Paradox of Thrift, Bernanke’s Global Savings Glut, and Monetary Policy

The General Theory of Employment, Interest and Money by John Maynard Keynes was labeled one of the ten most harmful books over the past two centuries by this group of folks who likely never read the book. Yet, its core thesis that an economy can fall below full employment has certainly received a lot of recent attention. Martin Wolf writes:

Mr. Greenspan’s former colleague, Ben Bernanke, has already referred directly to excessive savings in explaining the explosive growth in the US current account deficit. In doing so, he took issue “with the common view that the recent deterioration in the US current account primarily reflects economic policies and other economic developments within the United States itself”. Instead, he developed what he called an “unconventional” perspective that seeks the explanation in the emergence of a “global savings glut”. He was right to do so. To understand the present we need to go back to the 1930s. The “paradox of thrift” was the most counterintuitive and, to the classically trained economist, morally, theoretically and practically objectionable idea in John Maynard Keynes’ General Theory of Employment, Interest and Money, published in 1936, in response to the Great Depression. It is possible, he argued, for the private sector to want to save more than it wishes to invest. That is the paradox: what is good for individuals can be bad for an economy. Today, at the beginning of a new millennium, Keynes’ warning is again apposite. Unfortunately, in certain circumstances, even lower interest rates may fail to clear the market for investible funds. This is particularly likely if inflation is low – and still more likely if it is negative, as has been the case in Japan for many years. Large fiscal deficits may then be needed to mop up the excess savings, as has also been the case in Japan. Otherwise, the economy may fall into a slump.

This discussion reminds me of a recent post from Max Sawicky:

On the substance, I note that AG doesn’t think budget deficits negatively affect interest rates, since US Government securities float in the much larger ocean of international capital markets. Even though the volume of U.S. borrowing is large, it is not large enough to jostle market equilibrium rates. This is something left-Keynesians and other economically incorrect commentators have been saying for a long time, including your humble correspondent. By contrast, we have gotten hysterical interest rate projections from the Brookings Institution. Brookings influences all the liberal advocates in Washington, along with people like Clinton Administration alumni Robert Rubin and Gene Sperling … AG’s concern is the same as what I heard Paul Krugman talk about at a Concord Coalition conference years ago: solvency. Current budget trends are untenable because spending and revenues are headed in different directions. Execssive deficits lead to compounding interest costs and a fiscal crack-up. That will not actually happen. Adjustments will be made, and they won’t be pleasant. All that is different from the interest rate “crowding out” canard.

As a proponent of this “crowding out canard”, let me begin with stating that Lord Keynes had it right when he distinguished between the short-run effects from fiscal stimulus versus the long-term impact of lower national savings rates. And if Max’s point is that we are not yet at full employment, I absolutely agree. While I agree with Max that the labor market is still quite weak, consider the domestic economy IS-LM framework as developed in William Poole’s “Optimal Choice of Monetary Policy Instruments in a Simple Stochastic Macro Model” (Quarterly Journal of Economics, 1970). If the Federal Reserve targets output, then changes in fiscal policy will lead to complete crowding-out except in the case of a liquidity trap.

Consider the position of Mark Thoma in his Econoblog with Barry Ritholz. Mark argues that the FED is raising interest rates to stabilize output over the long-term. Barry, on the other hand, notes the FED often makes mistakes. With that said, Mark’s position of output stabilization is truer to the spirit of Poole’s article than Barry’s argument for price stabilization. In Barry’s defense, he is doing a much better job or articulating the goal of price stabilization than the pundits at the National Review – who often don’t even express that a price rule is their guiding principle for judging monetary policy. Unless one accepts the market clearing view of business cycles – as in Milton Friedman’s 1968 presidential address to the American Economic Association, a price stabilization approach differs from an output stabilization approach. And if one believes – like I do – that we are significantly below full employment, the FED’s decision to raise interest rates may even be a mistake from the standpoint of output stabilization.

Wolf notes that interest rates are currently low – not just in the U.S. but also in other nations. While low interest rates may be the byproduct of weak investment – in particular in the U.S., it does not follow that monetary policy has become ineffective. In fact, the international aspects of financial markets that Bernanke highlights in his discussion of why U.S. interest rates are so low despite U.S. fiscal stimulus point to another channel of monetary transmission. A mix of easier monetary policy with fiscal restraint should allow for dollar depreciation and a reversal of the decline in U.S. exports. Of course, this transmission mechanism assumes that we end this de facto Bretton Woods II regime and allow currencies to freely float.

Update: Max Sawicky is already one step ahead of yours truly providing some interesting testimony from James K. Galbraith.