Thematic BlogSpot - Is Secular Stagnation the New Normal?

Secular stagnation is central to the current policy debate. The review focuses on the policies to avoid another “lost decade for Europe and America”, as feared by Joseph Stiglitz.

A first sign that advanced economies may be facing a “secular stagnation,” is that forecasters have revised potential output in many advanced economies—down by 7.3 percent in the US in 2017 (compared to 2007) according to a Congressional Budget Office report (see graph 1). In the Eurozone, as pointed out by Larry Summers, potential output in 2014 is almost 10 percent lower than in 2008 (see graph 2).

GRAPH 1 – US Actual and Potential GDP

Source : Congressional Budget Office, Bureau of Economic Analysis

GRAPH 2 – Eurozone Actual and Potential GDP

Source : IMF World Economic Outlook Databases, Bloomberg

Another sign of secular stagnation is the fall in equilibrium interest rates. Laubach and Williams from the Federal Reserve show that the real rate of interest has declined substantially and continuously (see graph 3), especially since the mid 1990’s (Antonio Fatàs).

GRAPH 3 – US Natural Rate of Interest

Source : Thomas Laubach and John Williams, “Measuring the Natural Rate of Interest”

The reasons behind this decline include demography (older people tend to borrow less), low investment which leads to a lower demand for credit (graph 4), savings glut (countries with large current account surpluses have become net suppliers of savings to the rest of the world) and rising inequalities (Piketty and Zucman), that squeeze the middle class and therefore its economic ability to boost consumption.

GRAPH 4 – Investment in Advanced Economies (% of GDP)

Source : Fatàs

Is this more than a usual downturn? The definition of secular stagnation

Secular stagnation describes, in the words of The Economist, a situation where « something more fundamental has gone wrong than the usual down-phase of the business cycle ». The concept, first coined by Alvin Hansen in 1938 to describe the US economy after the Great Depression, was reintroduced by Summers in a November 2013 speech.

Secular stagnation develops in the context of an economy with a high propensity to save, a low propensity to invest, and a low level of inflation. It is the combination of three elements: a prolonged period of low demand, low real equilibrium rates (therefore very expansionary but ineffective monetary policy) and, as a consequence, “the emergence of financial stability problems”, Summers explains. Indeed, “prolonged monetary ease may also encourage excessive financial risk taking », according to the latest IMF GFSR, because, with real interest rates close to zero, investors are encouraged to take more risks to get higher yields.

Coen Teulings and Richard Baldwin (in a key VoxEU e-book) define secular stagnation as a situation where “negative real interest rates are needed to equate saving and investment with full employment.” But, because of the Zero Lower Bound (“Nominal interest rates cannot go below zero, because, if they did, people would hold cash rather than bonds”, Olivier Blanchard explains), savings are likely to exceed the long-term investments needed for future economic growth… and monetary policy becomes an insufficient policy tool.

The Secular Stagnation Debate: What’s to Blame?

Past disequilibria magnified by austerity? While secular stagnation was first seen as the result of demographic shocks (Alvin Hansen), Joseph Stiglitz enriched the set of potential causes, with pre-crisis disequilibria (growing inequality, insufficient structural reforms, persistent global imbalances, and too much speculation in the financial system) magnified by weakening demand and austerity. Paul Krugman adds that, behind the apparent stability of the Great Moderation (1985-2007), there was a rapid rise in debt, which supported demand. Now, with countries trying to lower their debt levels, this source of demand disappears. Krugman underlines also the role of monetary policies: low inflation targets and low interest rates create a liquidity trap, where quantitative easing and low interest rates do not affect unemployment and do not stimulate the economy.

Secular stagnation or just slow recoveries after a balance sheet recession? Barry Eichengreen argues that the economy’s supply-side potential has been permanently reduced by the Great Recession. The reason is that high long-term unemployment had a negative impact on the productive potential of the labor force. From an output side, Robert J. Gordon differentiates secular stagnation and slow long-term growth. He considers that past forecasts over-evaluated potential growth and therefore, made us think that current growth rates are far under their potential. For Gordon, we are not in secular stagnation, but revising overoptimistic growth forecasts due to a decline in total factor productivity (see graph 5). This calls for a pick-up in investment, in sectors like energy, agriculture or manufacturing.

GRAPH 5 - Annual growth rate of TFP in the US for ten years preceding years shown, years ending in 1900 to 2012

Source : Gordon

Richard Koo explains that when a debt-financed bubble bursts (Subprimes in the US or Sovereign Debts in Europe), people have no choice but to pay their debt with their cash flow, as soon as possible. But if every household in the US or every country in the Eurozone does it at the same time, there is a demand problem—typical of balance sheets recessions.

