No reason why the West should lose a decade

July 06, 2015 11:19
Japan's economy has been stagnating for years. Photo: Reuters

Has the West done away with the Great Recession?

Some say no.

To illustrate, real output in the West has not grown fast enough to reach its precrisis trend level.

Worse still, the West might never again reach that level, because potential output has been adjusted downward permanently, a recent paper by the Organization for Economic Cooperation and Development says.

This suggests why the rapid closing of output gaps in the United States and Britain concerns policymakers and commentators alike.

So what is contributing to this disappointing growth performance?

The answer may be “secular stagnation”.

The concept, first used by Alvin Hansen in 1939 and recently revived by Lawrence Summers, refers to prolonged, subdued growth that is well short of prerecession trends of potential growth.

To understand why secular stagnation occurs, I must first remind the reader of the zero lower bound (ZLB) constraint on nominal interest rates -- that is, rates can never fall below zero.

Otherwise, savers can always hide cash under their pillows.

The ZLB becomes a problem when the economy is in such a depressed state that warrants negative nominal interest rates to bring about negative real interest rates – arguably what matters in determining consumption and investment decisions -- and full recovery.

What has been the case is that the actual real rates and neutral real rates (the rates corresponding to stable inflation and full employment) have fallen to historically low levels in advanced economies in the wake of the crisis.

Falling rates are due to a variety of factors.

One of them is a fall in demand for debt-financed investment, thanks to continuous deleveraging, tighter financial regulation and the fact that business start-ups now require less capital than before (think Whatsapp).

Another factor is global imbalances.

What former US Federal Reserve chairman Ben Bernanke dubbed the “global savings glut” is a vivid description of the excessive build-up of foreign reserves by emerging economies since the turn of the century, channeling massive funds into the West and particularly the US and lowering rates.

Other factors are rising income inequality and the aging of the population. The rich and elderly have a higher propensity to save, depressing interest rates.

Consequently, falling real rates, coupled with low inflation in the past two decades, add up to dangerously low nominal rates, making the ZLB ever more imminent and giving central banks very little room to maneuver.

The result is that while the economy’s potential is still there, sluggish growth results.

Secular stagnation also gives rise to deflationary pressure, as the economy is under-utilised.

This accounts for dampened inflation in the West.

What’s more, as Summers puts it, “if you die in the short run, there is no long run”.

Stagnation in the short and medium run discourages business investment at the same time that it creates structural unemployment.

This ends up undermining the economy’s potential.

It is rather like the inverse of Say’s Law, Summers argues, where lack of demand creates lack of supply potential.

If true, this offers a damning prospect: not only that the West is not reaching its full potential, but also that its potential is permanently damaged.

The OECD suggests secular stagnation is biting the West.

In the US and Britain, actual real interest rates are only 1 percentage point below the neutral levels.

In Japan, actual real rates have been well above neutral rates ever since the 1990s.

And Europe is becoming more like Japan.

This does not appear to me to be a credible recovery story.

So, what can be done to combat secular stagnation?

It is useful to go back to the causes of falling real rates.

The solutions to secular stagnation may lie in measures to extend the retirement age, tackle income inequality and reduce global imbalances (if possible).

They take time.

Structural reform of other kinds, however, does not help, because the problem is demand-side, not supply-side.

Greater supply requires a lower neutral rate to stimulate demand, and without a corresponding expansion in demand, it could only reinforce the deflationary tendency.

Unconventional monetary policy, manifested by quantitative easing and forward guidance, is an innovative way to do away with ZLB, but it seems like a recipe for financial instability.

The inflation target of 2 percent in the US, Britain and eurozone can be raised to give further room for nominal rates to be cut.

Yet this raises the issue of central bank’s credibility: what assures investors that the target won’t be raised again?

This leaves us the option of more spending, both public and private.

The International Monetary Fund suggests that public investment is a free lunch – it more than pays for itself.

This calls for greater infrastructure spending amid a low interest rate environment.

Western economies can also encourage private investment by reaching trade agreements and reinforcing export promotion.

Overall, it is clear that the argument for combating secular stagnation is compelling, with Japan being the best example of what happens otherwise.

Most important of all, central bankers are now equipped with both the intellectual and practical tools to tackle secular stagnation head on.

There is just no reason why the West should lose a decade.

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EJ Insight contributor