Economics & Growth | Fiscal Policy
- In 2013, Larry Summers revived secular stagnation theory, suggesting advanced economies might be permanently trapped in a low-growth, low-interest rate regime.
- The key causes of secular stagnation are adverse demographic trends, lower productivity growth, and a decline in the natural interest rate. The consequences are higher asset prices, higher inequality, and permanently depressed aggregate demand.
- Even historically conservative institutions like the IMF, OECD, and the ECB have recently endorsed secular stagnation. So the theory has reached the mainstream.
Japan has been stuck in a zero-interest rate environment since the 1990s. While most consider the country an anomaly, economists like Paul Krugman and Ben Bernanke warned about the Japanese liquidity trap even before 2008. After the global financial crisis, many other advanced economies suddenly faced the zero-lower bound (ZLB) on interest rates too.
Krugman famously showed that central banks have difficulties increasing aggregate demand when interest rates are stuck at zero and that even large injections of base money (quantitative easing, QE) could be ineffective. However, the liquidity trap was supposed to be a temporary equilibrium.
In 2013, Larry Summers revived the secular stagnation theory and outlined that the low growth and low interest rate environment could be permanent. Ever since, interest rates and inflation rates have continued their downward secular trend, and growth rates have disappointed too.
The primary causes of secular stagnation are adverse demographics and lower productivity growth. Fertility rates have declined across advanced economies while longevity has risen, leading to rapidly ageing societies. Japan led this trend, experiencing negative population growth for over a decade while the active population already peaked in 1995. The old age dependency ratio has surged in recent decades (Chart 1). As people enjoy longer retirements, they must save more during their working age, which puts downward pressure on interest rates.
Declining productivity has led to lower growth rates and contributed to lower real interest rates (Table 1). And much recent technological progress since the early 2000s has boosted consumer welfare instead of productivity (think Netflix, Twitter, Facebook, etc.).
Other trends have also contributed to secular stagnation: declining demand for investment goods and monopolization.
Researchers Loukas Karabarbounis and Brent Neiman document the falling price of investment goods in recent decades. The new economy requires much less investment in capital goods, putting downward pressure on interest rates and leading to a lower labour share of GDP. Consider that a company like General Motors with factories worldwide and over 150,000 employees has only a market capitalization of about $80bn. Meanwhile, Facebook has just office space and servers but a market capitalization of $900bn, with only some 50,000 employees (Chart 2). The new economy is much less capital-intensive, and reduced demand for capital investments is lowering interest rates and negatively affecting growth.
Market concentration across sectors has also increased. Rising monopolization has lowered the labour share of GDP and contributed to rising inequality. High-income individuals have a much larger propensity to save, spurring the current environment of low aggregate demand.
Adverse demographics and falling productivity have caused the long-run decline in real interest rates, in turn also leading to an unprecedented boom in asset prices. House prices have more than doubled in real terms across advanced economies since the 1990s (Chart 3).
Similarly, both stocks and bonds have also enjoyed very high total returns in recent decades (Chart 4).
The asset price boom increased inequality since the ownership of financial assets is highly concentrated. And higher inequality compounded low aggregate demand in recent years, since the wealthy save more of their income, in turn putting further downward pressure on interest rates.
With interest constrained at zero, central banks struggled to rejuvenate the economy after 2008, and now again after Covid-19. While much empirical evidence suggests unconventional monetary policy can be effective, central banks acted far too timidly after the financial crisis. Moreover, asset purchase programs (QE) have limits, even if they are mostly political and institutional. As Krugman famously outlined, even large expansions of the monetary base might have little impact on broader monetary aggregates and nominal GDP in the liquidity trap. Stuck at the ZLB since the 1990s, Japan seems to exemplify this. While the central bank’s balance sheet now exceeds 130% of GDP, the country has experienced some of the lowest inflation rates globally.
Fiscal Multipliers at the ZLB
For the above reasons, many economists now argue fiscal policy must be the focus of macroeconomic demand stabilization. Much research shows fiscal multipliers are high when interest rates are stuck at zero and the economy is depressed. With a reasonably large multiplier and low interest rates, fiscal expansions might even be self-financing. This means a dollar of spending would generate over a dollar of economic activity in the long run. It can also explain why austerity in Southern Europe was self-defeating during the euro area debt crisis. The consolidation of government budget deficits led to a huge decline in economic activity so that debt-to-GDP ratios actually increased.
Obviously, the type of fiscal spending matters too. Former US President Donald Trump’s tax cut was an example that probably led to very little additional economic activity. First, most of the money went to the rich, who have a lower marginal propensity to consume. Second, the Fed was raising interest rates at the time, so monetary offset applies.
The current infrastructure and social programs the Biden administration is pursuing have significant economic benefits. Most acknowledge the US has an infrastructure gap and a problem with excessive costs for raising children and education. As President Joe Biden seems to be addressing many of the issues facing the country, the large fiscal spending programs will raise the economy’s long-run growth prospects and therefore might largely ‘pay for themselves’.
Furthermore, as interest rates have sunk, the burden of servicing debt has declined even as debt ratios have increased (Chart 5).
It increasingly appears secular stagnation has trapped most advanced economies since 2008; Covid-19 will only worsen this.
While initially met with great scepticism, many macroeconomists have now converged towards Summers’ viewpoint. Historically conservative institutions like the IMF, OECD, and ECB recently embraced most aspects of secular stagnation theory.
From a policy stance, fiscal policy must become more expansionary and with super low-interest rates, the additional debt burden is marginal. Central banks must realize that their current toolkit has been insufficient and that they must rethink their targets. In the US, this has already happened with the Fed’s new average inflation targeting framework. Many forward-looking indicators show inflation expectations have increased significantly. Moreover, the unprecedented fiscal and monetary stimulus will lead to more than 9% nominal growth this year. Surprisingly, the US economy is now on track to exceed its pre-pandemic growth level path. So it seems the Fed’s new target is working well – the US economy might escape secular stagnation whereas Europe’s growth prospects are more meagre.