Although the title of this presentation is similar to

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1 House of Debt Amir Sufi Professor of Finance University of Chicago Booth School of Business Chicago Many claim that the anemic economic recovery since the Great Recession is because of the severity of the downturn, but others believe that the US economy has been in a period of secular stagnation for several years, masked by easy access to credit that has distorted economic reality. Various causes of the stagnation include the substitution of capital for labor, the increased productivity of capital, reduced capital expenditures relative to market capitalization, and most importantly, greater income inequality. A potential consequence of the income inequality is that the wealthy do not spend as large of a proportion of their income, which puts stress on financial stability and economic growth. Although the title of this presentation is similar to the book I coauthored and recently published, 1 I want to give a more forward-looking presentation. Let me start by showing the harsh reality of what is going on in the US economy. Figure 1 shows the trend of real GDP growth since 1970 plotted using a logarithmic scale. For 36 years, the trend of GDP growth has gone up in nearly a straight line, which indicates a constant growth rate. But in 2007 and during the Great Recession, the US economy deviated significantly from the constant growth rate. More worrisome now is that the economy has not yet returned to the long-term growth trend. Certainly the Great Recession was quite severe, but the United States has experienced severe recessions in the past and the economy has always come back to trend. To put it into perspective, Figure 2 shows for the past 10 recessions the GDP growth from the peak before the recession to 27 quarters beyond each recession. The thick line at the bottom of the chart is the Great Recession and clearly indicates how weak the recovery has been. What Is Different This Time? The purely cyclical view of the recession is losing credibility. The cyclical view suggests that the economy was humming along in a healthy manner in 2006 and then experienced a shock. That view is closely related to the idea of a zero-lower bound (ZLB) on nominal interest rates. The problem with the economy is that it hit the ZLB on nominal This presentation comes from the Financial Analysts Seminar held in Chicago on July 2014 in partnership with CFA Society Chicago. 1 Atif Mian and Amir Sufi, House of Debt: How They (and You) Caused the Great Recession, and How We Can Prevent It from Happening Again (Chicago: University of Chicago Press, 2014). interest rates, and yet, rates were not low enough to encourage people to spend. People were so scared in 2008 and in subsequent years that they would almost have to be charged for saving, which is the idea behind negative real interest rates. That is why the Fed is trying to stimulate a little more inflation, which would create negative real interest rates and possibly motivate spending. This approach is based on the pure cyclical view of the recession. But after seven years in a depressive state, it is getting more difficult to accept that view. As an alternative view, consider that the economy was not humming along in a healthy manner prior to the recession. There were longer-term problems that were masked at the time, and the masks are now coming off to expose a much weaker economy than economists originally thought. I would argue that some of the growth that occurred during was actually artificial. Now, the weak economy is being exposed and former sources of growth, such as housing, are no longer available. The framework of this alternative view includes the concept of secular stagnation, an idea formed by economist Alvin Hansen in the late 1930s. Recalling that period of time, it seemed as though the economy was exiting the Great Depression during a boom of economic activity in only to then fall back into a very severe recession. The idea of secular stagnation is that there are secular trends in the economy that make it extremely difficult to generate enough demand to sustain economic growth. Larry Summers has reintroduced the concept in a recent series of speeches. The idea of secular stagnation actually offends some macroeconomists because they view the economy in terms of its productive capacity capital and labor. Their argument is that if the capital and 2014 CFA Institute cfapubs.org Fourth Quarter

