Secular Stagnation & Economic Policy

A good rule of thumb when looking at the UK economy is that ‘any speech or article by the Bank of England’s Chief Economist Andy Haldane is worth reading’.

2012’s “The Dog and the Frisbee” speech on financial regulation or his LRB article on banking equity, “The Doom Loop” are two excellent examples.

And last year his speech on the “Twin Peaks” of a UK economy ‘writhing in both agony and ecstasy”, was not only a great read but provided the excuse to make one my favourite Newsnight films.

Last night he gave a speech on economic growth. As usual it is worth reading in full.

At the core of the speech was the notion of ‘secular stagnation’. That’s an old macroeconomic idea which has once again become fashionable. Simply put, a belief that growth has fundamentally slowed.

To understand why this debate is happening — one needs to look no further than this Larry Summers chart from last August.

The question of whether or not the advanced Western economies are suffering from this affliction is one the biggest in modern macroeconomics. But this isn’t just a dry, theoretical debate — it has important real world policy consequences.

The Conservatives and Labour are going into this election with radically different fiscal plans. The Conservatives want to eliminate the entire deficit and run a surplus, Labour only want to balance the current budget and could still borrow for capital spending. That’s a difference of around £25–30bn. There are of course many reasons for this fundamental difference in fiscal stance, but one of them is a different underlying view on secular stagnation.

George Osborne has repeatedly rejected the notion. Ed Balls was the co-chair of a commission which reported last month and took the idea very seriously indeed.

Now, I very much doubt that we’ll be hearing the words ‘secular stagnation’ much in the election campaign, but the divergent views on this certainly give theoretical underpinning to the parties plans.

Before proceeding, it is worth being clear on what exactly is at issue.

The original secular stagnation hypothesis was associated with the US Keynesian economist Alvin Hansen in the late 1930s.

The idea was revived by former US Treasury Secretary Larry Summers in late 2013.

Last August Vox published an ebook with chapters written by a veritable who’s who of prominent macroeconomists discussing the theory.

In economic parlance, the editors of that collection define secular stagnation as follows:

First, a workable definition of secular stagnation is that negative real interest rates are needed to equate saving and investment with full employment.
Second, the key worry is that secular stagnation makes it much harder to achieve full employment with low inflation and a zero lower bound (ZLB) on policy interest rates

Translated from economese; the first point is that the level of investment required to generate full employment and fuller usage of economic resources can only be achieved with borrowing costs that are negative in real terms (i.e. after accounting for inflation).

The second is that if (as now) inflation is low and interest rates are already near zero in nominal terms, the real rates cannot be cut low enough to generate the investment required to produce full employment.

If we have secular stagnation, then the economy is stuck in a state whereby growth will be weak.

Larry Summers then takes the analysis one step further and adds a layer of worry about financial stability. He argues that holding real interest rates at levels low enough to try and generate the necessary investment to drive employment could cause an increase in risk taking and put the financial system in danger.

The really simple version is that growth has become reliant on a series of bubbles in assets prices — tech stocks in the 1990s, housing in the 2000s. The choice appears to be ‘dangerous and unsustainable bubble’ or ‘weak growth’. That isn’t a pleasant choice for policy makers.

It is worth noting that secular stagnation as an idea is distinct from the work of scholar’s like Robert Gordon and Tyler Cowen. Both of those sound similarly pessimistic on growth and their arguments are fundamentally about the supply side of the economy, a belief that technological progress has slowed and the ‘low hanging fruit’ that drives living standards higher has mainly been consumed.

By contrast, secular stagnation is more usually described as being firmly rooted on the demand side.

The straight forward policy call that comes from a view that we in a state of secular stagnation is for more government deficit spending, especially on infrastructure. A structural shortfall in aggregate demand can be met with borrowing financed spending (and the other factors at play — a high desired rate of saving — means there will be already market to purchase the newly issued debt).

But to say that secular stagnation is just about a lack of demand and that the appropriate response is simply to increase public spending is to not do justice to the theory.

To understand Larry Summers’ concern about secular stagnation and his desired policy response, one has to understand his explanation of what has driven the rate of interest required to generate full employment down to negative levels.

In his chapter in the Vox collection he lists slower population growth and possibly slower growth in technology (these two factors were the ones emphasised by Hansen in 1938), lower prices for capital goods, problems in the credit system, the behaviour of central banks and ongoing disinflation.

