Are the advanced economies in for a long period of economic stagnation?

by Viva Avasthi

I submitted this essay last month as my entry for the Royal Economic Society's Young Economist of the Year essay competition. I was delighted that the judges (a panel of teachers initially, and then Sir Charles Bean, RES President; Stephanie Flanders from JP Morgan; and Professor Tim Besley of the London School of Economics) thought it deserving of joint third place. I am now sharing it with you and hope that you enjoy reading it. Clicking on each graph will allow you to see it more clearly.

Since submitting the essay, reading this and this provided me with further insights into the 'secular stagnation' argument and other ways in which it might potentially be flawed. Please refer back to this when you reach the relevant point in the essay. I have marked that point with **
In hindsight, perhaps I didn't give enough credit to the ability of technological developments to boost growth, particularly considering how badly the impacts of growth in that sector are reflected in GDP... Unfortunately, the word limit (and the limited amount of time I had to write the essay after exams had finished!) prevented me from exploring a lot of ideas in as great a depth as I would have liked.


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31/07/14

The future: a murky blur of possibilities, problems, and potential shifts in paradigms. Attempting to make sense of our collective experiences in the past and present to make informed predictions about the future is one of the difficult tasks faced by economists across the world. At present the key question haunting economists and leaders of the advanced economies is the one which this essay attempts to answer.


Setting the stage for analysis

Since we are constrained by the word limit, let’s consider the advanced economies to be the US, UK and European economies. Most notably, Japan has been omitted. Several key reasons for this must be condensed into the following: Japan is structurally quite different from the other economies since it has a far stronger manufacturing sector, far better standards of education, and a greater social cohesion. Its prospects seem much brighter than the rest of the advanced economies’ for these reasons. Thus (perhaps rather controversially!) it was felt that there was no need for it to be included in this analysis.

Traditionally, economic stagnation is considered a prolonged period of little or no growth in the economy, often with annual GDP growth of less than 2-3%. High unemployment is generally perceived to accompany this low growth. However, perhaps such GDP growth benchmarks become redundant when one considers that ‘normal’ growth might not actually be normal at all. Pre-crisis levels of GDP growth can be described as being not normal for the entire period between today and the 1980s because of the existence of various bubbles providing artificial boosts and drags on GDP. Even before then, we were living in a world boosted by the massive demand created in the aftermath of the world wars, and so it would be irrelevant to compare the growth levels of today to those of that time. So perhaps measuring economic stagnation by looking at GDP growth alone doesn’t make much sense.

To measure economic stagnation we must consider what we value as important for an economy: growth levels in themselves, or standards of living, equality and sustainability of growth? A better measure of economic stagnation than GDP growth may be real median income levels. With 95% of the increase in American income since 2009 having gone to the top 1% (Saez and Piketty, 2012), it is clear that just looking at GDP growth can cause issues, since the sort of growth occurring does not benefit the economy as a whole. More suitable measures, perhaps, are unemployment levels (accounting for those who have given up actively seeking work), investment levels and productivity levels. 

The secular stagnation argument

As economists we might try to look back at history to provide us with some idea of what to expect for the future. Lawrence Summers (2013) recently looked back to the ideas of Alvin Hansen (1939) who argued that the end of the Great Depression would mark the start of a future of ‘secular stagnation’. Hansen wrote: "This is the essence of secular stagnation – sick recoveries which die in their infancy and depressions which feed on themselves and leave a hard and seemingly immovable core of unemployment." He feared that future investment levels would be poor because he thought that: the US’s invention engine had run out of steam; the population would decrease as fertility reduced; and the US was highly unlikely to discover new territories or new resources. Hansen turned out to be spectacularly wrong. The baby-boom years followed the War, technological development was phenomenal during the 30s, and in 1941 the US economy produced almost 40% more output than it had in 1929.

Summers looks at things slightly differently. According to him the advanced economies are in a secular stagnation situation where the natural real rate of interest (i.e. the rate at which desired savings and desired investment would be equal at full employment) is pretty much permanently negative, and has declined over time (see Fig. 1), but central banks have been and still are constrained by the zero lower bound. He argues that it’s only through the creation of bubbles that the natural real rate of interest is raised from negative levels. This explains why the advanced economies have had trouble in maintaining full employment, strong growth and financial stability simultaneously since the 1980s.

