I’ve heard the arguments that secular stagnation refers to a situation with low long-term interest rates – reaching the zero lower bound on nominal rate often – low inflation and low output growth. But what does this really mean?
The term “secular stagnation” was introduced by Alvin Hansen in 1938 and revived by Larry Summers in his speech at IMF in 2013.
A lot of threads are tied together when discussing these ideas, but my understanding is as follows. An economy in a secular stagnation suffers from insufficient demand for goods and services at an interest rate of zero. Nominal interest rates below zero are necessary to ensure that factors of production are fully utilised, however it is not possible (or perhaps technically or politically feasible) to do this.
As a result, government policies that would normally be accused of driving up interest rates could be used to drive up demand.
Causes of secular stagnation
At face value this sounds a bit like a free lunch – there are resources that are unused, and the government can decide to spend and use them. So what are some of the reasons that have been posited that may allow for this?
- Ageing population,
- low productivity growth/expected future growth,
- technological advancement,
- income inequality
- and surge in the digital economy.
That is not to say that these are the causes – that deserves a post of its own. But if there are reasons, why do we care?
Why is it a concern?
When we are stuck in a situation like secular stagnation – where insufficient demand persists for a long time – it becomes a concern for a wider economy. Two ways I like to think about this are:
- Multiple equilibria concern – due to expectations the economy can be trapped in a low output equilibrium which is Pareto inferior.
- Hysteresis concern – when a negative demand shock happens in a short-term, it will have enduring effect in long-run. For instance, a negative labour demand shock can impact economy detrimentally in long-run due to the loss of the skills.
Larry Summers argues that conventional monetary policy is weak to cope with this situation, and proposes to use alternative unconventional monetary policy tools such as fiscal policy stimulus to raise demand. (https://www.brookings.edu/wp-content/uploads/2019/03/On-Falling-Neutral-Real-Rates-Fiscal-Policy-and-the-Risk-of-Secular-Stagnation.pdf)
“Policymakers going forward will need to engage in some combination of greater tolerance of budget deficits, unconventional monetary policies and structural measures to promote private investment and absorb private saving if full employment is to be maintained and inflation targets are to be hit”
We need to be careful with the hypothesis of secular stagnation
There are two completely different hypotheses standing behind the secular stagnation issue.
- The neutral rate has fallen. Here we are saying that the natural interest rate is lower and long-term growth is lower.
- An earlier large shock threw the economy out of whack. Here we are stuck in a “sunspot” where low growth expectations are self-reinforcing, keeping interest rates lower.
Before rushing into diagnosis, we need to carefully consider which hypothesis we strongly believe in causation of secular stagnation.
The first hypothesis is saying that we have reached our limits, and economy cannot do anything else, and we should just accept a new level of lower economic growth. This is what Hansen was talking about prior to the WWII, which proved that he was actually wrong. Post-war and post-great depression economy has shown tremendous booms and a different level of economic capacity.
The second hypothesis allows us to think of possible alternative solutions central banks could think of in order to pull economy out of the low rate trap.
One issue with secular stagnation as it is framed is that “persistent insufficient demand” is a poorly defined concept – and at some point the new normal of lower growth is accepted as truth. However, as the failure of this hypothesis in the 1940s and 1950s indicates large economic shocks can create sunspots – and if that is what has happened then more active government provides a solution.
Although I have huge respect for Summers, in this way it feels like Larry wants to have his cake and eat it too – simultaneously claiming that there are real reasons why growth is low, but then suggesting there could be a scope for activist fiscal policy. By saying both it is hard to ever be wrong, but it is also hard to develop appropriate policy.