2 CFA Institute Conference Proceedings Quarterly Figure 1. US Real GDP Growth, = Trend 1.0 Actual Real GDP Notes: Data are plotted using a logarithmic scale of real GDP minus real GDP in The trend line past 2007 is based on the pre-2007 trend. Source: Based on data from the St. Louis Fed s FRED Series GDPCA. Figure 2. US GDP Growth in Recessions since 1953 Quarter before Recession = Quarters since Recession Began Source: Based on data from the Bureau of Economic Analysis s national income product accounts. labor are there, why should the economy be weak? Macroeconomists argue that prices will adjust so that capital and labor will be used and thus economic depressions should not occur. They further assert that supply rather than demand drives economic activity. But the demand argument is predicated on the notion that interest rates cannot get low enough to clear the goods markets, which is closely related to the notion of a ZLB on nominal interest rates. The secular stagnation view takes a longer perspective and suggests that the need for negative interest rates to stimulate demand is not necessarily cyclical but could be structural. Thus, economic trends appear that lead naturally to less spending, and those trends put the economy in a rut weak growth that continues for a long period of time. The argument now for secular stagnation is that it has been affecting the economy since the 1980s and 12 Fourth Quarter CFA Institute cfapubs.org

3 House of Debt various bubbles since then have masked the overall trend. Recall how strong corporate demand was in the late 1990s and how strong household spending was during the subprime housing boom. In retrospect, it is clear that the strong growth was being driven by bubbles, and yet there was not any inflationary pressure or economic overheating. In this view of the economy, bubble after bubble has been artificially propping up the economy, and now, the weakness of the underlying economy during this period is being revealed. Five years ago, the idea that the economy was in a state of secular stagnation may have been considered a fringe idea, but, more recently, it is being taken seriously. The behavior of interest rates may be the strongest clue in favor of this idea. Many who are investing today may view the current low rates as unique to today s environment, but that is not the case. Figure 3 shows average inflation and the average of 10-year interest rates on government bonds for France, Germany, the United Kingdom, and the United States for Since the 1980s, there has been a secular decline in interest rates. Even with today s low interest rates, people find it more desirable to save. Low interest rates are the result of demand for US Treasuries increasing, which causes the price of the Treasuries to go up and drives interest rates down. The argument that there is too much savings is essentially the secular stagnation argument. Causes of Secular Stagnation There are three primary causes of the economic situation in the United States, and understanding them will lead to a fourth and probably key cause. First, research over the past years has clearly shown that capital no longer complements labor but instead substitutes for it. 2 For example, in the past, having a new machine at a car factory led to improved wages and possibly more employment. Now, machines can be built that literally replace workers. The second cause refers to the price of productivity. Over the past 30 years, the price of investment goods has been falling rapidly. This decline suggests that capital is becoming extremely productive relative to its price. Consider the internet, robotics, or other similar trends. 2 See, for example, Loukas Karabarbounis and Brent Neiman, The Global Decline of the Labor Share, NBER Working Paper No (June 2013). Figure 3. Inflation Rate and Average 10-Year Nominal Interest Rate of Various Government Bonds, Percent Year Nominal Interest Rate Inflation Rate Notes: The interest rate on government bonds is the simple average of rates in France, Germany, the United Kingdom, and the United States. Inflation is calculated as the percentage change in the consumer price index. Sources: Based on data from Bloomberg, Haver Analytics, the OECD, the World Bank s world development indicators, and IMF staff calculations CFA Institute cfapubs.org Fourth Quarter

4 CFA Institute Conference Proceedings Quarterly The third factor relates to capital expenditures for the types of companies that are experiencing rapid growth. These capital expenditures are very small in magnitude relative to the companies market capitalizations. Consider the 10 largest companies by market capitalization in 1970 versus the 10 largest today. In 1970, the largest companies invested considerably more relative to their capital base. The combination of these three factors leads to a reduction in demand on the demand side of the economy. Taken together, these factors are also related to a fourth, very significant factor. The fourth factor is the increasing inequality of income. As capital starts to take a larger share of the overall economy, the people who benefit are those who own financial assets, and everyone recognizes that the holdings of financial assets are very skewed in the US economy. The top 20% of the wealth distribution owns 85% of the financial assets, which means that capital ownership is not sufficiently dispersed to generate a level of sustainable demand. The reason is that the rich tend to spend a much smaller fraction of their wealth than the poor. Related to the causes for the secular stagnation are two other important factors. The first is demographics and specifically the reduction in US fertility. The second is globalization and trade, which will lead to a reduction in wages of middle- to lower-income skilled workers. The result will be less spending by those individuals and a further drag on demand. Many macroeconomists would look to other forces