Summers though is not a one trick pony just calling for more fiscal stimulus. He also suggests raising the inflation target of central banks to give more room for negative real rates (it’s easier to have a negative real rate of interest with inflation at 5% than at 2%). And more broadly he has written about:

Appropriate strategies will vary from country to country and situation to situation. But they should include increased public investment, reductions in structural barriers to private investment and measures to promote business confidence, a commitment to maintain basic social protections so as to maintain spending power, and measures to reduce inequality and so redistribute income towards those with a higher propensity to spend.

This isn’t standard Keynesian macro — shortfall in demand, boost demand through government spending — but a hypothesis that things have changed in the structure of the economy that requires a wider ranging response. Many of Summers’ drivers of secular stagnation have counterparts in the work of Gordon and Cowen.

All of which takes us back to Haldane’s speech.

It contains this, rather striking, chart:

It is very hard to look at that take off in growth and living standards in the 1800s and conclude that it was driven by “better economic policy”. On straight forward explanation is technology — and if this was the case, long run macroeconomics would be relatively straightforward — just wait for the next wave of innovation.

Haldane though points to an alternative theory:

The factors driving growth are multiple, not singular. They are as much sociological as technological — skills and education, culture and cooperation, institutions and infrastructure. These factors are mutually-supporting, not exogenous and idiosyncratic. And they build in a cumulative, evolutionary fashion, rather than spontaneously combusting.

Turning to the future, Haldane notes that:

Today’s great debate is where next for growth. The sunny uplands of innovation-led growth, as after the Industrial Revolution? Or the foggy lowlands of stagnant growth, as before it? Which of the secular forces — innovation versus stagnation — will dominate?

As befits the Chief Economist of the Bank of England, his answer is measured.

I want to argue, in a typically two-handed economist way, that both sides of this argument are right. There are good grounds for believing technological forces are driving innovation and hence growth, in a classic Neo-Classical cycle. But there are equally-good grounds for believing sociological forces are retarding growth, in an endogenous-growth pattern.

In other words a new wave of technological change may be breaking — one that has the potential to drive living standards and growth much higher, but there are also factors that could be termed ‘sociological’ (Haldane’s preferred term) or to do with ‘political economy’, that could hold this back.

He lists the ‘secular headwinds’ to growth as inequality, human capital, short-termism and poor infrastructure.

Haldane’s essential point is that:

Growth is a gift. Yet contrary to popular perceptions, it has not always kept on giving. Despite centuries of experience, the raw ingredients of growth remain something of a mystery. As best we can tell historically, they have been a complex mix of the sociological and the technological, typically acting in harmony

The question “are we in a state of secular stagnation?” is easy to ask but difficult to answer. The mundane and boring (but probably most accurate) answer is “it’s too early to say”. The broad trends in world interest rates pointed to by those such as Summers certainly support it. But a few decent years of growth that aren’t accompanied by any sort of financial bubble could easily disprove it.

When Alvin Hansen first broached the topic eight decades ago, many people took it seriously. He turned out to be wrong.

Whatever concludes on secular stagnation, the worries of those like Summers and IMF Chief Economist Olivier Blanchard, should certainly be taken seriously. Especially when viewed in conjunction with the fears of Gordon, Cowen and Haldane’s balanced take.

What I think can be said at this point — if what we are really interested in is not growth or the next year or two but in the longer term — is that the close association of fiscal stimulus and secular stagnation in much of the debate, has become actively unhelpful.

Summers’ wider list of policies to increase investment, actually tie in neatly with Haldane’s concern for the ‘sociological’ factors at play.

If we are considering a future of ‘secular stagnation’ or ‘secular innovation’, then the ultimate destination will not be termed by the size of deficit spending or the level of central bank interest rates alone.

Haldane’s speech places economic growth in the long run in its proper place- firmly rooted in sociological factors and institutions.

Indeed, for all the attention that will heaped upon the different parties’ spending plans in the weeks ahead, it’s the wider range of economic policy (the kind of thing outlined here by Osborne and here by Miliband) that will have more impact in the long run.

If nothing else, the whole debate on secular stagnation is a useful reminder that there is much more to economic policy than tax, public spending and interest rates.