The Age of Secular Stagnation

February 17th, 2016

Summers published an article title, “The Age of Secular Stagnation: What It Is and What to Do About It,” in the February issue of Foreign Affairs. The article explores how expansionary fiscal policy by the U.S. government can help overcome secular stagnation problems and get growth back on track.

The Age of Secular Stagnation: What It Is and What to Do About It

February 15, 2016

published in Foreign Affairs

As surprising as the recent financial crisis [1] and recession were, the behavior of the world’s industrialized economies and financial markets during the recovery [2] has been even more so.

Most observers expected the unusually deep recession to be followed by an unusually rapid recovery, with output and employment returning to trend levels relatively quickly. Yet even with the U.S. Federal Reserve [3]’s aggressive monetary policies, the recovery (both in the United States and around the globe) has fallen significantly short of predictions and has been far weaker than its predecessors [4]. Had the American economy performed as the Congressional Budget Office fore­cast in August 2009—after the stimulus had been passed and the recovery had started—U.S. GDP today would be about $1.3 trillion higher than it is.

Almost no one in 2009 imagined that U.S. interest rates would stay near zero for six years, that key interest rates in Europe would turn negative, and that central banks in the G-7 would collectively expand their balance sheets by more than $5 trillion. Had economists been told such monetary policies lay ahead, moreover, they would have confidently predicted that inflation would become a serious problem—and would have been shocked to find out that across the United States, Europe, and Japan, it has generally remained well below two percent.

In the wake of the crisis, governments’ debt-to-GDP ratios have risen sharply, from 41 percent in 2008 to 74 percent today in the United States, from 47 percent to 70 percent in Europe, and from 95 percent to 126 percent in Japan. Yet long-term interest rates are still remarkably low, with ten-year government bond rates at around two percent in the United States, around 0.5 percent in Germany, and around 0.2 percent in Japan as of the beginning of 2016. Such low long-term rates suggest that markets currently expect both low inflation and low real interest rates to continue for many years. With appropriate caveats about the complexities of drawing inferences from indexed bond markets, it is fair to say that inflation for the entire industrial world is expected to be close to one percent for another decade and that real interest rates are expected to be around zero over that time frame. In other words, nearly seven years into the U.S. recovery, markets are not expecting “normal” conditions to return anytime soon.

The key to understanding this situation lies in the concept of secular stagnation [5], first put forward by the economist Alvin Hansen in the 1930s. The economies of the industrial world, in this view, suffer from an imbalance resulting from an increasing propensity to save and a decreasing propensity to invest. The result is that excessive saving acts as a drag on demand, reducing growth and inflation, and the imbalance between savings and investment pulls down real interest rates. When significant growth is achieved, meanwhile—as in the United States between 2003 and 2007—it comes from dangerous levels of borrowing that translate excess savings into unsustainable levels of investment (which in this case emerged as a housing bubble).

Other explanations for what is happening have been proposed, notably Kenneth Rogoff’s theory of a debt overhang, Robert Gordon [6]’s theory of supply-side headwinds, Ben Bernanke’s theory of a savings glut [7], and Paul Krugman’s theory of a liquidity trap. All of these have some validity, but the secular stagnation theory offers the most comprehensive account of the situation and the best basis for policy prescriptions. The good news is that although developments in China [8] and elsewhere raise the risks that global economic conditions will deteriorate, an expansionary fiscal policy by the U.S. government can help overcome the secular stagnation problem and get growth back on track.

STUCK IN NEUTRAL

Just as the price of wheat adjusts to balance the supply of and demand for wheat, it is natural to suppose that interest rates—the price of money—adjust to balance the supply of savings and the demand for investment in an economy. Excess savings tend to drive interest rates down, and excess investment demand tends to drive them up. Following the Swedish economist Knut Wicksell, it is common to refer to the real interest rate that balances saving and investment at full employment as the “natural,” or “neutral,” real interest rate. Secular stagnation occurs when neutral real interest rates are sufficiently low that they cannot be achieved through conventional central-bank policies. At that point, desired levels of saving exceed desired levels of investment, leading to shortfalls in demand and stunted growth.

This picture fits with much of what we have seen in recent years. Real interest rates are very low, demand has been sluggish, and inflation is low, just as one would expect in the presence of excess saving. Absent many good new investment opportunities, savings have tended to flow into existing assets, causing asset price inflation.

For secular stagnation to be a plausible hypothesis, there have to be good reasons to suppose that neutral real interest rates have been declining and are now abnormally low. And in fact, a number of recent studies have tried to look at this question and have generally found declines of several percentage points. Even more convincing is the increasing body of evidence suggesting that over the last generation, various factors have increased the propensity of populations in developed countries to save and reduced their propensity to invest. Greater saving has been driven by increases in inequality and in the share of income going to the wealthy, increases in uncertainty about the length of retirement and the availability of benefits, reductions in the ability to borrow (especially against housing), and a greater accumulation of assets by foreign central banks and sovereign wealth funds. Reduced investment has been driven by slower growth in the labor force, the availability of cheaper capital goods, and tighter credit (with lending more highly regulated than before).

Perhaps most important, the new economy [9] tends to conserve capital. Apple and Google, for example, are the two largest U.S. companies and are eager to push the frontiers of technology [10] forward, yet both are awash in cash and are under pressure to distribute more of it to their shareholders. Think about Airbnb’s impact on hotel construction, Uber’s impact on automobile demand, Amazon’s impact on the construction of malls, or the more general impact of information technology on the demand for copiers, printers, and office space. And in a period of rapid technological change, it can make sense to defer investment lest new technology soon make the old obsolete.

Various studies have explored the impact of these factors and attempted to estimate the extent to which they have reduced neutral real interest rates. The most recent and thorough of these, by Lukasz Rachel and Thomas Smith at the Bank of England, concluded that for the industrial world, neutral real interest rates have declined by about 4.5 percentage points over the last 30 years and are likely to stay low in the future. Together with the current price of long-term bonds, this suggests that the kind of Japan-style stagnation that has plagued the industrial world in recent years may be with us for quite some time.

DIFFERENTIAL DIAGNOSIS

Not all economists are sold on the secular stagnation hypothesis. Building on the monumental history of financial crises he wrote with Carmen Reinhart, for example, Rogoff ascribes current difficulties to excessive debt buildups and subsequent deleveraging. But although these surely contributed to the financial crisis, they seem insufficient to account for the prolonged slow recovery. Moreover, the debt buildups theory provides no natural explanation for the generation-long trend toward lower neutral real interest rates. It seems more logical to see the debt buildups decried by Rogoff as not simply exogenous events but rather the consequence of a growing excess of saving over investment and the easy monetary policies necessary to maintain full employment.

Gordon, meanwhile, has argued for what might be called supply-side secular stagnation—a fundamental decline in the rate of productivity growth relative to its golden age, from 1870 to 1970. Gordon is likely right that over the next several years, the growth in the potential output of the American economy and in the real wages of American workers will be quite slow. But if the primary culprit were declining supply (as opposed to declining demand), one would expect to see inflation accelerate rather than decelerate.