For all the better-than-expected economic news this year, the volume of economic activity across the developed world remains remarkably depressed. The language of recession and recovery no longer seems relevant. Instead, we are faced with persistent economic stagnation. Those who wonder whether the west risks entering a Japanese-style “lost decade” have missed the point. The question is whether we can escape from the lost decade that is already suffocating our economies.
Wages are depressed; interest rates have every prospect of staying at rock-bottom; government debt is incredibly high (and, in some cases, persistently rising); companies prefer to hoard cash than invest; and, despite the hum of the printing press, inflation is surprising on the downside. Policy makers did well to avoid another Great Depression following the 2008 collapse of Lehman Brothers and the ensuing financial meltdown. They have not, however, prevented the Great Stagnation.
As the Japanese have discovered, escaping from a lost decade is not easy. Too often, Japan’s problems have been seen in the west as “merely macroeconomic” and, by implication, easily solved with an aggressive tweak of monetary or fiscal policy. Yet the west remains stuck in the same kind of rut. Admittedly, fiscal policy has offered little support in recent years but, on the monetary side, central bankers have bent over backwards. The results of their generosity have been disappointing.
A new version of the “macroeconomic failure” story was provided by Lawrence Summers, former US Treasury secretary, just the other day. In a speech to the International Monetary Fund research conference on November 8, Professor Summers talked about the dangers of “secular stagnation”, offering an intriguing explanation for why the developed world may have to get used to a combination of low nominal interest rates and financial bubbles into perpetuity if policy makers are to deliver anything approaching full employment.
His argument is based on a simple observation — namely that inflation over the past two decades has mostly been lower than expected, regardless of cyclical highs and lows. Price pressures were low at the end of the 1990s and lower still in the years preceding the global financial crisis. As a result, Prof Summers believes it makes no sense to suggest that, at any point, there was excess domestic demand. Throughout the period, the danger was always of deficient demand, largely because interest rates – already very low – could not drop to levels that might deliver full employment. Instead, higher levels of activity could be met only by creating or nurturing financial bubbles, from the dotcom boom of the late 1990s through to the madness of the subprime world pre-Lehman.
Prof Summers suggests the level of real interest rates required to generate full employment might be, say, -2 or -3 per cent. In a low inflation environment, that is basically unachievable. Put another way, if Prof Summers is right, he may never be able to prove it. This rather reduces the power of the analysis unless central bankers prove both willing and able to pursue higher inflation than we have become accustomed to, a hard task in societies where populations are ageing and people are keen to hang on to their (nominal) savings.
There are two other problems with Prof Summers’ approach. First, he assumes that the absence of inflation somehow “proves” that there was not a problem with excess demand. This seems odd. Plenty of economies have suffered unsustainable economic and financial booms in the absence of inflation. Think of the US in the roaring 1920s, Japan in the late 1980s or Thailand (by the standards of the time) in the mid-1990s. All of them later suffered the consequences. Too often, persistently low or stable inflation – sometimes the result of favourable external circumstances – creates the false impression that activity can be sustained at too high a level, leading to excessive risk taking, financial bubbles and balance of payments crises.
Second, Prof Summers assumes his “secular stagnation” is primarily a demand problem. That is not at all clear. There are lots of other entirely plausible reasons for persistently lower-than-expected growth. In terms of economic performance, the late 20th century increasingly looks to have been a one-off “golden age” for the developed world, because of an end to the protectionism of the interwar period, a huge increase in labour supply thanks to the increased participation of women in the workforce, a dramatic rise in the numbers in tertiary education, a massive expansion of household debt (which, in turn, paved the way for more mass production) and, most obviously, the impact on labour supply of the baby boomers.
Technology continues to advance, of course, but technology alone does not fully explain the golden age. This one-off adjustment led to a period of unusually rapid economic growth that took the developed world closer to its productive potential. The same process is now happening in the emerging world even as the developed world stagnates.
This provides a completely different perspective on the secular stagnation. There is no magic interest rate (whether or not it can be reached). The absence of inflation over the last two decades may not indicate a chronic shortage of demand. Instead, developed economies no longer offer the supply dynamism of old. Worse, because policy makers have not recognised this new reality, they continue to pretend golden age growth rates may still be within reach, a convenient way to ignore the tough fiscal decisions that will eventually be needed.
A gap is growing between political and financial hope and the new economic reality. That gap will have to close. As it does so, some will lose out. Levels of mistrust will rise. Risk aversion will spread. Growth will remain stagnant. And the developed world is at risk of succumbing to Adam Smith’s “melancholy state” — a world in which one person’s gain is regarded as the cause of another person’s loss — whatever the level of interest rates.