A shortage of safe assets? Ricardo Caballero and Emmanuel Farhi note that, in recent years, the demand of safe assets, especially due to demographic and regulation reasons, outpaced supply. This shortage became more acute during the Global Crisis, and pushed real interest rates to new lows.

Is it “the end of normal”? In a book published recently, James K. Galbraith considers that secular stagnation has become “a fashionable view”, that doesn’t fit to reality. For him, the US economy has done as well as it can, and is not likely to “see full recovery on the familiar model”, because the general framework has changed: the workforce is getting older and technology is “replacing whole sectors with servers”. He explains that the aging workforce is not a problem, because retired people can be a new “potent source of purchasing power” and therefore of demand. A full return to normal seems impossible to him, even with a lot of stimulus.

Or is it simply a problem of inadequate measurement tools? The aggregate statistics used to measure the performance of an economy, such as factor productivity and GDP per capita are no more adequate to describe today’s economy, Joel Mokyr argues. He considers that these measures were designed for a “steal-and-wheat” economy, and are, therefore, not adapted for an economy where information and data are the most dynamic sector.

Poor public policies? For John Taylor, secular stagnation is only an alternative explanation to exonerate US policy from disappointing economic performance. He considers that business firms are reluctant to invest and hire because of policy uncertainty and increased regulation (Dodd Franck and Affordable Care Act), and not because of secular stagnation.

What policy response to secular stagnation?

According to Teulings and Baldwin, “new economic thinking is needed” to exit from secular stagnation, as “the old macroeconomic toolkit is inadequate”. Gauti Eggertsson and Neil Mehrotra add that there is no model to guide policy on secular stagnation, which amplifies the risk of policy mistakes. They propose a new model in which a prolonged slump in output is possible “without any self-correcting force to full employment.” With uncertainty about the diagnostic, it seems more adequate to adopt a comprehensive approach, that addresses both the demand (by using fiscal policy, to shift back the aggregate demand curve towards full employment) and the supply sides.

Regional differences call for different policies. Nick Crafts underlines that the risks of secular stagnation are much greater in depressed Eurozone economies than in the US. This difference appears clearly in the latest IMF World Economic Outlook, with a 2.2 percent 2014 growth forecast for the US and only 0.8 percent for the Eurozone.

Demand-side policies… Several economists (Summers, Stiglitz, Krugman, Blanchard) argue that raising demand, by increasing investment and reducing saving, is key. Germany is a good example, which, according to Marcel Fratzscher, would need 80 billion euros in annual investment to bridge its investment gap—especially in transportation infrastructure and green energy (Laurence Nayman). For Barry Eichengreen, it is essential to address the needs in infrastructure, education and training.

Supply-side barriers are also pointed out. Summers advocates bold reforms going beyond infrastructure investment, and including immigration reform and business tax reform. Robert J. Gordon adds raising the retirement age, drastically raising the quotas for legal immigration, and emptying the prisons of non-violent offenders. The objective of these measures is to increase the potential workforce that is falling because of aging population. But all these reforms won’t be enough if inequality continues to rise, especially in the educational system, Gordon adds.

Or a mix of the two? Octaviano Canuto from the World Bank thinks that both demand and supply side policies should be implemented, because “a working pair of scissors needs two blades”. For him, public action and spending are needed, as well as encouraging the process of creative destruction, described by Schumpeter, by implementing structural reforms.

Lowering real interest rates. Paul Krugman and Larry Summers stress the importance of reducing real interest rates further, for example by fixing a higher inflation rate target of 4% instead of 2%. Eggertsson and Mehrotra think that such a measure will ensure a full employment steady state when the natural rate is negative, without eliminating the secular stagnation equilibrium. While Guntram Wolff (Bruegel) considers that a higher inflation level is not the solution and that policymakers should focus on quantitative easing and public investment.

The role of macroprudential measures. Macroprudential policies can help to face financial instability, induced by prolonged monetary ease, and limit excess of savings, Summers argues. These policies can also help “shift the composition of investment away from more troublesome areas”, The Economist explains.

Adapting to the “new normal”. Considering that it is not possible to return to previous levels of growth, James K. Galbraith suggests that it is essential to extend social insurance programs to respond to the new demand of the elderly. He also calls for a restructuring of the financial sector and asks to give more attention to objectives that can improve living conditions as education, energy and fighting climate change.

By Paula Garzon and Line Rifaï

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