Breaking the negative feedback loop

By Lawrence Summers
June 3, 2012

With the past week’s dismal U.S. jobs data, signs of increasing financial strain in Europe, and discouraging news from China, the proposition that the global economy is returning to a path of healthy growth looks highly implausible.

It is more likely that negative feedback loops are again taking over as falling incomes lead to falling confidence, which leads to reduced spending and yet further declines in income. Financial strains hurt the real economy, especially in Europe, and reinforce existing strains. And export-dependent emerging markets suffer as the economies of the industrialized world weaken.

The question is not whether the current policy path is acceptable. The question is, what should be done? To come up with a viable solution, consider the remarkable level of interest rates in much of the industrialized world. The U.S. government can borrow in nominal terms at about 0.5 percent for five years, 1.5 percent for 10 years, and 2.5 percent for 30 years. Rates are considerably lower in Germany, and still lower in Japan.

Even more remarkable are the interest rates on inflation-protected bonds. In real terms, the world is prepared to pay the U.S. more than 100 basis points to store its money for five years and more than 50 basis points for 10 years. Maturities would have to reach more than 20 years before the interest rates on indexed bonds become positive. Again, real rates are even lower in Germany and Japan. Remarkably, the UK borrowed money last week for 50 years at a real rate of 4 basis points.

These low rates on even long maturities mean that markets are offering the opportunity to lock in low long-term borrowing costs. In the U.S., for example, the government could commit to borrowing five-year money in five years at a nominal cost of about 2.5 percent and at a real cost very close to zero.

What does all this say about macroeconomic policy? Many in both the U.S. and Europe are arguing for further quantitative easing to bring down longer-term interest rates. This may be appropriate given that there is a much greater danger from policy inaction to current economic weakness than to overreacting.

However, one has to wonder how much investment businesses are unwilling to undertake at extraordinarily low interest rates that they would be willing to undertake with rates reduced by yet another 25 or 50 basis points. It is also worth querying the quality of projects that businesses judge unprofitable at a -60 basis point real interest rate but choose to undertake at a still more negative real interest rate. There is also the question of whether extremely low safe real interest rates promote bubbles of various kinds.

There is also an oddity in this renewed emphasis on quantitative easing. The essential aim of such policies is to shorten the debt held by the public or issued by the consolidated public sector comprising both the government and central bank. Any rational chief financial officer in the private sector would see this as a moment to extend debt maturities and lock in low rates – exactly the opposite of what central banks are doing. In the U.S. Treasury, for example, discussions of debt-management policy have had exactly this emphasis. But the Treasury does not alone control the maturity of debt when the central bank is active in all debt markets.

So, what is to be done? Rather than focusing on lowering already epically low rates, governments that enjoy such low borrowing costs can improve their creditworthiness by borrowing more, not less, and investing in improving their future fiscal position even assuming no positive demand stimulus effects of a kind likely to materialize with negative real rates. They should accelerate any necessary maintenance project – issuing debt leaves the state richer not poorer, assuming that maintenance costs rise at or above the general inflation rate.

As my colleague Martin Feldstein has pointed out, this is a principle that applies to accelerating replacement cycles for military supplies. Similarly, government decisions to issue debt, and then buy space that is currently being leased, will improve the government’s financial position as long as the interest rate on debt is less than the ratio of rents to building values – a condition almost certain to be met in a world of sub-2% government borrowing rates.

These examples are the place to begin, because they involve what is in effect an arbitrage, whereby the government uses its credit to deliver essentially the same bundle of services at a lower cost. It would be amazing if there were not many public investment projects with certain equivalent real returns well above zero. Consider a $1 project that yielded even a permanent 4 cents a year in real terms increment to GDP by expanding the economy’s capacity or its ability to innovate. Depending on where it was undertaken, this project would yield at least an extra 1 cent a year in government revenue for each dollar spent. At any real interest rate below 1 percent, the project pays for itself even before taking into account any Keynesian effects.