to help fuel growth in the absence of spending by middle- and lower-income consumers. For example, a boom in investment can occur if interest rates are sufficiently low. But such offsetting forces have not been seen over the past seven years, and why they have not been seen remains an open question. Illustrations of the US Economic Situation The decline in manufacturing employment is the easiest way to see how the US economy has changed. In raw numbers, manufacturing employment has declined from about 20 million workers in 1980 to about 12 million in Another clue to what is happening in the economy can be seen in the relationship of nonfarm hours worked and output essentially, how output relates to the amount of labor put into it. From 1948 to the 2001 recession, the economy was essentially growing steadily in a straight line: Output increased with increases in hours worked. After 2001, the trend turns vertical. The interpretation of the change is that during the recessions of 2001 and 2007, output declined, but during the recoveries, output increased without a commensurate increase in hours worked. This result suggests that capital is becoming so productive that recessions can be used to retool capital stock and additional workers are not hired once the recovery is entrenched. The tendency to experience less job growth during recoveries is closely related to Figure 4. Data from the Bureau of Economic Analysis s national income and product accounts (NIPAs) and the Bureau of Labor Statistics (BLS) show Figure 4. US Labor Income as a Share of Total Income, Percent NIPA Data BLS Data Source: Margaret Jacobson and Filippo Occhino, Labor s Declining Share of Income and Rising Inequality, Federal Reserve Bank of Cleveland (25 September 2012): research/commentary/2012/ cfm. 14 Fourth Quarter CFA Institute cfapubs.org

5 House of Debt the percentage share of income going to labor for Think of wages as the return to labor and profits as the return to capital. The labor share of income has been declining dramatically in the United States over the past years. For many years, the percentage of labor s share was basically flat at 68% in the NIPAs. In fact, the trend was so flat that macroeconomists did not bother to estimate it; they merely stated that it was two-thirds because it was always two-thirds. But labor s share of income is not two-thirds anymore, and it appears to be continuing to fall. Figure 5 shows US productivity and median family real income for the same period ( ), and it starkly illustrates the trend toward income inequality. The US economy is not becoming less productive; if anything, the output per hour worked has increased more rapidly over the past years. But median real family income is basically flat over that period of time, which indicates who has the claim on the increase in productivity. Some people will argue that this view of median real family income does not include benefits, such as health care. Regardless of how income is measured, the gap appears to be widening over time and continues to do so. But Figure 5 does reflect one criticism of the general secular stagnation argument: The United States is able to generate growth in the economy, but the rewards for that growth go to those who put the money back into the financial system through savings. House of Debt and Secular Stagnation Debt is very dangerous because it masks problems in the economy and leads to severe economic downturns thereafter. To illustrate this concept, consider that the housing boom provided a sizable jolt to household spending, adding perhaps 1.3% to GDP during So, if real GDP growth was 3%, the argument can be made that some portion of the 1.3% contributing to that growth was artificial (i.e., not related to fundamental improvements in income). Also, the 1.3% relates only to people who borrowed against their homes. There were other distortions in the economy during the housing boom. For example, research indicates that the number of college entrants declined in cities that experienced strong growth in housing prices, with the presumed reason being that young people were able to find good jobs in the construction industry. 4 To a large extent, those jobs have disappeared now, and it is unknown whether those young people returned to college. Another example relates to spending on home-related goods, such as appliances, furniture, and electronics. From 2002 to 2006, the growth rate in this type of spending 3 Mian and Sufi, House of Debt. 4 Kerwin Kofi Charles, Erik Hurst, and Matthew J. Notowidigdo, Manufacturing Decline, Housing Booms, and Non-Employment, NBER Working Paper No (April 2013). Figure 5. US Productivity and Median Family Real Income, = Productivity: Output per Hour Median Family Real Income Sources: Based on data from the US Bureau of Labor Statistics and the US Census Bureau s Current Population Survey CFA Institute cfapubs.org Fourth Quarter

