Download Are the advanced economies in for a long period of economic

Are the advanced economies in for a long period
of economic stagnation?
Kartik Vira
At the time of writing, the signs for the advanced economies were looking more optimistic than at any
time since the financial crisis. The IMF reported that “Global activity strengthened during the second half
of 2013 and is expected to improve further in 2014–15. The impulse has come mainly from advanced
economies” (IMF 2014b). There would appear to be little support for the idea that the advanced
economies are stagnating. Yet that is precisely the argument made by a growing number of economists.
The serious discussion about long-run economic stagnation in the advanced economies was started by
Larry Summers’ speech to the IMF in 2013, where he argued that very rapid growth should have been
expected in the aftermath of the financial crisis, as businesses rebuilt inventories and began to use their
unused capacity. The fact that we have not seen this suggests that there is a long term problem with
growth in the advanced economies. This is illustrated in Figure 1: actual and potential GDP in the
advanced economies are both well below what was expected before the crisis. Summers refers to this as
“secular stagnation”. This term was first used in the aftermath of the Great Depression, most
prominently by Alvin Hansen, to explain the American’s economy’s weak performance. The post-war
boom largely discredited Hansen’s theory, but Summers argues that it is an accurate description of our
current situation.
Figure 1: From Davies (2013)
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Since secular stagnation is a long-run phenomenon, there must be evidence for it from before the crisis.
Many agree that the early 2000s was characterised by an enormous asset bubble (Bernanke 2010); this
should have increased aggregate demand greatly, by creating a wealth effect that enabled higher
consumption and borrowing, while having no impact on aggregate supply. The impact should have been
first to push the economy to its capacity, and then to lead to overheating as the economy exceeded its
capacity. There are key signs of an overheating economy that we would expect to see in the years before
2008: high inflation, unemployment below the estimated non-inflation-accelerating rate, very high capacity
utilisation, and growth above the estimated trend for the economy. Yet none of these things were actually
observed in the early 2000s. This is highly puzzling, and what the secular stagnation hypothesis seeks to
explain. If there had been a long-run decline in aggregate demand over the period, excluding the effects
of the bubble, the increase in aggregate demand from that bubble would not produce an overheated
economy, but might only have sufficed to bring the economy near capacity. The bubble was necessary to
prevent an output gap from being sustained.
This idea is often discussed in terms of interest rates. The natural rate of interest is defined as the rate
of interest at which desired savings equal planned investment at full employment. An interest rate set
below this natural rate will lead to excess investment demand, while a rate set above the natural rate will
depress aggregate demand. If the secular stagnation hypothesis is correct, aggregate demand was not
sufficient to produce full employment before the crisis, indicating that the interest rate set by central
banks and in financial markets was above the natural rate. But since interest rates were not significantly
higher than they had been in the past, the logical conclusion is that the natural rate of interest has fallen
significantly. This conclusion is supported by the long term reduction in various interest rates over the past
30 years reported in the World Economic Outlook 2014, as well as in Laubach and Williams (2003), the
updated conclusions of which are illustrated in Figure 2. There are two major problems caused by this
decline in the natural rate. The first is that such low rates of return will push investors to look for more
risky assets with higher yields, creating bubbles and financial instability. The second is that if the real
natural rate becomes so negative that nominal rates also have to be negative, then it is impossible for the
central bank to loosen monetary policy enough, and advanced economies will be left with permanent
output gaps as well as the instability created by low rates. Summers et al argue that this was the case
from the mid 2000s, but Figure 2 suggests that this argument does not have universal support.
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Estimated natural rate of interest (%)
5
4
3
2
1
0
1961
1965
1969
1973
1977
1981
1985
-1
1989
1993
1997
2001
2005
2009
2013
Year
Figure 2: The estimated natural rate of interest in the US, from Laubach and Williams (2003)
Nevertheless, if the natural rate of interest is declining, it is a worrying trend. It suggests that
advanced economies are doomed either to consistently have large asset bubbles, and a correspondingly
high level of economic volatility, or to have an economy that consistently under- invests, leading both to
output gaps and to lower potential growth; if nominal rates have to be negative to produce equilibrium,
they will have both. Relatively high growth rates, such as the 3.0% growth between Q1 2013 and 2014
in the UK, are consistent with the secular stagnation hypothesis – firstly because the economy is still well
below its trend level of output, and secondly because the possible development of new asset bubbles may
offset the impacts of secular stagnation.
