How I learned to stop worrying and love the bubble Paul Krugman had an insightful post this week on secular stagnation. It alluded to the fact that bubbles may increasingly be coming to our rescue by inadvertently propping up our economy in a way that usually boosts employment. An extract: We might try to figure out why we seem to need leverage and bubbles to have full employment, and try to fix it. More thoughts on that on another day. But what if that isn't an option? One answer could be a higher inflation target, so that the real interest rate can go more negative. I'm for it! But you do have to wonder how effective that low real interest rate can be if we're simultaneously limiting leverage. Another answer could be sustained, deficit-financed fiscal stimulus. But, you say, this would lead to exploding public debt! Actually, no - not if the real interest rate is persistently below the economy's growth rate, which it will certainly be if it's persistently negative. In that case the government can run a primary deficit even while keeping the debt-GDP ratio constant - and the higher the level of debt, the higher the allowable deficit. OK, I'm shooting from the hip here. The main point is simply that the weirdness of our current situation may well go on much longer than anyone currently imagines. As we noted in the widow's cruse economy, this makes sense if you realise that during a depression the best outcome is if people are employed doing something rather than nothing, because the job itself is a monetary distribution mechanism. And most of the time that something can be anything providing it doesn't lead to yet more non-distributable oversupply. If the government is not able to pick up the slack with welfare projects, grand social engineering, scientific endeavours, or even defence spending - it's understandable why during a depression burdened by over-capacity, we're more likely to direct capital to pointless ventures that reflect fads, frivolities or are based on nothing more than an emperor's new clothes type collective delusion or mania. The more we fill the void with extravagant frivolities, the more we are exposed to bubble instabilities - for if and when people come to their senses and notice the emperor has no clothes the consequences are usually much more dramatic than if the underlying had some utility. Hence the fundamental instability of bubbles. That's not to say bubbles are always focused around totally idle or aesthetic assets like tulips, art or collectibles, but even when they appear in housing, equities, or even commodities, they are usually fuelled by irrational expectations related to the prospects for the income of such assets or need. As in, they begin to acquire value beyond their utility at dramatic levels. This is probably because during depressions people with capital will be compelled to invest in the last remaining scarcities, potential scarcities, potential monopolies or anything that draws rent. Or at least anything they think *might* be a potential scarcity one day. But of course nine times out of ten sky-high bubble values only encourage copycat substitutes, methods that overcome those scarcities or encourage interest in the underlying to wane and for the fad to move on. Anyway, Krugman's points were also summed up and expanded by Dean Baker at CEPR here. He also added some observations about the role that trade deficits play in fuelling these bubbles (our emphasis): One important component of demand that has been big-time in the negative category in the last 15 years is net exports. This represents a serious failure of the international financial system. The old textbook story is that capital is supposed to flow from slow growing rich countries to fast growing poor countries where it can receive a higher rate of return and assist these countries in their development. The textbook story has never fit the data very well (net capital flows have often been in the opposite direction), but the flows from poor to rich have been especially large in the years following the East Asian financial crisis. The harsh treatment by the I.M.F. of the countries in the region (yes, this was the bailout led by the Committee to Save the World) led to a sharp increase in the accumulation of foreign exchange reserves (i.e. dollars) by developing countries. Countries in Latin America, Asia, and Africa suddenly began to accumulate as much reserves as possible with the idea that this would protect them against ever being in the situation of the East Asian countries. That led to a large rise in the value of the dollar and a big increase in the size of the U.S. trade deficit. The trade deficit in turn led to a big gap in demand that was filled at the end of the 1990s by the stock bubble and in the last decade by the housing bubble. A trade deficit means that income generated in the United States is being spent in other countries instead of the United States. There may well be a problem of secular stagnation even if trade were closer to balanced, but the huge expansion of the trade deficit in the last 15 years clearly aggravated the problem considerably. He goes on to point out that some countries have proved themselves more competent at dealing with such capital pressures by adjusting the number of hours worked in the economy: While the short-term story can be thought of as redistributing unemployment, the longer term picture is more interesting. Over the last three decades, workers in most European countries have taken much of the gains of productivity growth in the form of more leisure. This means 4-6 weeks a year of paid vacation, paid family leave and sick days, and in at least one country, 35 hour work weeks. These forms of leisure have been integrated into these countries" social structures in the same way as the weekend is taken for granted in the United States. People in Europe do not think of themselves as being partially unemployed because they work less than 1500 hours a year. In addition to creating a situation where more people are employed at the same levels of output, these types of leisure also allow for better work-family balances and more environmental-friendly life styles. In principle, secular stagnation is a story of wealth, not poverty. It means that we are capable of producing more goods and services than we are actually using. It is an incredible indictment of our economic system that it can lead to the sort of suffering we saw in the Great Depression and are seeing again today. For now, Krugman is not disagreeing. Related links: Trade and Secular Stagnation - New York Times In scarcity we trust - FT Alphaville The age of infinite equity? - FT Alphaville Krugman on Bubbles and Secular Stagnation - CEPR Towards a widow's cruse economy? - FT Alphaville