Our Next Economic Challenge

Economics is a subject that’s simultaneously incredibly important to our society, but also wrapped in a substantial amount of unhelpful rhetoric and general gobbledygook. It’s so bad that discussions about the state of the economy and economic theory often don’t seem relevant to a great deal of understandably disinterested people — but that all changed in 2008.

The veracity of the media coverage surrounding the 2008 financial crisis combined with the scale of government responses created a pervasive feeling in developed economies that even a high school student could understand: the bubble had popped and the house had come crashing down.

It would be a while until we fully understood just how close to a literal interpretation of actual events that was, or how dubious the financial practices that led to it were. But one thing is now clear; the economic crisis of 2008 wasn't a splash in the pond, it was a tsunami that the developed world still hasn't completely recovered from.

More than half a decade after the 2008 crisis, some economists are arguing that episodes like the GFC are merely symptoms caused by a far more insidious problem that’s been lurking beneath the surface of our economic discourse all along — secular stagnation.

Introducing Secular Stagnation

So just what is secular stagnation? Well, the good news is that there isn't a tide of religious apathy weighing on the global economy. The bad news? Many developed economies are suffering from long-term (secular) decreasing growth rates (stagnation) stemming from underlying changes in the economy that are as broad as demographic shifts and demand shortfalls.

But first some background:

Secular stagnation was originally theorized in the late 1930s by US economist Alvin Hansen in an attempt to describe the state of the American economy after the Great Depression. But it was quickly sidelined as WW2 began to kick the US economy back into shape. However, in more recent times the theory of secular stagnation has made its way back into the lexicon of economists.

It started with a 2013 speech at the IMF delivered by former World Bank chief Larry Summers. In what has since become a famous address, Professor Summers argued that much of the developed world was experiencing secular stagnation, and that developed economies have relied on bubbles (which aren't stable) to achieve substantive growth over the last 15–20 years.

To say this kicked up a fuss in the ivory tower of macro-economics would be an understatement.

Secular stagnation has become the topic of a long-form debate between some of the most influential macro economists in the world, including Nobel Prize winner Paul Krugman and former Federal Reserve chairman Ben Bernanke.

This incredibly public discussion has been extremely positive for the field of economics (think of it as an economists equivalent of a heavy weight showdown). But whether as a result of the inherent technicality of the issue or its long term focus in a world of short term politics; secular stagnation has been largely absent from the political agenda in developed states — particularly in Australia.

This is problematic because secular stagnation is hardly an issue for economists to toss around in the academic arena. Politicians may shudder at the thought of uttering the word ‘stagnation’ in an election speech, but this problem may have some all too real consequences for the long term prosperity of the developed world.

Growth & Developed Economies

Underpinning the theory of secular stagnation as an important issue facing developed economies is the idea that economic growth, that is to say, an annual increase in real (corrected for inflation) Gross Domestic Product (GDP) is desirable.

GDP is a measure of total production in a given economy and so it stands to reason that higher real GDP rates generally translate to better material conditions and economic opportunities for society in general.

The current Governor of The Reserve Bank of Australia, Glenn Stevens, summed up the importance of growth extremely well earlier this year:

“Raising the economy’s potential isn't just some esoteric concern for economists, or at least it shouldn't be. Our collective ability to deliver social policy outcomes, to enjoy the benefits of a ‘good society’, or at a more basic level to provide public services and even to defend ourselves, ultimately rests on a productive economy”

Furthermore, we know that GDP per capita (PPP) is correlated strongly with a number of important statistical indicators for a“good society”. These include (but aren't limited to): higher life expectancies, lower infant mortality rates and lower poverty rates.

Below is the annual GDP growth for a group of developed economies (including Australia) from 1960–2014.

Sources: ABS, World Bank

Declining Economies & Excess Saving

How bad is it? Well, it’s actually pretty difficult to tell, but as you can see above; GDP growth in a number of developed countries has been in decline for some time. It’s worse in some cases than others, for instance Australia has historically been a substantial outlier (see 2007–08) largely due to our primary resource exports. However, the commodities boom is waning and the most recent data points show Australia coming in line with the rest of the developed world.

