Photo: Bloomberg
Photo: Bloomberg

What explains the great global slowdown?

The spectre of secular stagnation haunts the world today

Who would have thought that a somewhat arcane economics concept from the 1930s would occupy centre stage in economic policy debates today? Yet, along with “financial instability", “secular stagnation" is now well on its way to becoming a household term. It befits an era of economic volatility in a global economy which is yet to recover fully from the great financial crisis of 2007-10.

Coined originally by Harvard economist Alvin Hansen in the wake of the Great Depression, the term in recent years has been given new currency by another famous Harvard economist, Lawrence Summers. Most recently, writing in the influential journal, Foreign Affairs, Summers argued that secular stagnation holds the key to understanding the current global macroeconomic situation. (For further background, readers may also wish to consult the 2014 VoxEU.org ebook, Secular Stagnation, here, which collects a range of academic and policy papers on the topic, including introductory reflections by Summers himself.)

Put most simply, secular stagnation refers to a situation of insufficient aggregate demand, or, equivalently, a situation of excess aggregate supply. While these two definitions are equivalent, the first points to the demand side, and the latter to the supply side, as the source of the problem.

Yet another equivalent, demand-side, definition is to say that secular stagnation reflects an excess of savings over investment. This is, as a matter of accounting, the flip side of insufficient demand for goods and services: as every student who has been taught the circular flow of goods and services in a first-year principles of economics class will know.

A somewhat more technical definition of secular stagnation is that it is a situation in which the “natural" or “neutral" real rate of interest is so low that it is impossible to achieve at a positive, zero or even slightly negative nominal interest rate. Recall that the natural or neutral real interest rate, a concept originated by Swedish economist Knut Wicksell, is that real interest rate which balances aggregate demand and aggregate supply at full employment.

(For the wonkish: Another way of saying the same thing, in more Keynesian terms, is that the Wicksellian real interest rate is that real interest rate which corresponds to the economy being at the non-accelerating inflation rate of unemployment or, equivalently, being on the vertical, long run Friedman-Phelps Phillips curve.)

While small negative nominal interest rates are theoretically and practically possible, contrary to what is sometimes believed, the nominal interest rate required to equilibrate aggregate demand and aggregate supply in a situation of secular stagnation is so large and negative that it would be impossible to achieve using conventional monetary policy.

The key reason is that depositors may tolerate a small negative interest rate as a convenience charge, but, facing a large enough negative interest rate, it would be cheaper to hold money in cash, even if one has to pay for storage and security. In theory, the government could directly tax currency holding at whatever rate it wishes, which would push even lower a sustainable negative nominal interest rate, but this seems impractical and politically difficult.

Summers argues that the current global macroeconomic picture is entirely consistent with a situation of secular stagnation. He writes: “Real interest rates are very low, demand has been sluggish, and inflation is low, just as one would expect in the presence of excess saving. Absent many good new investment opportunities, savings have tended to flow into existing assets, causing asset price inflation."

As evidence in favour of the hypothesis, Summers points to declining estimated neutral real interest rates and a body of research which documents a range of factors behind rising savings rates and declining investment rates.

To quote Summers again: “Greater saving has been driven by increases in inequality and in the share of income going to the wealthy, increases in uncertainty about the length of retirement and the availability of benefits, reductions in the ability to borrow (especially against housing), and a greater accumulation of assets by foreign central banks and sovereign wealth funds. Reduced investment has been driven by slower growth in the labour force, the availability of cheaper capital goods, and tighter credit (with lending more highly regulated than before)."

Stemming from his diagnosis of the global economy’s current woes, Summers’ policy prescription is a return to the centrality of fiscal policy, which has been neglected as of late. For a decade and a half before the financial crisis, the consensus view in the economics profession was that monetary policy, as delivered through inflation targeting, would suffice to fine-tune the economy and keep it close to its long-run potential level of output and employment, while at the same time overcoming, or at least mitigating, the ebb and flow of the business cycle.

On this view, which emerged during the so-called Great Moderation, fiscal policy would be too clumsy and imprecise a tool to be used for Keynesian countercyclical policy, and what is more, would be prone to political capture and distortion through pork barrel politics and the like.

In a sense, Summers’ policy prescription returns to the original Keynesian orthodoxy—not the more recent “new Keynesian" consensus view—which saw fiscal policy and monetary policy as two wheels of the macroeconomic policy bicycle, with each needing to push in the same direction if one wanted to move forward. And if, indeed, the current problem is secular stagnation, only fiscal policy, not monetary policy, could work to raise the neutral real interest rate, through government spending, closing the gap in deficient demand.

