Raghuram Rajan | Bracing for stagnation4 min read . Updated: 01 Jan 2015, 01:18 AM IST
Policymakers would be wise to understand the factors underlying the global economy's anaemic performance
As 2014 ends, the global economy remains weak. The US may be seeing signs of a strengthening recovery, but the euro zone risks following Japan into recession, and emerging markets worry that their export-led growth strategies have left them vulnerable to stagnation abroad. With few signs that 2015 will bring any improvement, policymakers would be wise to understand the factors underlying the global economy’s anaemic performance—and the implications of continued feebleness.
In the words of Christine Lagarde, the International Monetary Fund’s managing director, we are experiencing the “new mediocre". The implication is that growth is unacceptably low relative to potential and that more can be done to lift it, especially given that some major economies are flirting with deflation.
Conventional policy advice urges innovative monetary interventions bearing an ever expanding array of acronyms, even as governments are admonished to spend on “obvious" needs such as infrastructure. The need for structural reforms is acknowledged, but they are typically deemed painful, and possibly growth-reducing in the short run. So the focus remains on monetary and fiscal stimulus—and as much of it as possible, given the deadening effects of debt overhang.
And yet, the efficacy of such policy advice remains to be seen. It is worth noting that the Japanese checked each of these boxes over the last two decades: They held interest rates low, introduced quantitative easing, and launched massive debt-financed spending on infrastructure. Few would argue that Japan has recovered fully from its malaise.
An emerging narrative might better explain why stimulus efforts have been unsuccessful: As former US treasury secretary Larry Summers has argued, the world economy may be going through a sustained period of “secular stagnation".
The causes of the stagnation very much depend on which economist one asks.
Summers emphasizes the inadequacy of aggregate demand, exacerbated by the inability of central banks to reduce nominal interest rates below zero. The reasons for weak aggregate demand include ageing populations that consume less and the growing concentration of wealth among the very rich, whose marginal propensity to consume is small.
The economists Tyler Cowen and Robert Gordon, on the other hand, argue that the problem is on the supply side. In their view, the years following World War II were an aberration, with industrial countries’ growth helped by post-war reconstruction, rising education levels, higher workforce participation rates (owing to the entry of women), restored global trade, increasing investment, and the diffusion of technologies such as electricity, telephones, and automobiles.
Whatever the causes, growth started to slow in the 1970s, and adverse consequences such as high unemployment rates among immigrants and the young were compounded by the growing realization that governments would struggle to deliver on their promises of social security. These promises, notes the sociologist Wolfgang Streeck, had been made in the 1960s, when economies were surging and visions of a “great society" seemed affordable. Promises have since been augmented with pension hikes and old-age healthcare commitments for public-sector workers.
To meet their obligations, governments needed growth. So, from the 1970s on, they began to spend to stimulate the economy. Because of the supply-side problems, however, the spending translated into spiralling inflation. Price stability needed to be restored, but the spending had to be maintained. The ultimate solution was to finance spending not with the inflation tax, but with debt: first public debt, and then, as governments cut their deficits, private-sector debt. In 2008, these elevated debt levels—in banks, businesses, households, and governments—sparked the financial crisis.
Today, debt is making it difficult for developed countries to resume pre-2008 growth rates, let alone restore the levels of gross domestic product (GDP) that would have been attained if the subsequent great recession had not happened. Meanwhile, industrial countries’ overall debt/GDP ratios are continuing to grow.
In emerging markets, slow growth in the advanced economies has shut down a traditional development path: export-led growth. As a result, emerging markets have had to rely once again on domestic demand. This is always a difficult task, given the temptation to over-stimulate.
The abundance of liquidity sloshing around the world—the result of developed countries’ ultra-accommodative monetary policies—has made the task more difficult still, as the smallest sign of growth in an emerging economy can attract foreign capital. If not properly managed, these flows can precipitate a credit and asset-price boom and drive up exchange rates. When developed-country monetary policies are eventually tightened, some of the capital is likely to depart. Emerging markets will have to ensure that they are not vulnerable.
To be sure, the world’s economic outlook could still take a turn for the better. The US may become the world’s engine of growth. Declining oil prices could provide a major boost, especially to oil-importing developed economies. Technological advances could still come to the rescue.
But, overall, there is a palpable sense of gloom in the developed world, a feeling that growth is unlikely to take off in the foreseeable future. If secular stagnation persists, these countries will have to undertake painful structural reforms, figure out how to restructure their promises (debt, social-security commitments, and pledges to keep taxes low), and distribute the resulting burden.
After the city of Detroit filed for bankruptcy in 2013, it had to make tough choices between servicing its pensioners or its debt, keeping its museums open or its police force intact. As we head into 2015, similar difficult decisions may become increasingly common. ©2015/Project Syndicate
Raghuram Rajan is governor of the Reserve Bank of India.