In the autumn of 2013, former US treasury secretary Larry Summers proposed in a seminal speech at the International Monetary Fund headquarters in New York that the global economy had entered a long-term economic slump. Invoking a previously discredited 1930s theory known as secular stagnation, Summers argued that it may have become all but impossible to boost growth by using the age-old trick of lowering interest rates to encourage more investment and consumer spending. The answer, he argued, was for governments to spend more instead.
Summers would go on to suggest that secular stagnation “may be the defining macroeconomic challenge of our times”. There followed a major debate between heavyweight economists about whether he was right, but for several years the global economy contradicted him by growing steadily.
Now, however, this looks to be at an end. Look no further than the OECD projections from March 6, which foresee all advanced economies growing much more slowly than anticipated a few months ago. The left-hand chart below shows the OECD projections from last May, while the right-hand chart shows the latest outlook, complete with red arrows to indicate the sharpest downward revisions.
The overarching global theme seems to be Donald Trump’s trade war and the fact that central banks have been tightening monetary policy: the US Federal Reserve has hiked interest rates four times in the past year, while the European Central Bank is no longer “printing” money through its programme of quantitative easing. There are additional local reasons, such as UK fears about a hard Brexit, or excessive levels of private sector debt in China. Underlying all of this, however, is the growing feeling that secular stagnation is a major drag behind the scenes.
Back in fashion
The theory was originally put forward in 1938 by the Harvard economist Alvin Hansen in response to the Great Depression. He argued that America’s economy was suffering from a lack of investment opportunities linked to waning technological innovation; and not enough new workers due to an ageing population, too little immigration, and the closing of the old economic frontier in the American West.
In Hansen’s view, the weak growth in the economy was therefore here to stay – “secular” means “long term” in this context. Yet he would soon be proved spectacularly wrong as World War II provided a big temporary boost to the economy in the form of military spending, followed by a post-war baby boom and rapid technological progress in the 1950s and 1960s. Little more was heard of secular stagnation until Larry Summers’ intervention.
At the core of the theory today is real interest rates. This refers to the long-term interest rate, meaning the rate of return on ten-year government bonds, after inflation has been stripped out. For example, if a country’s long-term interest rate is 1% but the rate of inflation is 2.5%, the real interest rate is -1.5%.
When you take a global average of real interest rates from different countries, my own research shows that the global rate has declined from more than 5% in the early 1980s to below 0% after the financial crisis of 2007-09. Today, real interest rates remain negative in many advanced economies, including Japan, Sweden, Switzerland and the entire eurozone.
Summers has pointed to several structural factors behind this long-term decline. In an echo of what appeared true in 1938, rich countries are ageing as birth rates decline and people live longer. This has pushed down real interest rates because investors think these trends will mean they will make lower returns from investing in future, making them more willing to accept a lower return on government debt as a result.
Other factors that make investors similarly pessimistic include rising global inequality and the slowdown in productivity growth. It is a major paradox that labour productivity, the most important source of long-run economic growth, is actually rising much slower today than for decades, even though technological progress has seemingly accelerated.
This decline in real interest rates matters because economists believe that to overcome an economic downturn, a central bank must drive down the real interest rate to a certain level to encourage more spending and investment. This is referred to as the level required to reach full employment. Because real interest rates are so low, Summers and his supporters believe that the rate required to reach full employment is so far into negative territory that it is effectively impossible.
Summers argues that this problem is why the massive cuts to headline interest rates after the financial crisis did not solve the problem. In other words, monetary policy was actually much less expansionary than many people believe (even though quantitative easing was actually helpful here). Not only that, there is now substantial evidence that austerity policies in places like southern Europe made things significantly worse.
The upshot is that in the eurozone and elsewhere, there is little or no room to cut interest rates when the next recession comes – probably fairly soon given the current expansion is already a few years old. Central bankers will meanwhile be wary of using more quantitative easing, since it has generated a lot of political backlash.
So what to do instead? Interestingly, the one country not to have had a recession in almost 30 years is Australia, which has enjoyed very high population growth and has never seen interest rates as low as many countries. This suggests that in the long run, more immigration might be a vital part of curing secular stagnation. Summers also heavily prescribes increased government spending, arguing that it might actually be more prudent than cutting back – especially if the money is spent on infrastructure, education and research and development.
Of course, governments in Europe and the US are instead trying to shut their doors to migrants. And austerity policies have taken their toll on infrastructure and public research. This looks set to ensure that the next recession will be particularly nasty when it comes. Alvin Hansen may have been wrong in the 1930s but his analysis is looking increasingly persuasive today. Unless governments change course radically, we could be in for a sobering period ahead.