The threat of secular stagnation

Secular stagnation need not be a threat, but an impetus to re-evaluate economic models

Author: Rita Lobo
July 21, 2014

Former US Secretary of the Treasury Larry Summers has been doing the publicity rounds lately – talk shows, radio interviews and op-ed columns all over the world. Summers is a man on a mission. Not fighting crime or ending world hunger, the former Secretary of the Treasury wants to warn the world of the risk global economies are of becoming entrapped in a cycle of secular stagnation.

Outside of an undergraduate economics course, secular stagnation was last considered a newsworthy subject shortly after the Great Depression, but once recovery was assured, the concept was promptly forgotten by the mainstream. Since the global economic downturn, many parallels have been drawn with that grim period in the 1930s, so it was only a matter of time before secular stagnation was brought up again. However, as far as parallels go this one appears to be fairly pertinent – and it might be threatening the meagre economic recovery the US and Europe have experienced over the past year.

“Secular stagnation refers to the idea that the normal, self-restorative properties of the economy might not be sufficient to allow sustained full employment along with financial stability without extraordinary expansionary policies,” Summers told Ezra Klein of The Washington Post in January. “The idea was put forth first by Alvin Hansen in the late 1930s. Given the Second World War and the tremendous pent-up demand for consumer and investment goods after the war, it did not prove relevant. But the difficulty our economy has had for many years now in maintaining simultaneously full employment, strong growth and financial stability makes me wonder about its current relevance. So does the rather dismal growth performance in recent years of the remainder of the industrial world.”

Former US Secretary of the Treasury Larry Summers has been touring the world, warning leaders that global economies face the threat of secular stagnation
Former US Secretary of the Treasury Larry Summers has been touring the world, warning leaders that global economies face the threat of secular stagnation

In a nutshell, Summers argues, rather pessimistically, that this recovery is not a recovery at all, but yet another sign of the chronic underuse of potential resources in the economy. Over the past two decades, economies have been kept afloat not by new investments or innovations, but by asset bubbles based on ever-mounting levels of leveraging. Meanwhile, interest rates were falling, as were rates of expected profitability of investments. Crucially, however, expected profitability was sliding much faster than interest rates.

Not new, yet still prolific
Most experts agree that stagnation was indeed a risk during the worst of the slump, which is why many governments opted to inject money into economies through quantitative easing or other methods. What is unique to Summers’ argument, though, is that he suggests modern western economies have been in this slump for the past 15 to 20 years. If correct, that would mean major economies might never return to full employment and robust growth without policy support.

“While things are looking up now, it is only because the economy was performing so poorly before,” explains David Orrell, an economist and principal at Systems Forecasting. “Summers has a plot showing that GDP for the US, Euro area, Japan, and UK only recently recovered the ground lost following the crisis in 2007. The growth rate remains relatively slow, leading him to suggest that the potential economic output has been permanently lowered. Structural stagnation provides a narrative that explains the build-up to the crisis [a savings glut], the slow recovery, and the existence of asset bubbles.”

According to Summers, one of the main causes for concern is that even before the crash in 2008 the US economy was being propped up by an enormous housing bubble. But even that was “not enough to produce any kind of overheating as measured by wage and price inflation, or as measured by unemployment relative to traditional low points,” he told Klein. Were it not for the housing bubble and irresponsible credit, not much was left to drive the US economy between 2003 and 2007. “Housing investment would have been two to three percent lower than GDP, and consumption expenditure would have been considerably lower as well, resulting in very inadequate performance,” explains Summers.

In 1938 Hansen suggested that due to a slowdown in population growth, demand for capital would lower and the world would face an enduring issue of “secular, or structural, unemployment… in the decades before us.” Of course Hansen was wrong – the 1950s and 1960s saw some of the most robust employment rates on record, and growth was solid. However, it would be foolish to completely disregard Hansen’s predictions. A lot of the progress of this period was off the back of World War II, and growth was driven by the rebuilding efforts in Europe, and Cold War investments in the military in the US.

“Population growth was boosted by a war-induced baby boom and mass immigration into the US and Western Europe. New export markets and private investment opportunities opened up in developing countries,” Robert Skidelsky, a Warwick University professor and peer in the British House of Lords, writes in the Social Europe Journal. “Most Western governments pursued large-scale civilian investment programmes. Think of the US interstate highway system built under President Eisenhower in the 1950s.”

It is therefore not far-fetched to argue that these unusual circumstances merely postponed the falling demand and employment that Hansen had foretold. It is possible that when circumstances normalised and when birth rates started falling again, the global economy once again began to move towards the slump we are experiencing today.

