Where are we on Secular Stagnation?

Secular stagnation has been at the heart of economic debates since Larry Summers revived the theory in 2013 (see Is Secular Stagnation the New Normal?). The concept was first introduced by Hensen in 1938, explaining that a slowdown in population and in the pace of technological progress makes it difficult for the economy to achieve full employment for several years (see Ben Bernanke). Following the 2007 financial crisis, Summers notes the lasting impact on the economy as monetary policy proves inefficient, stating that secular stagnation is now the main concern of macroeconomics.

Some stylized facts…

The underlying stylized fact is a generalized downward revision to growth potential—especially compared to pre-crisis expectations (Figure 1 based on IMF data). Estimated employment is also below pre-crisis trend (Figure 2 based on ILO data), with a relative loss of 62 million jobs in 2013.

Figure 1: Output vs pre-crisis expectation

Source: IMF

Figure 2: Crisis-related global jobs gap

Source: ILO

Other signs such as low interest rates (see figure 3) and low inflation (see figure 4) back Summer’s argument (see Ben Bernanke or Michael Roberts for the US case). Laubach and Williams argue that due to lower output potential, the natural interest rate has declined in recent years (see a blogspot by Jeremie Cohen-Setton), reflecting a slowdown in demography and in technological progress (see Krugman), which goes back to Hensen’s theory.

Figure 3: Low world average interest rate

Source: Mervyn King (see Summers)

Figure 4: Low inflation (global)

Source: Thomson Reuters

While the concept is rejected by some economists (Coen Teulings), secular stagnation is still discussed by others (see Coen Teulings and Richard Baldwin). So how has the debate on the drivers of secular stagnation and the right policies evolved in the past years?

A Debate within the Debate

The debate over secular stagnation is, according to J. Bradford DeLong, one of the most important policy-relevant debates in the history of economics. In a VoxEu e-book, around 20 economists debate whether we are experiencing secular stagnation or just temporary headwinds. And within this debate, another debate emerged around the extent to which it was “a demand or supply issue” (Paul Krugman). Jeremie Cohen-Setton writes a blogspot on the issue of durable slow growth. The debate eventually led to a combination of secular stagnation (demand-side) and low potential growth (supply-side), which creates confusion when it comes to the right policies to adopt.

Spotting secular stagnation: Hysteresis effects. The recession has affected output in the short and in the long run (Paul Krugman), through hysteresis effects (see Jared Bernstein), seen as a sign of secular stagnation (WSJ). Measuring the impact on the potential output of 23 countries, Lawrence Ball found that it varies from almost no impact to a loss of over 30% in Greece, Hungary, and Ireland. He identifies a strong hysteresis effect, especially for hard hit countries that are still below pre-crisis potential growth rate. Blanchard, Cerutti and Summers provide empirical evidence that deviations of output from its optimal level are much longer-lasting and thus more costly than usually assumed.

The damage might thus be permanent, but through which mechanisms? Barry Eichengreen considers four factors that could contribute to a persistent period of below-potential output and slow growth: (i) a rise in savings due to the global integration of emerging markets, (ii) a decline in the rate of population growth, (iii) an absence of attractive investment opportunities, and (iv) a drop in the relative price of investment goods. (NBER)

SecStag vs Low Potential Growth: a Demand-Supply Debate

Demand-side drivers of secular stagnation include excessive indebtedness and high (income and wealth) inequality (VoxEu), that result in a permanent reduction in consumption. Demand has failed to pick up despite low inflation (Summers) and near the ZLB rates (Martin Wolf). This translates into a gap between demand and supply (The Financial Times). The situation remains particularly difficult in the Eurozone due to poor demographics and productivity (Jim O’Neill), high deficit and debt levels, and uncertainty around the banking system (Guntram B. Wolff). Based on OECD data, the Euro area (15) averaged a -3.2 percent output gap in 2014, with negative figures expected in 2015 and 2016. Germany fares better with a positive gap expected in 2016.

Supply-side hysteresis effect – Dysfunctional institutions, policies, rules, regulations and practices – depress current and expected future potential output growth (as well as effective demand) (VoxEu) by damaging labor force participation, capital accumulation, and in turn total factor productivity (Ball) with a ‘’deskilling of the unemployed’’ (Simon Wren-Lewis). Instead of creating jobs, economies end up growing just enough to prevent a rise in unemployment (Free Exchange Economics). Moreover, the IMF argues that pre-crisis growth was fueled by extensive rather than intensive margin (Constantin Gurdgiev) whereas Gordon associates the economic slowdown to demographics, education, inequality, and government debt (Bob Gordon). Recent empirical evidence shows that the decline in long-run growth is cumulative, with the slowdown in labor productivity being the main driver of weak global growth in recent years.