6 CFA Institute Conference Proceedings Quarterly far outstripped spending growth rates in all other goods. There has not only been a tremendous decline in spending on home-related goods since then but it also has remained low. Specifically, spending in this area is less today than during 2006, not adjusting for inflation or population growth. 5 When considering these economically distorting examples, what are the lessons for investors? Going Forward: Housing, Retail Spending, and Subprime Auto Loans The first lesson is that investors can no longer rely on housing to drive economic growth. What happened from 2002 to 2006 that is, subprime lending and borrowing home equity to buy cars or other goods will not happen again in the near future. For example, there are very few cash-out refinances today, even in the presence of rising home prices. Speaking of homes, the strongest growth today is in construction of multifamily space, which is consistent with the presence of more income inequality. Another illustration of why the United States cannot rely on housing to fuel economic growth is that from 2011 to 2013, growth in home prices was even stronger than during Even though prices were starting from lower levels, it seems that the growth should have translated into economic growth. One significant reason why it did not is the change in cash-out refinancing volume. From 2002 to 2006, this volume exceeded $600 billion, which reflects figures from only Freddie Mac and Fannie Mae; the actual totals were probably double that amount. In contrast, from 2011 to 2013, the volume was perhaps $100 billion. Reasons for this reduction include the fact that those who are most likely to draw equity out of their homes are not the ones experiencing the high rates of home-price growth, and in many cases, people no longer own homes. Another reason is tighter credit standards today than during previous years. Also consider residential construction. According to census data, nearly 4 million new units became available during During , the figure was less than half of the previous amount, which is another indication that strong home-price growth is not translating into real economic activity. In addition, forecasts for construction have been revised downward nearly every month since late The second lesson involves the debate between looser or tighter credit. Some people point to credit tightening since the Great Recession as the reason for 5 Data on household spending are obtained from census retail sales. 6 Data on growth in home prices are obtained from CoreLogic. the weak recovery. Their argument is that loosening credit standards will help in the secular stagnation framework because it will allow access to credit for low- and middle-income consumers, which would produce some growth. But in the absence of income growth returning to the lower-income segment of the population, the likely assessment is that economic growth resulting from loosened credit standards would not be sustainable. Forecasted economic growth for the remainder of 2014 is between 2.5% and 3.0%. But it is important to recognize that a significant portion of this growth is related to loosened credit standards for auto loans and credit cards. Economists learned from people s behavior during that there is a segment of the US population who, regardless of income or wage growth, will spend if they are given access to credit. Much of the loosened credit in auto loans is in the area of subprime auto loans. Obviously, auto loans are much smaller than home loans, but it is not difficult to consider a parallel to the past debacle in subprime home lending. Census retail data show that year-over-year growth in total retail spending in 2013 was about 3.5% nominally, or approximately 1.5% in real terms. In the first four months of 2014, growth appeared to be weaker, at approximately 1% in real terms. But if autos are removed from retail spending, real growth in retail spending was close to negative for the first four months of First quarter 2014 GDP was revised from positive to negative, and some people attribute the weaker growth to weather problems. But a good question for economists is, Why are autos performing so well if the rest of the economy is not? A significant part of the answer appears to be growth in subprime auto loans. Year-over-year growth in new auto purchases for the lowest versus highest credit score zip codes indicates that the lowest credit score zip codes have approximately twice the rate of sales growth. Thus, a significant part of US economic strength in spending is being driven by auto sales, and a significant part of auto sales is driven by lending to subprime borrowers. Those who are optimistic might consider this increase in sales a return to normalcy after tight credit standards. But more worrisome is the observation that it appears that the only way to generate strong economic growth in the United States is by extending credit to those with lower credit scores and lower income. To illustrate the role of subprime lending in spending, Figure 6 is indexed to 1998 and shows spending on autos and home-related goods from 1998 to The figure clearly shows the increase in home-related spending during the subprime mortgage boom ( ) and the increase in auto spending during the subprime auto loan boom ( ). 16 Fourth Quarter CFA Institute cfapubs.org

