite course:
"It is completely illogical for governments to impose severe austerity to reduce fiscal deficits while encouraging central banks to purchase safe assets and create unlimited bank reserves. All this does is create imbalances and weird distortions in the monetary system: The two actions cancel each other out and the result, as we are seeing, is stagnation."
In his speech, Kocherlakota said that safe-asset demand had increased for two basic reasons. First, the crisis has made people realize that deep downturns and anemic recoveries are more likely than they had previously believed. That in turn has made everyone more conservative in their saving and borrowing habits. On the whole, this is probably a positive development.
Kocherlakota also argued that the fiscal situation has put people on edge. His argument is somewhat confusing and possibly contradictory, so I will quote it at length in the interest of fairness:
"The federal fiscal situation is another key source of elevated uncertainty. The federal government faces a long-run disconnect between its overt commitments and the baseline path of federal tax collections. This disconnect can only be resolved by raising taxes and/or cutting the long-run arc of spending.
"Of course, this tension between revenues and expenditures pre-dated the 2007 downturn. However, it is at least arguable that the fiscal debates of the past few years have made more Americans aware of the uncertainties associated with resolving this long-run disconnect. And these uncertainties affect the demand for safe assets.
"The prospect of higher future corporate profits taxes gives businesses an incentive to demand safe short-term financial assets as opposed to engaging in long-term investments. The prospect of reductions in Medicare, Medicaid or Social Security gives some households an incentive to demand more safe assets as a way of replacing those lost potential benefits."
As I read him, Kocherlakota is saying two things: First, that the long-term mismatch between the government's promises and its ability to pay for them will be resolved soon through a combination of tax increases and cuts in entitlement spending. Second, that individuals and firms became much more aware of these tax increases and spending cuts sometime around 2007 or 2008. Their natural reaction, according to Kocherlakota, was to hoard Treasury bonds, since those instruments would benefit in a world of deficit reduction.
This thesis seems a bit peculiar. What could have happened in 2007 or 2008 that would suddenly make people that much more concerned about something they already knew? Why would people worried about the so-called "fiscal gap" necessarily conclude that they needed to increase their holdings of government fixed-income? After all, the gap could just as easily be closed by printing money, rather than austerity. That might create unwanted inflation, in which case any household or business that had accumulated a sizable position in Treasurys would lose badly. More generally, there isn't much empirical support for Kocherlakota's claims about how real people and businesses respond to long-term budget projections.
Suppose, though, for the sake of argument, that Kocherlakota is correct that the prospect of higher taxes and reduced entitlements has increased the appetite for safe assets and therefore lowered the "equilibrium real interest rate." If that is really the problem, why not simply make entitlement schemes more generous while refraining from raising taxes? According to Kocherlakota, this would help relieve the demand for safe assets, thereby raising the "mandate-consistent" real interest rate and allowing the economy to recover without the need for dangerous asset bubbles.
This isn't as crazy as it sounds, even if it requires several leaps of logic. As my colleague Josh Barro has written, Social Security is the most important source of retirement income for many Americans. Barro argued that this fact, along with the program's effectiveness as an anti-poverty measure, meant that it should be expanded, rather than cut. The potential impact this proposal could have on the demand for safe assets should make us consider it even more seriously. I doubt it could be worse than the existing recovery plan.
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