A Lingering Crisis
Ten years ago, as the Great Recession drew to a close, the consensus among experts was that the losses incurred during the crisis would be absorbed quickly during a short period of strong recovery. In this, they were, no doubt, influenced by Kenneth Rogoff, who had just published a masterly study of the many financial crises since the Second World War. The greater the recession, Rogoff concluded, the stronger the recovery that followed.1 Nobody doubted that the same pattern would be repeated.....MUCH MORE
The recovery never arrived—not really. Growth has been positive but sluggish. During the eight years following the end of the recession, the average US growth rate was reduced by half. In Europe, aside from Germany, the GDP of the eurozone only returned to its 2007 level in 2016, nine years after the start of the crisis; the US required six years.
A comparison to the 1930s is even more telling. Despite the extent of the decline in European production during the Great Depression, 1929 levels were regained by 1935. In the US, the rate of recovery between 1933 and 1941 was twice that of the last eight years. From this point of view, the period following the most recent crisis should be seen as a quasi-stagnation, a breakdown of sorts, or even, at worst, a latent depression.
The Origins of Secular Stagnation
In 2011 and again at the end of 2014, American observers believed that the long-awaited recovery was finally underway. They were disappointed. Growth proved to be short-lived. If growth proved short-lived, not so optimism. The US media relies on the unemployment rate, currently at historically low levels, as the basis for believing in the possibility of a return to full employment. If so, there should be tell-tale signs of acceleration across a variety of indicators for more than a few exceptional quarters. This is not what has been observed. On the contrary, all the evidence suggests that what is taking place now is a third, and weakened, repetition of what has already happened twice.2
Why do we seem to be stuck in this long period of slow growth?
Lawrence Summers has offered the most popular explanation, appealing to ideas first formulated by Alvin Hansen in the aftermath of the 1937 recession.3 Hansen was largely responsible for popularizing the ideas of John Maynard Keynes, and, as such, is an important, although little-known, figure in the history of economics. Hansen believed the great stagnation of the interwar period was due to an exhaustion of the three main drivers of American growth during the nineteenth century: territorial expansion, population growth, and technological innovation. When economic expansion returned during the 1950s, Hansen’s predictions were quickly forgotten. If Hansen had been mistaken, Summers argued, it had only been because he was several generations ahead of his time.
According to Summers, the single most important economic indicator of the current era is the declining trend in interest rates. Without this decline, nothing that has occurred since 2007 would have taken place. Rates are today close to zero, the result of a process that began in the late 1980s. Although the actions of central banks have played a role in depressing interest rates, three long-term structural factors are of greater importance: an aging population and declining birth rate; increasing income and wealth inequality; and a decline in the relative cost of capital. Although Summers does not mention it directly, there is a fourth factor that should be added to this list: the slowdown in productivity since the 1970s. This has been documented statistically by Robert Gordon, who regards the slowdown as a point in Hansen’s favor.4 These four factors are very much in keeping with the spirit, if not the details, of Hansen’s analysis.
Summers has suggested that this combination of long-term factors has led to a deficit in aggregate demand that is likely to continue beyond the short term. This deficit had long been disguised by an increasing indebtedness among households, businesses, and public authorities. These groups artificially maintained their levels of consumption at the cost of colossal financial imbalances, which made it inevitable that some bubble or other would eventually burst. In theory, changes in interest rates during the crisis should have then led to a reset and a fresh start. As it turned out, the excessively low levels of interest rates effectively neutralized this mechanism. Borrowers kept borrowing.
During the early twentieth century, Knut Wicksell argued for the importance of a natural interest rate. If nothing else, a natural rate would make it possible to define an equilibrium state for the economy corresponding to normal growth. That equilibrium defined, interest rates could be changed, either to slow down the economy, or to revive it. Despite it serving as a compass, of sorts, for monetary policy, we have no empirical means of knowing precisely what a natural interest rate might be. In response to this problem, the central banks have developed rules of thumb for managing rates from inflationary trends. If inflation is increasing, interest rates are too low. Conversely, if inflation is trending downwards and approaching zero, interest rates are too high.
When nominal rates are already close to zero, adjustment mechanisms no longer work. This was the case at the end of the Great Recession, and inflation has continued to decline ever since. If interest rates became negative, economic players would have every incentive to hoard their wealth in cash instead of using it to refinance the economy. This scenario is known as a liquidity trap—the traditional tools of monetary intervention are rendered ineffective in an economy hamstrung by low inflation and lasting stagnation.5
These are the circumstances, Summers is persuaded, into which the developed capitalist economies have gradually settled since the crisis. There is only one possible solution: largescale state intervention in the form of major works and massive public investment in order to boost global demand. The twin perils of the liquidity trap and excessive debt would be overcome by a return to higher rates of inflation. If these policies are not instituted, there is little point hoping for a miracle. The risk of a new and even deeper financial crisis will be ever-present, and the world will have to become accustomed to a new era of slow growth, or secular stagnation. It is this scenario that Summers, along with Paul Krugman and others, feel best reflects the economic breakdown observed since 2008.
The BIS versus Summers
The influence of these ideas can be clearly seen in the medium-term forecasts published by the US Congress Budget Office and the US Federal Reserve Board. The specter of secular stagnation has shaped their vision of the future. Even the venerable Banque de France recently organized a symposium devoted to this theme.6 Nonetheless, this view is the subject of intense controversy among economists, particularly those working at the Bank for International Settlements (BIS) in Basel, the world’s oldest international financial organization.7 The BIS is owned and operated by 60 central banks and monetary authorities....
Last week from Inference Review:
Emanuel Derman: "Trading Volatility"
And previously:
Disease, Famine, Drudgery, Bondage: A Lively Look at the Birth of the Modern
Not that kind of bondage. Not that lively a look, sorry.
Refunds available at the entrance.
"Reviewing Mervyn King's The End of Alchemy: Money, Banking, and the Future of the Global Economy"
"The Euro Is Doomed"
Lo and Behold: Andrew Lo's Adaptive Markets
"The Subjective Statistician"
Review: "The Great Leveler: Violence and the History of Inequality from the Stone Age to the Twenty-First Century"
One Euro, One Europe (One Love)
When France Invented The Internet
Tribes and States: Human Self-Organization
"The Great Transition: Climate, Disease and Society in the Late-Medieval World"