This logic suggests that countries regarded as havens that can borrow long term at a very low cost should be rushing to take advantage of the opportunity. This is a view that should be shared by those most alarmed about looming debt crises, because the greater your concern about the ability to borrow in the future, the stronger the case for borrowing for the long term today.

There is, of course, still the question of whether more borrowing will increase anxiety about a government’s creditworthiness. It should not, as long as the proceeds of borrowing are used either to reduce future spending, or raise future incomes.

Any rational business leader would use a moment like this to term out its debt. Governments in the industrialized world should do so too.

35 comments

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I’m pretty sure you mean positive feedback loop. Negative feedback is stabilizing. Positive feedback is destabilizing [http://en.wikipedia.org/wiki/Negative_f eedback]

The problem is that positive feedback was used to get us to these unsustainable levels in the first place. Governments and people were happy when positive feedback was creating the bubbles in asset prices, entitlements, and out-of-line pay rates to begin with. There is no cure other than to let the system unwind these imbalances.

Posted by ischumacher | Report as abusive

I’m a Republican. I would prefer to do nothing and hope that the economy gets even worse. That way we may have a chance of winning the 2012 presidential election (Romney’s looking a little shakey at the moment). If people lose their jobs, their houses, their savings, that’s their tough luck. I’m OK…I can ride it out.

Posted by foiegras | Report as abusive

Hayek explained that Keynesian deficit spending during a recession subtracts from economic growth during the recovery phase. Keynes agreed yet he quipped, “In the long run we are all dead.” Economists such as Larry Summers and the PIIGS finessed by never repaying debt over a dozen business cycles.

Here we are seventy years later and Keynes is indeed dead. The PIIGS cannot pay interest on the Keynesian stimulus debt they owe to their banks. The USA only pays the debt because the Federal Reserve has the power to create money, devalue the dollar, and is making a prodigious effort to do so.

Hayek was correct. The debt is subtracting from economic growth.

History teaches that inflation is a rare event. Inflation occurs in hundred year cycles followed by a symmetrical hundred year deflation. Long periods of stable prices intervene. The USA is approaching the deflation phase. The 1914 dollar is worth three cents today. The Federal Reserve and Keynesian deficit stimulus were two failed experiments.

Posted by mulholland | Report as abusive

foiegras: “If people lose their jobs, their houses, their savings, that’s their tough luck. I’m OK…I can ride it out.”

You’re a Republican alright. Christian too, maybe? Just wondering.

Posted by flashrooster | Report as abusive

flashrooster: Bible thumping Christian I should think!!!!

Posted by Vidya3049 | Report as abusive

This week’s story on CNN is about California’s high speed train that is already going to cost 3 times estimate without delivering true high speed. Last year’s Federal Story was about Solyndra going bankrupt on the tax payer’s dime. China for all its investment has empty office towers and malls. And in Europe we see the state of Greece and Spain. So I have to challenge Mr. Summer’s view about the returns of his accelerated future investment. And lest we forget a major factor that caused our current financial crisis was the deregulation of the banking industry that he so championed and administered under Bill Clinton.

Posted by Sechel | Report as abusive

Looks like a few people sucked in on “foiegras” the troll. Republicans want fiscally conservative precisely because the foster a stable economy, jobs and houses. Don’t bother trying the “Bush and the Republicans did it” garbage. Bush was a PROGRESSIVE and the Republicans in congress were RINOs.

Deficit spending and paying people to sit on their butts got us here. Graduating kids from high school that can’t count change or read an analog clock are making us less competitive every year. Single parent families are the fastest way to child poverty. Multiple kids from multiple partners break up homes and make for non-productive kids/adults.

But that’s the Demoncrat’s way.

Posted by iq160 | Report as abusive

Refinancing can help chip away at the margins of the problem, but also runs the risk of digging the hole deeper if the money is misspent (look at what it did to homeowners). The only real cure is to change real spending patterns. That means less spending on the military and more on infrastructure in our own country. It is just the type of thing that the Republicans are incapable of; it is not in their psyche at all. And asking them to pay for their adventures out of their own pockets is of course hopeless, when they can just borrow from China.