Figure 5: Decomposition of (a) long-run output growth and (b) labor productivity

Source: Antolin-Diaz et al. 2015 (see VoxEu)

Scepticism about Secular Stagnation

Ben S. Bernanke agrees with the recent critique of secular stagnation by Jim Hamilton, Ethan Harris, Jan Hatzius, and Kenneth West, according to which recent slow growth is less likely due to secular stagnation than to temporary “headwinds”, such as the housing bust, problems in the banking sector, and restrictive fiscal policy. Rogoff argues that we are in a debt supercycle where, after deleveraging and borrowing headwinds subside, expected growth trends might prove higher than simple extrapolations of recent performance might suggest (Lo and Rogoff 2015). Furthermore, optimists like Erik Brynjolfsson and Andrew McAfee, who do not believe in “technological exhaustion”, one of the main drivers of secular stagnation according to Bob Gordon, argue that technological progress and productivity growth are rather badly measured. Their lower levels are therefore not a reflection of the world running out of ideas, space and room to innovate.

The policy debate

Depending on the interpretation of recent growth performance, policy recommendations vary substantially (see Steindl after Summers on stagnation policy): from macroeconomic policies to support demand and address temporary headings to structural reforms dealing with low potential growth, or on both addressing the SecStag and low potential growth combination.

Escaping secular stagnation through demand support. The role of fiscal Policy is debated. Josh Bivens, Andrew Fieldhouse and Heidi Shierholz argue that the withdrawal of economic support in the US, Japan and Europe before full recovery was a mistake. They make the case that the most effective policy remains deficit-financed government spending, even if it might be politically infeasible. However, for Summers, more fiscal spending might not be an entirely satisfactory long-term response as government debt is already very large, and public investment will eventually lead to diminishing returns (Ben S. Bernanke).

Fiscal policy vs monetary policy. Under the hysteresis hypothesis, a more aggressive monetary policy than the one in Europe facilitated recovery in the US (Michael Spense). However, with an aging population, a zero rate monetary policy reinforces the savings-investment mismatch and damages the return to higher long-term growth (Constantin Gurdglev). Olivier Blanchard notes the uncertain effects of unconventional monetary policy. Since monetary policy is already stretched to the limit in many cases, fiscal policy remains crucial to cope with Secular Stagnation (Bivens et Al.). But in order to close the output gap, the Eurozone needs an effective combination of monetary and fiscal policies, possibly including the use of “helicopter money” (Buiter).

Figure 6 : Public investment could support growth without worsening debt ratios

Source: OECD Economic Outlook (2015)

Should structural reforms complement economic policy? To accompany public investment, complementary structural reforms could encourage private investment and innovation (Michael Spense). A policy package that includes restoring public investment in advanced countries in a credible multi-year stabilization plan (instead of low interest rates and elevated asset prices) would help shift toward external demand, removing structural rigidities and increasing leadership in developing countries according to Spence. Similarly, as potential growth reflects a decline in long-term factors (Zia Gureshi), a macro-structural growth agenda should include boosting public and private investment while enhancing regulatory reforms to spur competition and innovation. It should also include boosting labor force and employment through reforms, tax and transfer systems, as well as education and training. Additionally, to reverse the decline in returns on human capital investment and to generate higher value added growth from technological innovation, restructuring taxation and public services provision is a possible “disruptive reforms” (Constantin Gurdglev).

Figure 7 : Structural Reforms and the probability of skill mismatch in labor markets

Source: McGowan, M., and D. Andrews (2015) (see VoxEu)

The need for two-handed policies

There is a growing consensus on the need to tackle secular stagnation through both demand-side policies and structural reforms. Willem Buiter argues that we need both demand-side stimulus such as debt restructuring combined with monetary-fiscal stimulus, and supply-side structural reforms including judicial, social security, and tax reforms in order to close the output gap of both actual and potential output (VoxEu).

However, confusion between secular stagnation and slow growth makes it difficult to draw clear conclusions. On the one hand, macroeconomic policy requirements vary from a country to another (IMF). On the other hand, structural reforms present implementation challenges from political resistance from short-run losers to implementation lags (Michael Spense - see the example of Greece by Dani Rodrik).