But what’s the link between Hansen and Summers’ ideas? The ageing population argument. When the US economy was last able to sustain full employment without bubbles, during the period from 1960-85, the US labour force grew 2.1% annually, on average. Looking forward, the working population is expected to grow at an annual rate of just 0.2% between 2015 and 2025. Thus, linking to Hansen’s point, sustaining investment will be difficult in the future, considering the accelerator effect. In support of Summers’ natural real rate of interest theory is the Samuelson consumption-loan model (1958) which suggests that the natural rate of interest equals the rate of population growth. Although the model seems a tad over-simplified, the general connection seems to make sense, in which case Hansen’s factor of decline in population growth will affect the natural rate of interest in the way Summers expects.

This idea of a declining natural rate of interest is a fascinating one, but one which others seem to have accepted far too readily. One wonders whether the actions of central banks could have led to this trend emerging artificially. Digging into research reveals that low interest rates may be self-reinforcing and therefore not ‘natural’ (Borio and Disyatat, 2014). Figure 2 indicates how policies which do not tighten against booms, but ease aggressively during busts force a downwards bias in interest rates over time and an upwards bias in debt. This might be considered a sort of "debt trap" which could have serious implications for financial stability in the long term.

Taking this alternative approach into consideration, Summers’ ideas of how secular stagnation may have arisen might be flawed. ** Regardless, the underlying solution to the issues raised is the same: monetary policy should be used very little and the focus needs to be on fiscal and structural policies to improve growth potential in the long term and strengthen demand in the short term. While politicians remain hostile to increasing budget deficits in the short term, however, the risks for the long term seem very real indeed.



Risks from unwinding QE
 
What Andrew Haldane of the Bank of England calls "the single biggest risk to global financial stability" is something too many people ignore when considering the future of the advanced economies. Quantitative easing, that is. Whatever the BofE and Fed might say, QE has no real precedent at all. "But Japan," people often cry, "used QE measures in the 2000s!" The difference, though, is that whereas the US and UK engaged in QE using long-term bonds, Japan largely used short-term ones, so the complications which may arise for Britain and America when they begin to unwind QE are some which never existed for Japan.

The trouble is that the UK and US central banks are now the largest buyers of their own government bonds. This means that it is impossible for them to sell back into the market since, their being the biggest players in the market, if they sold, everybody else would start selling and interest rates would surge. This potentially massive rise in interest rates could make government borrowing more expensive for years to come, impacting long term growth. The alternative, writing these debts off, doesn’t seem feasible either, since that might damage the UK and US’ credibility with international debt markets and so potentially raise borrowing costs for a long time.

Figure 3 indicates how Koo (2013) thinks the tapering of QE will lead to instability in the long term. Initially, long term interest rates fall much further than they would in a country without a QE policy, leading to a faster economic recovery. However, as the economy picks up, local bond markets anticipate the central bank will unload its holdings of long-term bonds, so long-term rates rise sharply. Demand then falls in sectors sensitive to interest rates, such as housing, leading to an economic slowdown and forcing the central bank to relax its policy stance. Again, the market heads towards recovery but again, the market fears that the central bank will absorb excess reserves, and so the long-term rates surge in a cycle Koo calls the QE "trap". Unfortunately, Koo’s analysis seems to make an awful lot of sense, and, despite much pondering, not a single solution springs to mind, at least, not at the moment…

Therefore, QE (which will have to be wound down at some point to prevent the risk of massive inflation once liquidity eventually enters the economy) clearly provides a significant threat to the long-term recovery of the advanced economies. But by exacerbating the already existing issues of inequality, it provides further risks…


 Inequality bites economies where it hurts 
 
Stan Druckenmiller (2013) called QE "the biggest redistribution of wealth from the middle class and poor to the rich ever". But how much of a problem is inequality for an economy in the long-term? A recent (2014) paper by some IMF economists draws some fascinating conclusions. It appears that inequality functions as a significant determinant not only of the pace of medium-term growth, but also of its duration. More surprisingly (or not, depending on your previous knowledge!), redistribution measures, which many on the right of the political spectrum argue are harmful to growth, apparently only have direct negative impacts on growth in extreme cases.

