Finance & Development,
We should adopt appropriate fiscal policies that provide for expansionary investment.
You are reading this because of the long, steady decline in nominal and real interest rates on all kinds of safe investments, such as US Treasury securities. The decline has created a world in which, as economist Alvin Hansen put it when he saw a similar situation in 1938, we see “sick recoveries… die in their infancy and depressions… feed on themselves and leave a hard and seemingly immovable core of unemployment…” In other words, a world of secular stagnation. Harvard Professor Kenneth Rogoff thinks this is a passing phase—that nobody will talk about secular stagnation in nine years. Perhaps. But the balance of probabilities is the other way. Financial markets do not expect this problem to go away for at least a generation.
Eight reinforcing factors have driven and continue to drive this long-term reduction in safe interest rates:
- Higher income inequality, which boosts saving too much because the rich can’t think of other things to do with their money;
- Technological and demographic stagnation that lowers the return on investment and pushes desired investment spending down too far;
- Nonmarket actors whose strong demand for safe, liquid assets is driven not by assessments of market risk and return, but by political factors;
- A collapse of risk-bearing capacity as a broken financial sector finds itself overleveraged and failing to mobilize savings, thus driving a large wedge between the returns on risky investments and the returns on safe government debt;
- Very low actual and expected inflation, which means that even a zero safe nominal rate of interest is too high to balance desired investment and planned saving at full employment;
- Limited demand for investment goods, coupled with rapid declines in the prices of those goods, which puts too much downward pressure on the potential profitability of the investment-goods sector;
- Market failure in the information economy—which means markets cannot properly reward those who invest in new technologies, even when the technologies have enormous social returns—which lowers the private rate of return on investment and pushes desired investment spending down too far;
- Increasing technology- and rent-seeking-driven obstacles to competition, which make investment unprofitable for entrants, and market cannibalization possible for incumbents.
The result is that with rates so close to zero, central banks can no longer easily and effectively act to maintain full employment by cutting interest rates in recessions. Central banks typically—and powerfully—operate by buying and selling bonds for cash to encourage investment spending by leading the value of assets in the future to be higher and encourage consumption spending by making people feel richer. But when there is little room for cutting rates central banks are reduced to using novel, uncertain, and much weaker tools to try to guide the economy.
The magnitude of this decline in safe rates since 1990 is demonstrated by US Treasury securities. The short-term annual interest rate has fallen from 4 percent to 1.2 percent in real (inflation-adjusted) terms and from 8 to 0.5 percent in nominal terms, with long-term rates following them down.
The natural response to this secular stagnation is for governments to adopt much more expansionary tax and spending (fiscal) policies. When interest rates are low and expected to remain low, all kinds of government investments—from bridges to basic research—become extraordinarily attractive in benefit-cost terms, and government debt levels should rise to take advantage of low borrowing costs and provide investors the safe saving vehicles (government bonds) they value. Harvard’s Lawrence Summers argues that interest rates are so low that the inability of central banks to conduct effective monetary policy has become a chronic condition. He says that there is no sign we will emerge from this state for a generation, and so we should adopt appropriate fiscal policies that provide for expansionary investment the private sector is reluctant to undertake.
Critics of Summers’s secular stagnation thesis miss the point. Each seems to focus on one of the eight factors driving the decline in interest rates and then say that factor either will end soon or is healthy for some contrarian reason.
Since the turn of the century, the North Atlantic economies have lost a decade of what we used to think of as normal economic growth, with secular stagnation the major contributor. Only if we do something about it is it likely that in nine years we will no longer be talking about secular stagnation. ■
Opinions expressed in articles and other materials are those of the authors; they do not necessarily reflect IMF policy.
Photography: courtesy of University of California, Berkeley.
Policy Is the Problem
Productivity growth is depressingly low now—actually negative—but there is nothing secular about this.
Secular stagnation has been the subject of much debate ever since 2013, when Lawrence Summers proposed the hypothesis “that the economy as currently structured is not capable of achieving satisfactory growth and stable financial conditions simultaneously.”
Speaking at a recent conference, Summers posited that for the past decade and a half, the economy had been constrained by a “substantial increase in the propensity to save and a substantial reduction in the propensity to spend and invest,” which were keeping equilibrium interest rates and economic growth low.
Few dispute that the economy has grown slowly in recent years, especially when the financial crisis is taken into account. But secular stagnation as an explanation for this phenomenon raises inconsistencies and doubts.
Low policy interest rates set by monetary authorities, such as the US Federal Reserve, before the financial crisis were associated with a boom characterized by rising inflation and declining unemployment—not by the slack economic conditions and high unemployment of secular stagnation. The evidence runs contrary to the view that the equilibrium real interest rate—that is, the real rate of return required to keep the economy’s output equal to potential output—was low prior to the crisis. And the fact that central banks have chosen low policy rates since the crisis casts doubt on the notion that the equilibrium real interest rate just happened to be low. Indeed, in recent months, long-term interest rates have increased with expectations of normalization of monetary policy.
For a number of years going back to the financial crisis, I and others have seen a more plausible reason for the poor economic growth—namely, the recent shift in government economic policy. Consider the growth in productivity (output per hour worked), which along with employment growth is the driver of economic growth. Productivity growth is depressingly low now—actually negative for the past four quarters. But there is nothing secular about this. Indeed, there have been huge swings in productivity in the past: the slump of the 1970s, the rebound of the 1980s and 1990s, and the current decline.
These shifts are closely related to changes in economic policy—mainly supply-side or structural policies: in other words, those that raise the economy’s productive potential and its ability to produce. During the 1980s and 1990s, tax reform, regulatory reform, monetary reform, and budget reform proved successful at boosting productivity growth in the United States. In contrast, the stagnation of the 1970s and recent years is associated with a departure from tax reform principles, such as low marginal tax rates with a broad base, and with increased regulations, as well as with erratic fiscal and monetary policy. During the past 50 years, structural policy and economic performance have swung back and forth together in a marked policy-performance cycle.
To see the great potential for a change in policy now, consider the most recent swing in productivity growth: from 2011 to 2015 productivity grew only 0.4 percent a year compared with 3.0 percent from 1996 to 2005.
Why the recent slowdown? Growth accounting points to insufficient investment—amazingly, capital per worker declined at a 0.2 percent a year clip from 2011 to 2015 compared with a 1.2 percent a year increase from 1996 to 2005—and to a decline in the application of new ideas, or total factor productivity, which was only 0.6 percent during 2011–15 compared with 1.8 percent during 1996–2005.
To reverse this trend and reap the benefits of a large boost to growth, the United States needs another dose of structural reform—including regulatory, tax, budget, and monetary—to provide incentives to increase capital investment and bring new ideas into practice. Such reforms would also help increase labor force participation and thus raise employment, further boosting economic growth.
While the view that policy is the problem stands up to the secular stagnation view, the ongoing debate suggests a need for more empirical work. The recent US election has raised the chances for tax, regulatory, monetary, and perhaps even budget reform, so there is hope for yet another convincing swing in the policy-performance cycle to add to the empirical database.