Bending the rules
Summers is not alone in reviving Hansen’s idea of secular stagnation to explain growth patterns in the world today. Brown University economists Gauti Eggertsson and Neil Mehrotra have recently published a paper suggesting the US economy will not recover any time soon. Despite close to zero short-term interest rates, the Federal Reserve will be “unable to generate a sufficient monetary stimulus”, which they say will lead to a “permanent slump in output”. “It’s not a baseline scenario, but I think people should at least be starting to consider the possibility that this could go on for a while,” Eggertsson went on to tell CNBC.

Source: International Monetary Fund. Notes: Figures post-2013 are IMF estimates
Source: International Monetary Fund. Notes: Figures post-2013 are IMF estimates

Neither Eggertsson, Mehrotra or Summers use the term ‘liquidity trap’, as it is understood that the current state of the economy means monetary policy is effectively being held back by the ‘zero bound’. Paul Krugman has discussed Summers’ secular stagnation theory as “a situation in which the “natural” rate of interest – the rate at which desired savings and desired investment would be equal at full employment – “is negative.” He describes a de facto liquidity trap, in which “normal rules of economic policy don’t apply. As I like to put it, virtue becomes vice and prudence becomes folly. Saving hurts the economy – it even hurts investment, thanks to the paradox of thrift. Fixating on debt and deficits deepens the depression.”

Though the argument has been mainly about the US economy, secular stagnation is certainly a global phenomenon and is best observed through the development of industry. All over the world, from Europe to Japan, industrial output has cooled off and Summers argues there is virtually no chance of the industrial world recovering within the next five to 10 years, relative to potential and employment.

Since the onset of the crisis in 2008, a number of countries have been in the habit of accumulating huge amounts of foreign reserve in an effort to maintain steady exchange rates that will benefit trade; but this practice has a knock-on effect on demand globally. As a result central banks have been left with few choices to stoke demand, so interest rates have come sliding down. “Central banks have tried to boost the economy by lowering interest rates, but instead of stimulating investment and employment the money seems to have been channelled into asset price inflation, for example, house prices in the UK or here in Canada,” explains Orrell. “The problem is that monetary policy is an indirect, top-down way of stimulating economic activity. So lowering interest rates might not have the effect that the central bank is aiming for.”

Creating demand with demand
Summers suggests the only way to tackle the long-term economic slump looming on the horizon is for countries to engage in a period of expansionary investment policy by governments. “I am convinced it would still be better to raise demand in the economy in ways that do not work through reduced interest rates but operate at any given level of rates,” he told Klein. “Consider my favourite example: debt-financed infrastructure spending. Notice several things: first, when your growth rate exceeds your interest rate – which is surely going to be true for a long time for short-term debt – then you can issue debt, roll over the debt to cover interest and still have a declining debt-to-GDP ratio. Further, debt-financed infrastructure increases GDP (see Fig. 1) by increasing productivity, which makes us wealthier and stimulates demand in an economy that is demand-constrained.

“Finally, if we fix Kennedy airport today, we don’t need to fix it tomorrow. If the concern is the obligation placed on future generations, then our accounting leads us seriously astray if it teaches us to fret over the treasury debt that will be left behind but not the deferred maintenance liability that will be left behind.”

Concerned: Gauti Eggertsson, Senior Economist of the Federal Reserve Bank of New York, has co-authored a report that raises concerns over how quickly the US economy can recover
Concerned: Gauti Eggertsson, Senior Economist of the Federal Reserve Bank of New York, has co-authored a report that raises concerns over how quickly the US economy can recover

Not everyone agrees with Summers though, and many have seen his suggestions as a pot-shot at austerity policies. He has written extensively on the subject in a series of columns for The Financial Times, suggesting that though growth in Britain is picking up, it is only because of the extent of the problem Britain has created for itself with its harsh austerity measures. The argument is that the only way to avoid a prolonged period of economic stagnation is to invest in real assets that increase an economy’s capacity. “A main problem with this thesis is that it does not fully take into account the fact that money is created by private banks whose incentives are not perfectly aligned with the needs of the economy,” says Orrell. “The central bank therefore has limited influence on the way in which money is invested (which is one reason so much ends up in unproductive things like real estate). So one way to tackle this problem at source is to go to 100 percent reserve banking, and prioritise business investment.”

One of the main arguments in Summers’ theory of secular stagnation is that central bank policy is fuelling the creation of bubbles, but if it were succeeding in creating adequate demand, it is also likely the fiscal stimulus necessary would lead to huge increases in nominal interest rates. “I would argue that central bank policy, plus the fact that most money creation is private, is creating bubbles; and this has an indirect effect on employment,” says Orrell. “We need investment in green projects which don’t necessarily boost economic growth as measured by GDP. So I would say that he has put his finger on a central problem of the economy, but for solutions we need to look more critically at the way money is created and invested in the first place.” Secular stagnation need not be a threat, and should instead be an opportunity to re-evaluate economic models that pursue indiscriminate growth ahead of a healthy and sustainable economy.