However, there is unfortunately no guarantee that Democrats will do better. As Robert Rubin says, we have to set a goal of deficit reduction and stick to it over a decade, so that the deficit is not all cut at once, which would throw us into a recession (or worse). But sticking to long-term goals, even if they can be set, is not the forte of the American political system these days. I think you can blame both parties for that. But the fact that our last balanced budget was under Bill Clinton means that it is not impossible.

Posted by Jim1648 | Report as abusive

Remarkably (or politically) Summers neglects to mention the very first thing we should do, given flat or negative real interest rates — refinance the current debt down to nil.

Posted by Kady101 | Report as abusive

This is a very important cycle: “It is more likely that negative feedback loops are again taking over as falling incomes lead to falling confidence, which leads to reduced spending and yet further declines in income. ”

If a deflationary contraction is to occur, due to an overabundance of material from china and declines US and European property, underconsumption will be a necessity. It will be necessary, since saving rates are falling among households, although not among banks. Demand will not grow, factories will close, and tax bases will decline.

Mr. Sommers suggests the government or corporation steps in on a project; I agree.

And here’s a more definite suggestion. The rhetoric for public spending has only been for loans or infrastructure, but what about commodities? If confidence is to fall, as a position in this cycle, government steps into commodities at their lowest point to fix prices, maybe increasing oil or food reserves. Rather than investing before the confidence shift, the money is placed into real goods (rather than futures) for the common good. By stockpiling vital economic products that will begin to go scarce in the medium term due to shortages, a corporation or government would be well positioned to respond after prices start to stabilize again.

Posted by eddiefresh | Report as abusive

Any rational person that understands inflation’s effect on the real cost of money would jump at the chance to refinance debt at a lower real interest rate, especially long term debt like mortgages and large investments in other real property. The problem I see with this strategy being used by our government is two fold. First, There is no assurance that funds the government borrows will be used to pay down our more expensive debt and second, government stimulus, as it is used to attempt to counter slow growth, just doesn’t work.

Also, For this proposal to work, the Fed will have to stop printing money in excess of the demand for it in the private sector. Currently the Fed’s actions are feeding government spending which produces nothing but inflation, right now hidden by real unemployment.

The medicine for our economy is one of thrift and sacrifice for the sake of our future. As has been said by many, The economy will tumble when we can no longer spend other people’s money.

If our congress were to make it law that this proposed debt swap be just that and only that, the proposal makes sense. But for the government to spend a dollar of that new debt otherwise is folly. It is time we take our medicine before the pill becomes to big to swallow.

Posted by Ezekial1258 | Report as abusive

And for those of you that say let them eat cake, you may find yourselves eating cake one day and wish you hadn’t inserted your foot so deeply into your mouth. A free society is a compassionate society. Read some history you greedy, sociopathic cowards. The negative feedback loop exists because you feed it big, juicy steaks at every opportunity.

Posted by Ezekial1258 | Report as abusive

Nice theory but it doesn’t work. Being a “safe haven” provides enormous opportunities for governments that purchase goods and services with service life exceeding the duration of debt service. States, Counties, and Municipalities fall into that category. They own the huge majority of assets that are used on a day-to-day basis by Americans.

The Federal Government owns nothing of value that we use on a day-to-day basis. Military assets are the exception, but they are a very small percentage of the asset pie chart.

To make this theory work, the Federal Government would be spending borrowed money on goods and services that fully depreciate long before the debt service has been retired. We would be borrowing ten-year money to pay for our monthly Food Stamps.

People like Lawrence Summers got America into its current mess by pushing cheap government-money towards mortgage payments that couldn’t be sustained through the duration of the Bonds that financed the mortgage in the first place.

This theory hasn’t worked in the past and is not apt to work in the future.

Posted by mkelter | Report as abusive

So, can govt. borrow 15.7T at 0.5% for 5 years as you state, to payoff outstanding public debt that it is currently paying (nearly half-a-trillion interest) at the rate of 3%?

