LARRY SUMMERS NAILED INFLATION. BUT IS HE RIGHT ON WHAT COMES NEXT? / THE WALL STREET JOURNAL

Larry Summers Nailed Inflation. But Is He Right on What Comes Next?

Once inflation is brought under control, the former Treasury secretary sees a return to slow-growth secular stagnation

By James Mackintosh

Larry Summers, shown at a G-20 meeting last year, thinks the Federal Reserve’s hawkishness will start a recession./ PHOTO: ANDREAS SOLARO/AGENCE FRANCE-PRESSE/GETTY IMAGES

In February 2021, Larry Summers was right and I was wrong. 

The former Treasury secretary warned that President Biden’s stimulus package was far too large and would lead to far too high inflation. 

I was less worried and thought the Federal Reserve would be willing to raise interest rates to head off any inflationary problem. 

My faith was misplaced, and it took me until June to realize my mistake. 

The Fed waited another nine months to act.

Markets are finally focused on whether the Fed’s newfound hawkishness will start a recession—Prof. Summers thinks it will. 

There is a longer-term question that matters, too: Once inflation is finally brought under control, do we return to the post-2009 secular stagnation, or will there be a new paradigm? 

Here again I find myself disagreeing with Prof. Summers, who thinks the likelihood is we return to the status quo ante. 

I think there is a greater chance of a new economic regime, with more inflationary pressure and higher real interest rates.

The question is far from academic for anyone thinking about how to position their portfolio in future years. 

A return to the miserable growth and excess savings of the decade before the pandemic sets up the same trade that prospered for years: long everything that benefits from the Fed going back to loose money. 

That would mean buying expensive technology stocks, bonds and private assets and ignoring cheap, economically sensitive cyclical stocks.

Prof. Summers set out the case over a late-afternoon dish of cured salmon at a London hotel.

“It’s 60-40 that we’re going back to something that’s kind of secular stagnation,” he said. 

Just as in the aftermath of the 2008-2009 recession, interest rates will be held down by increased savings resulting from an aging population and the uncertainty that comes after a crisis. 

Rapid technological development will again keep the cost of capital goods down. 

More savings and less investment means lower after-inflation interest rates are required to balance the economy.

He sees the threat of recession, even with 10-year bond yields at just over 3%, as strong evidence that he is right that the U.S. and the world can’t cope with higher rates.

“The fact that such low rates seem to be causing a recession is quite prohibitive,” he argues.

Yet, even this only leads him to put a 60% chance on a fast-forward to the past. 

Governments worried about climate change and energy self-sufficiency might spend big on a green transformation, which would raise investment and so real rates. 

Restrictions on banks brought in after the collapse of Lehman Brothers in 2008 might be relaxed, helping match savings and investments more efficiently.

Plus, if secular stagnation does hit, governments might be more willing to act against it than last time.

Recent stock-market performance has gotten people talking about a possible U.S. recession. 

I differ on both points. 

I think secular stagnation is less likely, because some of the other causes have gone away. 

And I think Western governments will be more willing to spend than in the aftermath of the 2008-2009 recession. 

Still, I would only go so far as 60-40 the other way to Prof. Summers, because of the powerful forces he cites.

The biggest forces pushing for higher long-term rates are deglobalization and newly empowered workers. 

Globalization was a powerful antidote to inflation in the past four decades. 

It increased competition and added hundreds of millions of low-paid employees to the global workforce. 

Now at best we can hope that globalization has merely peaked, and won’t go into retreat. 

The geopolitical standoff with China and Russia adds to the protectionist pressures already visible from both Democrats and Republicans, while former champions of free trade, such as the U.K., have turned inward.

The empowerment of workers has only just begun. 

Labor unions have formed in previously unassailable places, including sites of Amazon, Apple and Starbucks. 

So far the activity is small, but it is notable, and true in other countries, too; in Britain strikes are under way or threatened by railway workers, nurses, teachers and even some lawyers.

Stronger unions make for a more inflationary environment, meaning higher real rates are needed to keep prices under control.

If the West falls back into secular stagnation, I expect quite a different response from the authorities. 

Back in 2010, the stimulus was too small and central banks too cautious. 

That lesson was part of the reason that President Biden was so generous with stimulus, overheating the economy and exacerbating current inflation. 

When the focus switches back from inflation to unemployment, the White House and the Fed won’t want to repeat the post-financial-crisis mistakes. 

Fiscal and monetary support for the economy is likely to be bigger and faster than a decade ago.

The markets seem to agree with Prof. Summers that inflationary pressures won’t last. 

The best measure of after-inflation yields, Treasury inflation-protected securities, are still priced for secular stagnation for the long run. 

For those who think we are heading for a new world where central banks will be fighting new inflationary pressures, real yields should be far higher. 

That means most other asset prices should be quite a bit lower.