The secular stagnation hypothesis is relatively new in the modern context, and little formal research has
been conducted on secular stagnation after the post-war boom discredited the original theorists.
However, Eggertsson and Mehrotra (2014) recently created a model that explains some ways for the
natural rate of interest to become negative. They find that under some unconventional but justifiable
assumptions1, various factors can lead to the equilibrium natural rate of interest being negative;
significantly, many of the factors that they identify as theoretical causes of secular stagnation are observed
in advanced economies.
Their model includes three heterogeneous generations, rather than one representative agent, as is usually
used in similar models.
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The first of these is demographic. Aging and slower-growing populations will reduce future demand for
products, both because the middle aged and old have a lower marginal propensity to consume than the young,
and because the fall in population growth will mean fewer people needs have to be fulfilled. This means that
less investment is required to increase capacity to meet demand, so planned investment falls and the
natural rate of interest decreases. Almost every developed country has seen their population age in recent
years, as life expectancy increases and fertility rates decline. Japan, which has been in stagnation for over 20
years (Economist 2009), is one of the countries with the most aged populations; in 2010, more than half of its
population was over 45 (UN 2013). This provides some real-world evidence that an aging population could
lead to stagnation, and suggests that the other developed economies may follow suit.
Another possible cause of stagnation is income inequality. Briefly, inequality redistributes income from
the poor to the rich, and as the rich tend to have a higher marginal propensity to save, this will increase
desired saving in the economy, causing the natural rate of interest to fall. Income inequality has been rising in
almost all developed economies; the OECD (2011) reports that the average Gini coefficient across its
members increased by 10% between the 1980s and the late 2000s, while Piketty (2014) has documented
similar trends in wealth inequality. So inequality is another theoretical cause of secular stagnation that is
observed in the advanced economies.
A third possible cause is a “deleveraging shock”. This occurs following a so-called “Minsky moment”
which is the moment when a financial bubble collapses, and borrowers start to reduce their debt levels, or
deleverage. This forces them to reduce their consumption or borrowing and increase their savings,
contributing further to the fall in the natural rate of interest. In combination with the other factors
contributing to secular stagnation, it may take a long time for the deleveraging process to be completed, as
increased saving will reduce incomes and therefore make it harder to reduce their debt levels – the classic
paradox of thrift. Japan’s period of stagnation was triggered by a financial crisis in the early 1990s,
which is likely to have been accompanied by deleveraging, and the other advanced economies all suffered
similar shocks in 2008. Debt levels have fallen in these countries after their financial crises, but remain fairly
high in some sectors (IMF 2014a). However, while deleveraging contributes to secular stagnation, high
levels of leverage contribute to economic instability. So deleveraging is associated with the same growthstability trade-off that is characteristic of secular stagnation more generally.
The final cause suggested by the model is a reduction in the relative price of investment goods. If
investment goods become cheaper, the total spending on investment across the economy will decrease, as
investment will only take place to the extent that it fulfills a demand for a product; demand for investment
is a derived demand. This decline in desired investment spending will cause the natural rate of interest to
fall further. We observe such a long-term reduction in relative prices in data from the US, illustrated in
Figure 3.
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Figure 3: The price of investment goods relative to consumption goods, as an index where the value in 2005 is
1. From FRED (2013)
The model does not take account of international capital flows, and there is reason to believe that these
also contributed to the fall in interest rates. Rising incomes in developing countries, particularly China,
greatly increased the global supply of savings, reducing interest rates globally. The greatly increased financial
flows between countries in the past decades mean that this decline will be passed on to the national interest
rates in developed countries.