Posted by Mott | Report as abusive

This is just another scheme to divert more money into the public sector. When the government borrows, the money borrowed is money that is diverted into government hands that would otherwise be diverted to the private sector. Once again we would see the same results we have seen so far, a depressed economy. Secondly, government is inefficient, and when large sums of money are earmarked for projects, these sums of money don’t go into maintenance, they don’t go into buying buildings previously leased, they go into projects that have one intention only: to re-elect politicians. This is what happened with previous stimulus efforts, and this is what will happen with any future stimulus efforts. Without an obvious destination for the money (as there was in WWII) the money will surely be spent on boondoggles such as public sector pension funds, Solyndras and any number of other destinations that have no positive economic effect. Government is not the vehicle to improve the economy.

Posted by s.c.f. | Report as abusive

foiegras is a Democrat repeating the Democrat talking points in reverse. Can’t you see right through his remarks.

Posted by wfclyon | Report as abusive

So basically the US should refinance its debt? Or at least some of it?

I would fully support the US spending now, while money is cheap, on things we need to fix anyways. *COUGH* HIGHWAYS *COUGH*. But that won’t happen. Instead they’ve gone and done things like developing a stealth destroyer equipped with a giant rail-gun that costs about 3B a pop. Because that’s really what we need right now. Not education, not infrastructure…rail-guns.

Posted by CapitalismSays | Report as abusive

The simple rule is: If there’s too much of a thing in the system, don’t create more.

Posted by danshanteal | Report as abusive

I admit that the current interest rates are attractive. I have refinanced my own home. I might even borrow money at low rates to buy the stock of a company that yields good steady dividend. However borrowing money, even at low rates, is not advisable unless one has some sort of productive use for it. It makes no sense to borrow money for a trip to Disneyland. Likewise one should not fritter borrowed money on risky boondoggles aimed at making solar panels that no one wants to buy. Likewise bailing out the retirement plans of bankrupt auto companies with borrowed funds produces no return on investment. Spending millions to add a few years to the life of old people on the verge of death is not a reasonable use for borrowed money. Educating an intelligent young person in the prime of life might will usually yield an decent return, but subsidizing the training of lazy illiterate drug addicted felons is not advisable unless interest rates a negative. In short, if one has a government that is profligate and they is every day wasting vast sums on money losing projects, then one cannot entrust that government with the delicate task of spending borrowed money. (fullstop).

Posted by hacimo | Report as abusive

Fiscally speaking, Summers is right. However, as some have already pointed out, the Government isn’t necessarily going to take the increased revenue from any stimulus and do what is right. Furthermore, there is a little error in Summers’ math Congress isn’t likely to obey.

Summers wrote: “Consider a $1 project that yielded even a permanent 4 cents a year in real terms increment to GDP by expanding the economy’s capacity or its ability to innovate. Depending on where it was undertaken, this project would yield at least an extra 1 cent a year in government revenue for each dollar spent. At any real interest rate below 1 percent, the project pays for itself even before taking into account any Keynesian effects.”

This assumes a tax rate of 25%. Given Romney’s return showing that multimillionaires pay only around 15% in income tax, we’re going to need to fix the tax code for the plan to work. I think extending Bush tax cuts for low and moderate income people is the solution to the debt problem because it gets the people who benefit from the system to keep it going.

There are several important things to consider. Right now is the time to invest on future growth while interest rates are low and wages are low. Wages for the middle and lower economic sectors is not keeping up with inflation. Average wages are going up by just under 2% and inflation is above 2% resulting in a loss in real wages. This is compounded by the fact that executive pay rose by 6% last year. So you can pretty much guess that the average Joe didn’t even get a 2% increase last year. Finally, when you account for the block of unemployed that aren’t even getting unemployment compensation, the numbers look even bleaker.

So, who has to pay for the stimulus? The rich, of course. But they are the job creators, you say? So where are the jobs, I ask you?

If the average person cannot get a loan, the banks are saving more, and real wages for average workers are declining, then there is only one way out, and that is as Summers suggests, another stimulus. But in order to work, we have to be able to pay it back. So, taxes on the rich must rise.

All the pieces need to be in place otherwise it will be as @foiegras hopes. And Since Republicans will block any attempt to tax the Romney’s of the country more, any stimulus without tax increases for the rich, will ultimately put us deeper in the hole.