7 House of Debt Figure 6. US Spending on Home-Related Goods and New Autos, = Home-Related Spending New Autos Spending Note: Home-related goods include appliances, furniture, and home improvement spending. Source: Based on data from the US Census Bureau s retail trade reports. A third lesson relates to jobs. The important element is the types of jobs that are being created, not just the number. When employment numbers are released, most analysts focus on the numbers without assessing the types of jobs. The reality is that many new jobs are in low-wage industries, such as in retail, leisure and hospitality, and restaurants. Instead, analysts need to focus on whether the US economy can generate the type of jobs that will sustain strong income growth for the lower part of the income distribution. Credit booms are not a sustainable way to grow the economy; growth requires appropriate jobs. The fourth lesson considers asset pricing and secular stagnation. The majority of the fluctuations in asset prices are driven by changes in people s discount rates rather than changes in cash flows. That is, the price of any asset is the discounted value of the cash flows, which is the view of asset pricing that both those who take the efficient market hypothesis view and those who take the behaviorist view believe to be true. What the two views do not agree on is whether the fluctuations in discount rates are rational or irrational. But most will agree that valuation metrics today are high, which suggests that current discount rates are low. The components of a discount rate are the risk-free rate and the risk premium. The secular stagnation argument is that the risk-free rate is quite low, which justifies low discount rates. The new argument coming from the Fed and from many academics is that investors assess a lower risk premium when interest rates are so low, which, in turn, suggests that investors are willing to tolerate more risk when interest rates are very low in a reach for additional yield. In this case, it is an excess liquidity argument. Provision of substantial liquidity from the Fed has led to asset price inflation. Low risk-free rates and low risk premiums lead to more bubble behavior in a world of secular stagnation. Conclusion Table 1 shows the Federal Open Market Committee s (FOMC s) GDP projections given at the January 2011 through June 2013 meetings, along with the actual GDP during that same period. The Fed has systematically overestimated GDP growth in each quarter. Its forecasting errors seem to be decreasing because even the Fed is apparently becoming more pessimistic about the economy. The bottom line is that the US economy is struggling. This article qualifies for 0.5 CE credit CFA Institute cfapubs.org Fourth Quarter

8 CFA Institute Conference Proceedings Quarterly Table 1. FOMC Economic Projections for GDP since 2011 and Actual GDP for Projections Meeting Date Long Run Actual GDP January % 3.95% 4% 2.7% 1.82% April June November % January April June September % December March June Note: Projections are the average of a range. Actual GDP is inflation adjusted. Source: Based on data gathered from the Fed by Lance Roberts on 18 Fourth Quarter CFA Institute cfapubs.org

9 Question and Answer Session Amir Sufi Q&A: Sufi Question: Could the United States have dealt with the financial crisis in a manner that would have permitted the economy to recover better than it has? Sufi: In nearly every financial crisis, there are two causes. There is a banking crisis and a private debt crisis. To get the best results, both problems need to be attacked simultaneously. For example, liquidity support needs to be provided to the banking sector while decisions are being made about potential restructuring of excessive household debt burdens. I think that the US policy response to the household debt issue was woefully inadequate. The issue was essentially ignored, which is why 15% to 20% of mortgage holders remain underwater on their loans today. This inadequate response was definitely a factor in the severity and length of the recession. Question: Would you have a problem with bailing out money market funds, which might be seen as equivalent to bank runs? Sufi: I would argue that when a banking crisis occurs, bank runs are what need to be stopped. The liquidity payments crisis must be stopped. During the recession, it seems that there was an excessive preoccupation among policymakers with protecting the shareholders and long-term creditors of banks. That was possibly counterproductive because then household debt assistance is viewed as a threat to bank shareholders. From a policy perspective, this stance was questionable. Question: Broadening the topic of auto loans, do student loans represent another subprime borrower situation that is similarly booming? Sufi: I do not see a huge crisis brewing in student loans, partially because much of the funds being loaned are from the government and the market is not nearly as large as mortgages. A huge default situation could put a hole in the government budget, but it would not be likely to cause a problem in the banking sector. From another perspective, student debt can help to explain the weak spending growth among younger people between the ages of 25 and 35. Student debt can be very bad for the borrower, especially in a recession. Graduates are forced to accept jobs with a