Further monetary loosening, if that were possible, would even have the perverse effect of reducing interest rates (both nominal and real) and thereby further fuel asset price bubbles and excess savings without reducing insufficient demand. That would also tend to rule out tax cuts as a viable solution, since the extra income in the hands of households would likely be saved rather than spent.

It should not be surprising that, in a hotly contested arena such as macroeconomics, Summers’ diagnosis, and the prescription which flows from it, is not universally shared. Principal competing theories are: the “debt overhang" hypothesis of Harvard economist Kenneth Rogoff; the supply-side productivity-driven hypothesis of Northwestern University economist Robert Gordon; the “savings glut" hypothesis of Brookings Institution economist and former US Federal Reserve chairperson Ben Bernanke; and the Keynesian “liquidity trap" explanation of Nobel-winning economist Paul Krugman.

Perhaps a more accurate statement is that at least some of these alternative explanations are not strictly competing but potentially complementary hypotheses. Thus, the main point of contention between Rogoff and Summers is not the existence of a private sector debt overhang and the subsequent painful deleveraging, which is not in doubt, but rather whether it is the cause or the effect of deficient demand and of unconventional monetary policies which were put in place to cure it. Rogoff sees it as a cause, Summers as an effect.

Meanwhile, Gordon’s theory might be considered a supply-side alternative to Summers’s demand-side explanation. Gordon’s principal contention is that labour productivity has declined sharply in the US from the golden century 1870-1970 during which it rose steadily, and that this accounts for the current protracted economic stagnation in the US and other advanced economies.

But, as Summers rightly points out, Gordon’s hypothesis is one of insufficient supply—not of excess supply—and, if true, should result in inflationary pressures, of the type the global economy witnessed during the so-called stagflation of the 1970s following successive oil shocks. Instead, however, advanced economies are currently experiencing low inflation, with deflation—rather than high inflation—the present worry. However, bucking the consensus, Fed vice-chairperson Stanley Fischer has suggested recently that he see the “first stirrings" of resurgent inflation. This, however, still appears to be a minority view among policymakers and experts.

Bernanke, by contrast, has emphasized the global savings glut, driven by excessively high savings in major emerging economies, principally China. These large savings, which cannot be productively invested at home, are instead channelled into capital outflows that finance low household savings and high fiscal deficits in advanced economies such as the US.

The savings glut is also, therefore, one of the culprits of the global financial crisis itself, as Chinese and other foreign savings, in effect, allowed unsustainable amounts of leverage to build up in the US subprime housing market and elsewhere.

This also ties back to Rogoff’s debt overhang hypothesis as another natural corollary. Another question tied to the Rogoff thesis involves reopening an old debate on whether emerging economies should impose capital controls to stem volatility, but that is one for another occasion.

Evidently, Bernanke’s and Rogoff’s theories are basically complementary to Summers’s, and both would push in the direction of ramping up an aggressive use of activist fiscal policy, rather than relying purely on monetary policy at least till aggregate demand picks up pace. Rogoff and his colleague and co-author Carmen Reinhart are, however, among the more cautious advocates of fiscal policy tools in the profession. Gordon’s theory is perhaps the most pessimistic, since there is no easy fix to a long-run decline in labour productivity, certainly not conventional fiscal or monetary policies.

Rounding out the major explanations for current global economic woes is the classical Keynesian liquidity trap hypothesized by Krugman. In a way, this hypothesis is observationally equivalent to Summers’s explanation. For the essence of a liquidity trap as theorized by Keynes and his followers is that the creation of additional liquidity by a central bank is absorbed by the private economy as additional savings, which remain unspent or are not invested.

Typically, this is thought to occur at or close to a zero nominal policy interest rate—the so-called zero lower bound, at which point conventional monetary policy ceases to be effective. Japan went through such a liquidity trap for a decade, and, in a sense, the unconventional monetary policies employed to combat the global financial crisis in the US and elsewhere have led to what one could argue is a liquidity trap like situation.

The Krugman and Summers explanations converge on the reality of low inflation, or even deflation, being the norm for the near to medium term, as a counterpart to the continuing stagnation of output and employment. They also converge on the ineffectiveness of conventional monetary policy as a cure, but for different reasons, and the policy advice also, therefore, differs.

