Via Capital Economics:
A recent paper by Larry Summers and Lukasz Rachel has been doing the rounds among economists and has revived debate in financial markets about “secular stagnation”. But what is “secular stagnation”, and what might it mean for economic growth, monetary policy and asset prices?
One problem is that there are competing definitions of secular stagnation. Summers’ theory is anchored in a view that the global economy is prone to prolonged periods where demand runs well below potential supply. (In other words, desired savings exceed desired investment.) As a result, even with extremely supportive monetary and fiscal policies, economies struggle to reach full employment. What’s more, so far as monetary policy goes, this policy accommodation then runs the risk of inflating asset prices and increasing financial vulnerabilities. This version of secular stagnation therefore represents a form of demand pessimism – a belief that policymakers will struggle to generate sufficient demand to keep their economies at full employment in a sustainable manner.
However, the original idea of secular stagnation can be traced back to work by the economist Alvin Hansen in the 1930s. His thesis was rooted in part in pessimism about the supply potential of America’s economy in the wake of the Great Depression. This has echoes in the views espoused by some of today’s “productivity pessimists”, who argue that a new and persistent weakness in productivity will prevent GDP growth in the advanced economies from returning to pre-2008 rates.
On the face of it, the evidence to support Summers’ version of secular stagnation seems fairly compelling. After all, despite an unprecedented amount of policy support, the recovery from the 2008-09 financial crisis in the developed world has been among the weakest on record. This has been accompanied by a steady reduction in estimates of the so-called neutral real interest rate (or R* in the jargon). This has major implications, including for how policymakers in the advanced economies respond to the next economic downturn. For one thing, it means that central banks are likely to have to delve deeper into the world of unconventional monetary policies. It also means that fiscal policy is likely to have to play a greater role in stimulating demand and reinvigorating growth.
Meanwhile, there also appears to be evidence to support the second idea of secular stagnation rooted in supply-side concerns. As Chart 1 shows, trend productivity growth in the G7 has been grinding lower for several decades and is now running at well below 1% y/y. The counterpart to this has been a reduction in potential GDP growth in the world’s major developed economies.
Chart 1: G7 Labour Productivity Growth (% y/y, 10-year rolling average)
So it seems that we should take both the Summers and Hansen version of secular stagnation seriously. The key question, however, is just how “secular” this phenomenon might be. The answer depends on what is behind the shortfall in demand – and what is driving the weakness of productivity growth.
For each country, there are four potential sources of weak demand: households, businesses, government and foreigners. Disentangling the extent to which each has been responsible for demand weakness is made difficult by data deficiencies and measurement problems. But it’s fair to say that all four have played a role in suppressing demand over the past decade.
On the domestic front, Chart 2 shows how growth in household spending and fixed investment in the G7 has slowed sharply over the past decade. Likewise, Chart 3 shows how fiscal policy (i.e. governments) exerted a substantial drag on demand in the early years of this decade.
Chart 2: Growth in G7 Household Consumption & Fixed Investment (% y/y, average)
Chart 3: Change in Cyclically-Adjusted Budget Balance (G7 average, %-pts GDP)
To some extent all of these challenges may simply be a legacy of the global financial crisis: over-indebted households curbed their spending to repair balance sheets, problems in the banking sector and increased risk aversion weighed on investment and governments tightened their purse strings in order to balance their books.
Some of these domestic headwinds are fading. Household balance sheets are in better shape and, as labour markets have tightened, consumer spending has accelerated in most parts of the developed world over the past couple of years. Likewise, a long period of government austerity now appears to be behind us. But others remain. In particular, business investment in many countries remains much weaker than we might otherwise have expected given the current point in the economic cycle. This may reflect political and policy uncertainties, from Brexit to trade wars, but it may also be a function of deeper-seated issues related to regulation, corporate governance and boardroom incentives.
Meanwhile, on the external front, while the current account surpluses run by the world’s major net savers have narrowed in recent years, they remain large by historic standards. As I argued a few weeks ago, these represent a drag on demand in the rest of the world. Efforts to bring them down could therefore provide a significant boost to global demand and must surely form part of any effective response to secular stagnation. This process may be helped by demographic shifts, as ageing populations in the major surplus economies in parts of Asia and the euro-zone begin to run down their savings.
What about challenges on the supply side? The weakness of productivity growth is, in arithmetic terms, simply the counterpart of sluggish demand. In this respect, it may also reflect a hangover from the global financial crisis. But as I also noted a few weeks ago, some of the more fundamental pessimism about the failure of digital technologies to deliver productivity growth feels overdone. The lesson from previous waves of technological development is that it takes time for infrastructure and processes to adapt in order to realise the full benefit to productivity. The situation may appear rather different in a few years’ time.
None of this is to underplay the potential challenges posed by “secular stagnation”, or the implications for policymakers now seemingly faced with a global downturn. But by the same token, there nothing about secular stagnation that is inevitable. The structural weakness of demand could be remedied through a combination of looser fiscal policy, reforms to restore the corporate mojo and boost investment and measures to reflate the world’s major current account surplus countries. At the same time, it’s too soon to give up on the idea that digital technologies may lead to faster productivity growth. The immediate evidence in favour of secular stagnation looks compelling, but it may yet prove to be a passing phase.