Our country came out of WWII very strong, and with a 90% tax rate in the top bracket. This was a period of growing jobs and affluence. If taxes kill jobs, how come a 90% tax rate brought such prosperity? The answer is complex, but it proves the Republican stand is on shaky ground and more likely based on thwarting Democrat’s efforts to improve the economy.

http://wallstreetpit.com/92677-wage-grow th-the-business-cycle
http://westfaironline.com/23658/executiv e-compensation-up-6-percent-in-2011/
http://inflationdata.com/inflation/infla tion_rate/HistoricalInflation.aspx

Posted by LEEDAP | Report as abusive

“use a moment like this to TERM OUT its debt”
Yes definitely

“use a moment like this to borrow more money to spend and artificially reduce unemployment”
No, No and No

Each ‘no’ above corresponds to each year that borrow and spend policy was implemented just to see the problem comes back the following year.

The disease is chronic (structural) yet the doctors keep throwing in drug that is meant for acute (cyclical) ones.

Posted by trevorh | Report as abusive

Summers: You must be a minion or the Wealth Oligarchs, to suggest that municipalities borrow more now, at the current low rates! We must end this feeding of the profit covers o the Oligarch. I hereby advise municipalities: Borrow not.

Vote out of office the minions of the Wealth Oligarchy!

Posted by Tom1934 | Report as abusive

Why can’t we do short-term stimulus, long-term austerity, structural reform, and debt write downs all at the same time?

Why do we always fall back to the “This vs. That” debate instead of a “This and That? solution?

Do it all, we have 20% unemployment or underemployment, even if the Republicans find this to their advantage.

The President should put forth a comprehensive plan that includes the best ideas from all sides and then nail the Republicans to the wall if they won’t go for it.

Posted by Farcaster | Report as abusive

I chuckle at posts like LEEDAP’s. “Our country came out of WWII very strong, and with a 90% tax rate in the top bracket. This was a period of growing jobs and affluence. If taxes kill jobs, how come a 90% tax rate brought such prosperity?”

One variable, the tax rate, is cited as if it alone explains our post-war growth and prosperity. Economics involves lots of variables, some matter a lot, some matter very little. Would the fact that much of the rest of the industrialized world was reduced to rubble after the war have anything to do with our post-war success?

Posted by jambrytay | Report as abusive

Why is anyone listening to Larry Summers? He should be in prison for being one of the architects that destroyed the US economy and now wants to spend more money? Obama with the disastrous duo of Summers/Roemer borrowed $5 trillion and we are heading into a depression.

I’m so tired of these idiot, Ivy league, elites who have never accomplished anything except economic destruction. I bet Larry has never had a real job, digging ditches, caddying or even as a paper delivery boy.

Posted by Genevaroth | Report as abusive

I wonder if Prof Summers has given any thought to why people are prepared to lend money at such low interest rates to governments such as those of the US, Germany and Japan? Could it be that they fear that serious deflation may happen world wide and that it is their best option for safeguarding their money? If they are proven to be right, then these low interest rates could turn out to be handsome investments (with significant real returns). (Conversely these cheap government borrowings would turn out to be very expensive indeed.)

Posted by GivaFromOz | Report as abusive

I was just thinking of this same thing today, that govts should borrow and borrow and borrow and pay the ridiculously low rates so as to cover their liabilities of tomorrow. Imagine if the USofA borrowed $100 trillion at 1% interest. That would only be $1 trillion/year in payments to handle all the future social security, medicare, and medicaid payments we should have covered already. Better yet, why not just have the Fed print the cash to buy the bonds and then sort of forget about those silly ol’ pieces of paper. I wonder if those good people in Congress would be able to keep their hands off that money? I’ll be they could. ;)

Posted by Freethinkerguy | Report as abusive

Can we really borrow more and spend more to get out of the approaching storm of another world-wide recession? In the past any adjustments to fiscal and monetary policies would solve a economic crisis, but only temporarily, and would inevitably lead to the next economic crisis. The world economy is now crying out loud “Deflation!” Why don’t we come up with policies to accommodate this natural trend. The policy makers’ desire to resist this trend is just a desire to protect banking interests and debtors, of which the U.S. is the biggest one.