As with most things it’s much easier to get an idea of what’s actually going on by looking at multiple factors simultaneously. With that in mind, below is a representation of saving in Australia that depicts the prevalence of saving before and after the Global Financial Crisis.

Sources: ABS, RBA

Professor Summer’s 2013 thesis comes into focus here, as he attempts to deal directly with the causes of this economic slowdown by suggesting that:

“there may be a chronic structural mismatch between the proclivity of people to save and the desire for those savings to be translated into investment.”

In other words, Professor Summers is saying that some developed economies may be experiencing a savings glut, where economic actors are holding money rather than putting it back into the economy to drive growth.

For instance, if we consider the balance of aggregate investment and saving in the economy to represent an equilibrium point where full employment is achieved, then a situation whereby there is more saving than investment (disequilibrium) would be one in which the economy isn't operating at capacity and is thus less productive than it could be.

Full employment is essentially a situation whereby everyone in a given economy who wants to work has work. Economists can’t agree about what level of unemployment represents full employment, but most estimates place the value from anywhere between 2–7%. Crucially, full employment isn't the same as 0% unemployment because of frictional factors such as (but not limited to) people moving between jobs.

Full employment is important because the under-utilisation of human capital represents a significant loss in potential productivity (unused capacity).This is why economists use the concept of full employment as a standard that represents an ideal economic situation.

Open market operations are far from an exact science!

Monetary Policy

There are two primary policy mechanisms by which this disequilibrium can be combated: monetary policy and fiscal policy. The former involves a central bank (in Australia’s case the Reserve Bank) setting the interest rate in a process called open market operations.

According to Professor Summers, monetary policy attempts to simultaneously achieve three things:

· Adequate economic growth (GDP)

· Capacity utilization (full employment)

· Financial stability (doing the first two in a sustainable manner)

In other words, according to Professor Summers, open market operations involve adjusting the interest rate so that aggregate debt and credit (saving and investment) exist in a state of equilibrium where full employment is achieved.

For instance, a central bank may lower the nominal interest rate by increasing the supply of money in the economy in order to stimulate investment and bring about equilibrium.

Following the Global Financial Crisis, central banks around the world slashed interest rates (below) in an attempt to drive growth and avoid worsening the effects of the recession. But more than half a decade after the crisis interest rates are still low, and output (GDP)isn't responding very well. Which begs the question: why is monetary policy seemingly less effective in the post GFC world?

Central banks around the world slashed interest rates following the GFC. Source: actionforex.com

The Zero Lower Bound

To understand Summer’s argument consider an economic situation whereby savings and investment are in equilibrium and full employment has been achieved (that is to say that, everyone in the economy who wants to work is working). If we accept that interest rates are fundamentally tied to the balance of investment and saving, then it stands to reason that there is a “natural” rate of interest that corresponds to this equilibrium.

The goal of monetary policy is then to engage in open market operations in an effort to push the economy towards that natural rate of interest (where the economy is at full employment). But suppose that the natural rate of interest is actually negative.

If this is the case, then what’s known as the zero lower bound on interest rates comes into effect.

The idea is that as interest rates approach 0 (or some level close to 0) the relative ability of monetary policy to stimulate inflation (and thus growth) diminishes. This is also known as a liquidity trap and it’s reminiscent of Japan's ongoing deflation crisis.

A visual representation of a liquidity trap

There are still serious disagreements about economists about the effectiveness of monetary policy, the nature of interest rates, and the mechanics of monetary policy. But as Professor Summer’s points out; it’s at least an open question as to whether or not central banks can successfully hit targeted inflation rates (thus stimulating growth).

So, in summary: If the natural rate of interest is negative, monetary policy may be unable to stimulate demand.

Demographics — We’re Getting Old

The second cause that underpins secular stagnation aside from a shortfall in demand is the nature of demographics in developed economies.

First consider this: if GDP is a measure of overall output in a given economy then there must also be input (the “we don’t pull stuff out of thin air” theory). There are numerous inputs that flow into a given economy, but of all those inputs the most important one (especially for developed economies) is its people. So the productivity of this human capital is thus of immense importance to growth.

