Watch Larry Summers Explain the Biggest Economic Problem of Our Time (VIDEO)

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Nov. 18 2013 12:30 PM

Larry Summers Explains the Biggest Economic Problem of Our Time

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"The underlying problem may be there forever," Larry Summers told an audience at the International Monetary Fund conference last week.

Photo by BRENDAN SMIALOWSKI/AFP/Getty Images

This post originally appeared in Business Insider.

At the IMF Research Conference on Nov. 8, Larry Summers gave a succinct presentation that explained what may be the most pressing economic matter of our time. The speech is being widely praised (by Paul Krugman and others) for being a brilliant and thorough elucidation of an issue that's underdiscussed. Over the past 50 years, the Federal Reserve has cut short-term interest rates during recessions to spur economic growth, but a new problem has arisen recently. The Fed cut the rate to zero, but we still have had a slow recovery.

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The problem is that the natural interest rate—where investment and savings bring about full employment—is now negative. However, the Fed cannot cut the nominal rate below zero because people will choose to hoard money instead of putting it in the bank. This is called the zero lower bound and has reduced the power of Fed policy.

To offset that, the Fed has used unconventional programs such as quantitative easing (QE) to push long-term rates down to try to bring about greater investment. QE is the technical term for the Fed buying billions of dollars of Treasuries and mortgage-backed securities.

Even with that though, the natural interest rate is still stuck below zero. Cutting short-term interest rates is the Fed's greatest power to bring about full employment during recessions, but it has been hamstrung by the zero-lower bound. While this has caused a weaker recovery so far, the larger problem is that this is not a short-term issue.

If another recession were to hit now or in the next couple of years, the Fed will have even less power to combat it since rates are already at zero. This is what Summers warned of in his speech at the IMF.

"Imagine a situation where natural and equilibrium interest rates have fallen significantly below zero," Summers said. "Then conventional macroeconomic thinking leaves us in a very serious problem because we all seem to agree that whereas you can keep the federal funds rate at a low level forever, it's much harder to do extraordinary measures beyond that forever, but the underlying problem may be there forever."

There are a couple of other ways we could attack this.

- The Fed could allow for greater inflation, and thus incentivizing people to spend now if they're hoarding money.

- We could also move to a cashless society where all money is electronic. This would make it impossible to hoard cash outside the bank, allowing the Fed to cut interest rates to below zero, spurring people to spend more.

Both ideas would theoretically overcome the problem of the zero lower bound.

Earlier this year, Summers was considered the favorite to become the next chairman of the Federal Reserve, but withdrew himself from contention after liberal Senate Democrats opposed his candidacy. President Obama instead nominated current Fed vice chair Janet Yellen. But Summers' speech is a reminder to all liberals that he is a brilliant economist who grasps the long-term issues of monetary policy and would likely have made an exemplary Fed chair.

"I think that [what the] world has underinternalized," he said, "is that it is not over until it is over, and that is surely not right now and cannot be judged relative to the extent of financial panic, and that we may well need in the years ahead to think about how we manage an economy in which the zero nominal interest rate is a chronic and systemic inhibitor of economic activities, holding our economies back below their potential."

His full speech is worth a listen:

Danny Vinik is a political reporter at Business Insider. Follow him on Twitter.