Posted by jlpeng | Report as abusive

mulholland, I don’t know what you mean. The basic idea of both Keynesian and neo-classical counter-cyclical policy is to save during recoveries to ease the pain of recessions. That’s what “counter-cyclical” means. The only difference is who does the savings, and whether that savings is achieved through fiscal or monetary tightening.

So yes, recoveries are somewhat less, but that’s because the economy is saving for the next recession, and this happens in one form or another in all modern schools of economic thought.

As for your deflation theory, I would like to remind you that fixed exchange rates are dead and have never lasted more than 70 years; that gold was not used unchanged for thousands of years–sovereigns depreciated gold the same they do money–and thus there is no historical imperative to deflation.

Global deflationary pressure is caused by global demand distortions, specifically the artificially depressed levels of demand in Asian and some Middle Eastern economies, engineered by governments jealously guarding their current account surpluses.

Posted by JoeEagar | Report as abusive

Ah jlpeng, don’t banks love deflation, and the higher real interest rates it brings? They certainly did under the Gold Standard. Why do you think William Jennings Bryan was so popular during the post-civil-war deflation?

Posted by JoeEagar | Report as abusive

I totally agree with with foiegras’ comment, solely because I think it is the only practical way to rid ourselves of this wealthy-driven government — allow it to collapse under its own greed and stupidity.

ONLY THAT will break the present “feedback” loop.

Posted by PseudoTurtle | Report as abusive

Some may sneer, but there are still the “Bond Vigilantes.”
Attempts to bring out more debt, with longer terms, will change the markets instantaneously – and this despite the fact that the rate of return on invested capital (productive assets funding)is now around 1.6%, that rate having declined over 25% since 1965.

To expect funds to move into non-productive assets (government debt) at longer terms, without substantial increase in higher “yields” would seem to require some “suspension of rational e3xpectations.”

And, as noted by others, the emperical evidence of the forms of political disbursements of increased borrowings are more likely to follow the Mancur Olson Theory, which would not produce the results anticipated by Dr.Summers.

Posted by Schweitzer | Report as abusive

LEEDAP falls into the oh-so-simple trap of assuming that all marginal rates are created equal. To begin with the 90% top marginal rate after WWII kicked in well above the top 1% but using the Obama $250k is rich math we see a much different story today. What’s worse is that s/he honestly seems to believe that all of our fiscal problems are due to insufficient taxes on the so called rich. The reality is that repealing the Bush tax cuts only on those earning $250k and above would raise about $800B over the next decade. Unfortunately, the “middle” class tax cuts are costing the Treasury $3.2T over that same time frame. The sad fact is that it is unfunded middle class entitlements that are driving our dire fiscal outlook and not our marginal tax rates.

Finally, I would remind LEEDAP that we didn’t have Medicare and Medicaid in the years immediately following WWII. Would s/he be willing to revoke those programs in exchange for the higher marginal rates? Somehow I doubt it…

Posted by Skippy321 | Report as abusive

One fatal flaw to Dr. Summer’s logic:

He is assuming that the borrower (i.e., politicians, specifically the U.S. politicians) will be responsible with the proceeds from the borrowing.

They often have not been in the past, so it is naive to believe they will be in the future?

I believe spendthrifts, whether individuals, or government officials, should not go deeper into debt, regardless of how low interest rates are!

Posted by Tskm | Report as abusive

It is disturbing that a professor is mis-using the term negative feedback loop, and this problem is being copied by financial journalists.
For example to quote from second paragraph:

“feedback loops are again taking over as falling incomes lead to falling confidence, which leads to reduced spending and yet further declines in income”

This is a classic example of a positive feedback loop where a trend causes influences that cause the trend to increase. A negative feedback loop is used to maintain stablity (provided the feedback is applied in time). Since feedback loop theory is taught in universities worldwide how are we getting into this problem?

Posted by drrck32 | Report as abusive