European Central Bank’s Financial Stability Review November 2013, page 19. The left chart is output gaps (blue 2007, red 2013) i.e. differences between current and estimated potential or “full employment” GDP. Most eurozone countries have output gaps below 2.5 percent, including some with extremely high unemployment, like Ireland. Output gaps were large and positive in 2007. Current unemployment rates associated with these small output gaps can be surmised from the right-hand chart — many are in double digits. Among the many implicit assumptions of the typical analysis that accompanies such charts is that if two extreme points have been attained, then somewhere in between must be feasible.

As you’ll know if you’ve been near any economics-oriented blogs, secular stagnation is the hot topic i.e. that advanced economies are prone to needing negative real interest rates to achieve full employment and in the inability to achieve that at low inflation, bubbles might be helpful. One surprising thing about the debate is that given the Cambridge Mass. lineage of those involved in it, the concept of “dynamic inefficiency” has not been raised in tandem.

This was something that emerged in the  modeling of overlapping generations economies by Paul Samuelson and Peter Diamond, and referred in particular to the possibility of the economy where “the” interest rate was less than the growth rate and thus in a sense the economy’s saving vehicles were less efficient at transferring wealth to the future than its growth process. The intuition was that such an economy had accumulated too much capital and driven down its return, while the saving needed to maintain the capital at that level (due to depreciation) was squeezing current consumption.

Such an economy has the possibility that weird stuff — like bubbles, paper money, and unfunded social security — can make everyone better off. Also, the government can pile up debt, and seemingly dubious investments like land are good for everyone.

Indeed, such an economy is essentially a long-term version of the liquidity trap, where the standard instincts about good and bad policy don’t work very well. It’s also mathematically interesting, which perhaps is why it’s such a staple of graduate level textbooks.

So why is no one talking about it, at least not explicitly? Is it that the intuition of overinvestment doesn’t sound right for economies seemingly short of infrastructure, like the USA and Germany? Or correspondingly that the high saving part doesn’t sound right, at least for the USA? Perhaps it’s the fact that various means of increasing current consumption at the non-expense of future generations — like selfish tax cuts! — are helpful.

In any event, much of the secular stagnation discussion has been conducted in terms of the static relationship between saving and investment. The dynamic inefficiency tradition has the merit of looking at the cumulative impact over time of all that excess saving. In the secular stagnation world, where is all that capital going?

Above a suggested choice for the single take-away chart from the presentations at the Kansas City Fed’s economic policy symposium in Jackson Hole, Wyoming. It’s from Helene Rey’s paper (London Business School). It shows all types of capital inflows expressed a percentage of world GDP on a quarterly basis since 1990, plotted against the VIX, which is a measure of perceived volatility embedded in options markets (in green, higher level=lower risk).

The argument (which has been confirmed by deeper research of herself and others) is that there is a remarkably simple (conceptually) component in capital inflows worldwide which seems to correspond to a single driver across many markets, countries, asset types, and exchange rate regimes.

As she notes, the implication is that these capital flows might need to be regulated, including by various instruments that wouldn’t have been mentioned in polite economic society a few years ago.

The open question may be that if this capital flow beast is so virulent and global, are normal means of country policy and international coordination strong enough to do anything about it? We might actually need one of these global super-regulators that people seem to think we already have.

From the Bank for International Settlements Annual Report, the topic is the difficulty that central banks might face in exiting from the current stance of ultra-low interest rates and massive balance sheet expansion —

Central banks also face various political economy challenges as they consider
exiting. History has shown that monetary policy decisions are best when insulated
from short-term political expediency considerations; hence the importance of
operational autonomy. This applies with particular force in extreme conditions such
as those prevailing today. On balance, political economy pressures could make exit
harder and work towards delaying it […] Second, central banks’ finances could easily come under strain, raising questions about their use of public money, reducing government revenues and possibly even undermining the institutions’ financial independence. The public’s tolerance for central bank losses may be quite low. (p73)

Thus, the so-called “central bank for central banks” believes that central banks are essentially just regular banks that have been given a specific mandate by the government. That may reflect a loose extrapolation from the history of central banking in the USA and UK, but it’s not correct. Karl Whelan explains here. It’s no wonder that central banking attracts so much conspiracy-theorizing when central banks themselves are so obtuse about what they do.

 Niall Ferguson in the Wall Street Journal ahead of his new book The Great Degeneration —

In only one category out of 22 (in World Economic Forum Global Competitiveness Report) is the U.S. ranked in the global top 20 (the strength of investor protection). In seven categories it does not even make the top 50. For example, the WEF ranks the U.S. 87th in terms of the costs imposed on business by “organized crime (mafia-oriented racketeering, extortion).” In every single category, Hong Kong does better. 

The chart above is the actual responses from the WEF survey of US executives asked to rank the top 5 constraints on business (page 360). The weighted response is 1.1 percent for any kind of crime. That’s lower than the responses for “foreign currency regulations.” Apparently moving dollars around is somewhat difficult too. Somehow WEF is able to translate these country-specific responses into a global ranking that conveys American businessmen cowering in the executive suite as mobsters rampage on the factory floor. It’s a miracle the country has any growth at all!

Q&A portion with Mario Draghi during the ECB news conference yesterday —

Q: […] Are you telling the Spanish, Portuguese, Irish or even Italian people that the ECB can’t do anything else with inflation actually lower than 2%?

Draghi: Well, I am not sure I get the point, but I think I get it. First, the fact that inflation is low is not, by itself, bad; with low inflation, you can buy more stuff.  

Advice to students of economics: don’t begin your essay on inflation with the claim “with low inflation, you can buy more stuff,” even if cited to Draghi, M, 2013.

UPDATE: More from Paul Krugman.