lower wage, but their student debt payments do not change, which ends up reducing their overall spending. Student debt may be an important drag on economic activity even if it is not a potential crisis. Question: Do you think a liberal immigration policy affects economic growth and is a reversal of the offshoring trend critical to getting GDP growth back on track? Sufi: Even if there was agreement that offshoring or globalization was leading to problems in the United States, it is not obvious that the trend could ever be reversed. It would probably be better to embrace the trends and devise a strategy to provide higher wages to US median-income workers. Accomplishing that would include better education opportunities and better skill development for low- and middle-income workers. Providing for those needs is likely to be easier than trying to reverse globalization or stop offshoring. On the immigration issue, most secular stagnation proponents would argue that immigration on net is quite positive for the US economy, especially given low demographic growth. It could be argued that more skilled immigrants are needed or that more visas should be given to graduate students. Research shows that immigration tends to affect some lower-income workers, but it also gives a significant boost to economic activity through higher employment growth, which, in turn, has a positive impact on overall economic growth. Question: Will your idea of capital substituting for labor lead to sustained above-average market price multiples because of the higher income of the wealthy, who have a greater propensity to save or invest? Sufi: The short answer is yes, but let me reinterpret the question. I think the question is whether I expect risk premiums to remain low or to continue to decline. A big issue with some recent research is the notion that wealth mechanically goes up for the rich if the price of wealth goes up. That is, if discount rates go down, risk premiums go down. London is the perfect example. London housing is not going to generate more rental income in the future, but people are demanding more housing, so the price goes up. Although I do not have definitive evidence, I am leaning in the direction that greater wealth inequality is one of the reasons for a secular increase in P/Es over the past 30 years. With more wealth held by a smaller group of people, the demand for certain assets increases, which pushes the price up relative to earnings or cash flows CFA Institute cfapubs.org Fourth Quarter

10 CFA Institute Conference Proceedings Quarterly Question: Does the increase in auto sales possibly reflect the replacement cycle of an aging auto fleet and the ability to add safety and fuel-economy features? Sufi: It may be overly pessimistic to say that the only reason for the increase in auto sales is because of subprime auto loans. One view is that because auto loans were not available at all for two years, this increase is merely a natural catch-up. It is not difficult to be sympathetic to that view. But if it is subprime auto lending that is fueling the auto purchases, is the growth sustainable? If people begin to default on subprime auto loans and the securitization chain gets disrupted, it may not lead to a financial crisis or a recession, but it could cause a sharp decline in auto sales in the short run. Given that auto sales are currently driving economic growth, defaults on subprime auto loans could throw the economy into a minor recession. Question: In light of the current state of the US economy, what should the Fed be doing now? Sufi: Most economists have concluded that the Fed s actions are unlikely to cause rampant price inflation; there may be 2.5% or 3% inflation and then the Fed might worry. The trade-off that is now being discussed is the benefit of keeping interest rates low versus the financial stability concerns of the direct effect of Fed policy on asset prices. A colleague and I conducted a type of event study on the June 2013 and September 2013 events caused by Fed comments, which we called the taper tantrum and the taper head fake. We looked at Vanguard index funds to determine which assets responded to these events. The results left me with no doubt that the Fed is having a substantial impact on asset prices. On this issue, I support a loose interest rate policy for the following reasons. If rates are raised right now, there will be a direct effect on growth for example, in the auto markets and mortgage markets. There will also be a very tangible, negative effect on real GDP from tightened interest rates. On the financial stability side, it is hard to look at asset prices and believe that there will be a huge macro- economic impact from a market downturn. I do not think that today s asset price inflation is distorting real economic growth in a significant manner. Distortion may exist from high-yield firms that are refinancing old leveraged loans with new leveraged loans. Or distortions may exist if creditors have to accept lower interest rates. It seems to come down to the belief that the economic downside of raising interest rates is tangible, whereas the real economic effects of experiencing some financial instability in asset prices are not