So most of the theoretical causes for secular stagnation are, in fact, occurring in at least some
advanced economies at present. This would seem to suggest that it is at the very least a strong possibility.
But if it is true, do we have to accept lower real growth rates? Three main possibilities have been
suggested for escaping secular stagnation.
The first, and least desirable option, is the “business as usual” scenario: more asset bubbles. Bubbles in
the 1990s and 2000s managed to maintain growth at trend levels, despite the fact that secular stagnation
had already begun to take hold. This worked, as described above, by the asset bubbles producing a wealth
effect that enabled higher consumption and borrowing, thereby pushing up interest rates and maintaining
aggregate demand. If similar bubbles are allowed to form again, we should see the same effect. This should
be good enough to raise our growth rates back to the trend level. Of course, there are some downsides to
such a policy. Pre-2008 growth rates based on pre-2008-style asset bubbles will inevitably result in 2008-style
financial crises. Bubbles increase growth at the cost of macroeconomic stability, and that is not a trade-off
that people are likely to accept, given the very high social cost of recessions. Unfortunately, it is
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perhaps the most likely path for the advanced economies, given that it requires government inaction
rather than action, although the trend towards giving central banks macroprudential powers suggests that
various governments are trying to avoid new bubbles forming. However, some markets seem to be reentering bubble territory, such as in the London housing market, where house prices rose by 4.5% in Q1
2014 and are expected to continue rising (Bank of England 2014). This could be an explanation for the
unexpectedly high growth rates recorded in the UK in recent months.
The second option is to increase inflation. The secular stagnation problem centres around the fact that the
central bank cannot reduce rates low enough to produce full employment, as the natural rate is negative.
However, the natural rate is expressed in real terms, while the central bank rate is a nominal rate. The zero
lower bound is, in real terms, a lower bound of 0% minus the inflation rate. If the real natural rate of
interest is, say, -3%, then given inflation of 4% the central bank could set this rate by setting the nominal
rate to 1%. If inflation is 2%, however, they are unable to reach this interest rate and it will therefore
not be possible to reach full employment. So if we are in conditions of secular stagnation and real interest
rates are negative, raising inflation could help to close the output gap by allowing the real interest rate to
fall to its natural rate. However, there are also significant problems with this course of action. The
inherent disadvantages of inflation will intensify if the inflation target is increased. It is possible that a
moderate increase – for example, from 2% to 4% – will not increase these costs so much that they override
the benefits of lower output gaps. However, an additional consideration is that a central bank raising its
inflation target may cause it to lose credibility. So this policy could only be successful if central banks
could show that the raising of the inflation target does not constitute a more lax attitude towards inflation
generally.
The third option is the one proposed by Summers as the best solution, but also the least probable
one. If the governments in advanced economies finance high levels of public investment, they will be able to
close the output gaps and achieve full employment; this will consume the excess saving that are
characteristic of stagnation without allowing them to be driven into damaging asset bubbles. As the key
problem is that interest rates are too low and not enough investment is taking place, crowding out of
productive private sector investment is unlikely to be a major problem. Investment in infrastructure and
major projects will have three positive effects: increasing aggregate demand and closing short-term
output gaps, reducing the long- term impact of these output gaps on growth through hysteresis, and
increasing the economy’s productive capacity. Politically, however, the trend in recent years has been
away from fiscal intervention, and it seems unlikely that any government will consider permanent fiscal
stimulus until another crisis develops.
On balance, there appears to be evidence that investment in the advanced economies is low and
declining, due to forces that are predicted by the model of secular stagnation. As a result, relative
economic stagnation seems to be a likely outcome over the next few decades; even if growth rates are
fairly high at times, this is likely to be offset by increased economic volatility, so that trend growth rates
over the business cycle decrease significantly. However, there are solutions to this; none of them are
perfect, but increased government investment appears to be the most effective solution. If governments
carry this out, it should be possible to mitigate at least some of the effects of stagnation. The advanced
economies are not doomed to stagnation, but they need to take action if they want to avoid it.
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