The problem, at least from the purview of secular stagnation, is frankly that the population in many developed economies is ageing. That’s right — the baby boomers are getting old.

The Economist explained this point very well:

“Economic growth consists of having more workers and making them work more efficiently. Even if one is [optimistic] about technological change … productivity will have to work very hard indeed to offset demography.”

The Economist was referring to data on the US, UK, Germany, France, Italy and Japan; however the Australian data tells a similar story. Below is a projection of Australian population growth indices by age group.

Source: Australian Treasury

The 2015 inter-generational report published by the federal treasury predicts that proportion of the population aged over 65 will double in the next 40 years to about 25 per cent of the overall populous (above). The cause can be drawn back to a mix of longer life expectancies and a lower fertility rate — which has been below the replacement rate since the mid 1970s.

So unless we find a way to reverse ageing in the next 30 years the productivity of Australia’s human capital is certainly at risk and may continue to be a detriment to our economic prosperity.

Fiscal Policy — The Keynesian solution

What do you do when the wrinkles are starting to show and monetary policy has lost its zing? Well, to put it simply: you load a large fiscal cannon and shoot it at the economy (repeatedly if needed).

Professor Summer uses less emotive terms, but certainly agrees:

If reducing rates to equate saving and investment at full employment is infeasible or likely to lead to financial instability, fiscal policy in general and public investment in particular is a natural instrument to promote growth.”

One way to stimulate growth using fiscal policy is the creation of new infrastructure and the improvement of existing capital in the economy. Which essentially means building stuff (think public transport networks, roads and fibre optic internet lines).

These things come with a fairly substantial price tag attached, and would thus need to be serviced by an increase in public debt.

Thus, understanding this solution requires accepting the economic truism that debt isn't always bad, and with it the acknowledgement that the macro economy doesn't follow the same rules as our personal finances.

For instance (as was touched on earlier) one persons spending in the economy is another persons income, and so sustaining a situation whereby the flow of spending and investment in the economy slows (a shortfall of demand) is actually incredibly harmful to overall economic prospects.

Some economists take it further and argue that currency issuing governments are able to reach and maintain full employment through a process of fiscal stimulus financed by a rolling public deficit.

It’s often accepted (to varying degrees) amongst economists that simply printing money to finance fiscal schemes is inflationary,which is to say that it will devalue the currency. But some theorists argue that printing money to finance fiscal stimulus is only inflationary if the given economy undermines its supply capacity (its ability to produce stuff). Thus, because the government issues its own currency, it can effectively never run out of money.

This might seem like one of those “too good to be true” scenarios, but all this suggestion means is that the economy is constrained by its real capacity rather than financial factors, and so deciding not to utilize those real factors is a choice rather than a constraint.

One way the government could achieve full employment, according to Professor Bill Mitchell of Newcastle University, is to create a “job guarantee program” whereby the government would purchase excess labour from the private sector when it wasn't in demand and sell it back to the private sector as needed.

“If there’s too much labour without a job the government can buy all that stock up at a fixed price … When the private sector resumes its strength after a downturn then because its been at a fixed price -and you would set the price at the bottom of the private sector wage structure- the private sector can then buy that labour back any time it wants if it offers the right terms and conditions,” suggests Professor Mitchell.

In other words, the “we need to balance the budget” rhetoric that’s become the standard for economic discourse in Australia is long overdue a trip to the graveyard of terrible ideas.

The notion that we need to avoid going into substantial debt so as to avoid leaving future generations with a “crushing burden” is an exercise in moral hypocrisy.

If our goal is to leave future generations with the best possible economic situation, then our primary focus should be on stimulating the economy with a sizeable fiscal cannon so that our children’s children aren't born into the economic equivalent of an ice age.

If there’s one thing that we can learn from the musings of Professor Summers and from what the data tells us about our economic situation, it’s that we desperately need to overcome the notion that frugality is a wise economic decision. It’s time to go on a spending spree.