nearly as obvious. Question: It has been suggested that those who are particularly worried about income inequality want a higher minimum wage, but would an increase accelerate worker replacement as well as impose additional costs on small businesses? Sufi: On the topic of minimum wage, I have been thoroughly convinced by Thomas MaCurdy, a Stanford University professor of economics, that increasing the minimum wage is a very inefficient method of attempting to boost the income of lower-income workers. The reasons are that, first, many lower-income workers do not have jobs. Second, many minimum wage earners come from families that are not low income. Third, the type of goods that would be most affected by increases in the minimum wage tend to be the type of goods that lower-income workers purchase. As an alternative strategy, I am surprised there is not a more dramatic expansion of the earned income tax credit. Unfortunately, a credit of this nature counts against the government budget, so that makes the legislation more difficult to pass. The credit essentially supplements a taxpayer s wages if he or she is a minimum wage earner. This credit would be an inducement to work and a more advisable policy than increasing the minimum wage. Question: What is your opinion about the manufacturing renaissance that some economists say has begun in the United States? Sufi: The word renaissance should be considered carefully. Many people show statistics that begin in 2006 and consider the uptick to be a renaissance. But if the statistics go back to 1970, the current uptick is a very small increase. A bigger question is, What is going to happen to labor costs in China? If labor and transportation costs continue to increase in China, the United States will have continued manufacturing growth. But the substitution of capital for labor is likely to stifle manufacturing employment. I tend to agree with the ideas on productivity presented in the book The Second Machine Age, by Erik Brynjolfsson and Andrew McAfee. 7 They point to the truly innovative technologies that are either currently available or are being developed, such as driverless cars. The real worry is not the fundamental engine of productivity growth in the United States but how the distribution of 7 Erik Brynjolfsson and Andrew McAfee, The Second Machine Age: Work, Progress, and Prosperity in a Time of Brilliant Technologies (New York: W.W. Norton & Company, 2014). 20 Fourth Quarter CFA Institute cfapubs.org

11 Q&A: Sufi wealth might influence the economy. Innovators should benefit from their innovations, but if all of the gains go to a very small segment of the population, it could lead to excessively low interest rates and difficulty in generating economic growth. Question: If risk premiums remain low, do you think interest rates have risen to their equilibrium levels for the foreseeable future? Sufi: I do not foresee interest rates increasing significantly in the next two years. Most economists foresee the FOMC raising the targeted federal funds rate near the end of The hope is that it will be raising rates because the economy is recovering, and interest rates naturally increase when the economy is recovering. But it is hard to imagine yields on 10-year to 30-year Treasuries in the 5% range within two years. I think that 2.5% 3.5% is the more likely range over the next two years. Although forecasting further out is obviously more difficult, most people do not believe that rates will increase dramatically over the next several years. The FOMC has rates going up in 5 to 10 years, but recall that its forecasts tend to be overly optimistic. Question: How does the changing energy landscape or even energy independence in the United States affect your outlook? Sufi: The most important effect that innovations in fracking or energy independence can have on the US and world economies is to keep the price of energy down. Energy markets are world markets and thus prices will be set globally. What is interesting for the US economy is that energy prices are often a significant source of inflationary pressure. If price growth can be controlled, the United States might be able to push monetary policy further without inflation increasing. Question: Is it possible that the US economy is becoming more mature, like the UK economy, which has had GDP growth around 2% for the past 40 years? Sufi: There are basically two hypotheses about what is happening: the maturation view and the secular stagnation view. In the maturation view, interest rates are linked to GDP growth, which I disagree with. It is not as obvious to have the ZLB persistence problem if the maturation view is accepted. An example of why I am skeptical of the maturation view is the truly innovative things that are being developed in such places as Silicon Valley. It is hard to imagine that those innovations could not potentially lead to a lot of growth. I tend to prefer Hansen s secular stagnation view, and I would again refer you to The Second Machine Age because that is what convinced me that, technologically speaking, we may see a huge jump in growth given such things as the artificial intelligence and robotics industries CFA Institute cfapubs.org Fourth Quarter