For Summers, as discussed, monetary policy near the zero lower bound cannot close the gap between excess savings and insufficient investment, a gap which can only be filled by fiscal policy in the form of government spending.

In contrast, for Krugman, the ineffectiveness of monetary policy in a liquidity trap is self-evident; the cure, for him, is to change expectations of future monetary policy, so that investors believe that the central bank will persist with loose monetary policy even if inflation begins to tick up. That, in turn, implies a lower real interest rate, which should help jump-start forward-looking investment and other interest-sensitive economic activity today.

(For the wonkish: expected inflation creates a wedge between the nominal interest rate and the real interest rate. High enough expected inflation means that the nominal interest can be positive even if the real interest rate is negative. Higher expected inflation tends to drive down the real interest rate, as investors rebalance their portfolios away from money towards other assets, so that the nominal interest rate rises by less than in proportion. This is known as the “Mundell-Tobin effect".)

Policymakers and central bankers alike pooh-poohed the Summers-Krugman line of argument in the years following 2008, arguing that monetary policy—initially unconventional, and then transitioning back to conventional—could do the job of fixing what ailed the global economy.

Such a view was echoed by mainstream opinion, including in widely read and influential publications such as The Economist and the Financial Times. That thinking now appears to be shifting in the direction of more radical policy options which would have been considered beyond the pale a few years ago.

Thus, in its 20 February issue, The Economist carried a cover story and linked leader which advocated a return to fiscal policy, echoing the arguments of Summers and others. But the magazine went considerably beyond this, putting on the table a range of radical ideas, most notably a so-called “helicopter drop" of money.

Originally proposed by Nobel-winning economist Milton Friedman, a helicopter drop involves paying for government spending or tax cuts directly by printing money, rather than through issuing bonds, which requires the mediation of the financial system.

Recall that the monetary effects of conventional debt-financed fiscal policy can be sterilized by the central bank through open market operations. In contrast, a helicopter drop requires that fiscal and monetary policy work in lockstep, with fiscal policy in the lead, which is why it is so radical.

It would practically be as if a government helicopter loaded up with cash commandeered at gunpoint from the central bank would pass overhead and shower everyone below with newly printed currency notes.

More technically, helicopter money involves the central bank buying bonds for money, through conventional open market operations or through unconventional asset purchases (“quantitative easing"), while simultaneously the government sells bonds in order to finance transfer payments of money to the public.

More recently, Martin Wolf, chief economics commentator for the Financial Times, also batted for bold new thinking, including seriously considering helicopter drops. For interested readers, a 2014 research paper by economist Willem Buiter makes a theoretical case for the effectiveness of a helicopter drop.

Advocates of such policy argue that by putting spending power directly into the hands of households and short-circuiting the intermediation of a broken financial system—in particular, banks that prefer to hoard cash rather than to lend—governments might be able to galvanize consumer spending and hence growth. But this outcome is far from certain. The Economist makes the case thus: “The sheer recklessness of this would, in theory, encourage people to spend the windfall, not save it." This sounds like wishful thinking.

It is at least as likely that, fearing ongoing economic volatility, job uncertainty and so forth, households which are the beneficiary of a helicopter drop might literally put the money under a mattress rather than spend it, which would make it a self-defeating policy that would worsen the excess savings problem rather than cure it.

What might be more effective, instead, is if helicopter money is used to finance government spending rather than go through the uncertain route of money-financed tax cuts intended to boost household consumption. But to do so would, as noted, fuse fiscal and monetary policy in a way that governments have taken a long time to wean themselves off of.

It would, in effect, be using the printing press to pay for government spending. In one fell swoop, helicopter money would eliminate monetary policy independence in favour of a “new" monetary policy regime which simply monetizes fiscal policy. These are exactly the bad old ways that developing and emerging economies, including India, have had to struggle for decades to get away from!

That helicopter drops—a cure worse than the disease, perhaps—are actually under serious consideration points to how grave the current global economic malaise is and the desperate measures that serious folk in the advanced economies are willing to advocate. The Economist, after all, is not a Marxist or post-Keynesian journal.

The reader should, thus, fully expect to see many more discussions of “secular stagnation" and “helicopter drops" in these and other pages in the months and years to come. What is old is new again.

The author would like to thank Nick Rowe, associate professor of economics at Carleton University, Ottawa, for inputs.

Economics Express runs weekly, and features interesting reads from the world of economics and finance.

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