What should we take from this? Consider Figure 4. It shows that inequality has been on the rise for some of the key advanced economies and that even after the financial crisis, it looks set to grow. Tying this in with the conclusions drawn by the IMF report, inequality seems to be a considerable threat to long-term economic prospects. It is one which governments should seriously aim to tackle to ensure the welfare of their people and economies. One slightly radical long-term approach might be for governments to equip badly performing schools with the tools to incentivise students to pay better attention during lessons. This might be through liaising with theme parks and offering well-behaving or high-achieving students free tickets to such places. The idea behind this would be that by paying closer attention in lessons, students might come to realise how fascinating the topics taught at school actually are, and educational attainment levels might increase. Perhaps using ideas from behavioural economics more commonly could allow governments to find better, smarter solutions to the issues they face.


The spectre of hysteresis
  
What about the long-term effects of the financial crisis? As Figure 5.1 indicates, potential output for most countries is far below pre-crisis trends: 11% below for Britain and 4.7% below in America. The chart seems to suggest serious structural issues at play, particularly in the Eurozone, which might be fixed through massive increases in investment and immense structural reform. One reform of the Maastricht Treaty which ought to be pushed is allowing European countries’ deficit to GDP ratio to be increased from the current 3% limit when they are in serious recessions. This would potentially allow individual countries to stabilise their economies without having to turn to the ECB for help.

Looking at Figure 5B, the biggest problem going forward for the US seems to be labour-force participation, and a third of this drag is due to ageing (Hall, 2014). In addition, the US and the other advanced economies face the issue of providing the long term unemployed (who have now given up searching for jobs, thereby lowering the unemployment figures) with the incentives and skills to try to get back into the labour-force. The severity of the situation is illustrated by the following: if the US unemployment rate were adjusted to include people no longer actively seeking work, it would be over 9%. If it were adjusted to include those working part time involuntarily, it would be over 12% (Stiglitz 2014).

Worse, senior Fed economists argue in a working paper (2013) that fewer businesses are being created and existing ones are spending less on R&D, so productivity could suffer in the long term. Real R&D has grown only 1.6% per year since 2007, compared to 3.6% on average from 1990 to 2007. The fact that R&D investment has reduced at a time when many argue that we aren’t advancing technologically at the pace that we should anyway does not bode well for the future. But to what extent can it really be argued that the advanced economies aren’t doing well in terms of technological developments?


 Technology engine running out of steam?

Some economists (Gordon 2012) and others (Kasparov, Thiel 2012) have argued that technological progress is far more limited today than it was during the industrial period until 1970. While our inventions today might be ‘cool’, they are incomparable in their usefulness and potential to generate employment to the ones of the past. Gordon wrote: "The rapid progress made over the past 250 years could well turn out to be a unique episode in human history". This approach seems to be too pessimistic. It takes time before a new discovery is found which revolutionises technological development, but when that happens, development is very rapid indeed. It could be that robotics, which has really lifted off as an industry recently, with the number of industrial robots sold globally hitting a record high of 179,000 in 2013, will lead the next tech revolution. Frey (2013) predicts that 47% of existing US jobs are at "high risk" from work automation over the next two decades, but agrees that automation will improve people’s livelihoods as companies’ extra revenues will feed back to shareholders and employees, increasing consumer spending and creating more jobs. Rather than worrying about the perceived lack of technological progress, governments might do better to invest in R&D and STEM education to prepare the labour-force for the future.


 Heading into the mire of stagnation
  
Where does our analysis bring us? Almost all the factors we’ve considered seem to suggest a bleak outlook for the advanced economies. Yet sound policy-making has the potential to move us in the right direction. That governments need to step in and stimulate demand in the short-term and make structural improvements for the long term is a given. They also need to consider the importance of microeconomic-level policies in ensuring stable economic environments in which businesses and consumers feel safe to spend. Could the British government, for example, consider imposing a larger tax (maybe of 90-100%) on second homes which aren’t being rented out, but have only been bought to accumulate wealth because people are speculating that property prices will rise? Though it is probably politically unfeasible, it could do a great deal to stabilise the housing market and the economy as a whole. With serious economic reform not on the horizon, though, the advanced economies seem to be headed towards a not-too-bright future.



Bibliography and references:
 
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