Secular stagnation: the curse that still haunts developed economies

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The financial crash of ten years ago was something of a paradox for conventional economists. It took most of them by surprise, and dented their reputation. And yet economists became more important than ever to the running of our world. But now, to listen to most of them, the equivocation is over. We’re back to normal, as the global economy looks in much better shape. This looks complacent.

The crash was a double shock to economists. The first was how it happened at all, when most economies seemed to be purring on at a relatively steady rate of growth (often referred to as the trend rate), which seemed to relate to growing productivity, and which most economists, driving through the rear-view mirror, assumed to be a law of nature. The second shock was that developed world economies, especially the British one, were so slow to recover. Economists  simply assumed that with a bit of stimulus, economies would not just return to trend growth, but make up for lost ground too. I don’t think any advanced economy has done this – and in Britain we lag far behind. In the years after the crash an expression was coined, or rather resurrected, to describe this second problem: secular stagnation.

The person whose name is most attached to this is Lawrence Summers, who had been prominent in the Clinton administration. By it he meant that economies could only achieve growth by extraordinary and unsustainable efforts to stimulate it. And, as Mr Summers recently pointed out in the FT, you cannot say that it has disappeared. Growth has returned, but the measures required to produce it are unsustainable. What he is referring to is the extraordinarily low interest rates prevailing in the developed world.

This has been going on for so long that we have become accustomed to it. But what do negative real interest rates mean? They mean that in order to use up available savings we have to create investments that have little or no financial return. Now that is at the margin, not on average, but even so it does not suggest an economy that is at all healthy. If investments don’t produce a return, productivity will not advance, and growth will not be sustained. And in particular we will accumulate debt that cannot be paid off. Or not without inflation which destroys the accumulated wealth of the middle classes. And sure enough, many economists are warning us about mounting debt levels. In due course this will lead to a financial crisis.

Why are we in this situation? And what can we do? There are many speculations as to why, and most commentators, including me, tend to gravitate towards the one that suits their overarching narrative. Many blame a skewed distribution of income for creating a surplus of savings that cannot be used properly. Others say that modern businesses don’t need so much traditional capital (Google doesn’t need to issue debt or share capital to keep its investments going). Then there is the gradual ageing of the population reducing the size of the workforce. Others blame the wrong sort of stimulus – if only government spending hadn’t been cut back (“austerity”), we’d have bounced back in no time. My favourite is the Baumol effect which suggests that we are in a transition towards industries, like healthcare, that are less financially productive, though still improve human wellbeing. Whatever it is (and it could be all at once) it’s a problem because it is dragging down the potential growth rate.

And what can we do? People often talk of unconventional policies, but what are they? The most interesting idea is  to run up bigger government budget deficits. Piling up government debt is much safer than piling up private debt, as we are doing now. Why? Because governments can finance that debt by a process that is usually referred to as creating money, and the burden can be shared more equitably.

But piling up debt and creating money often ends in tears. The best current example of that is Argentina, with rampant inflation and impatient foreign creditors. The problem for Argentina is that its monetary system has been mismanaged for so long that much borrowing, public and private, has to be in foreign currency, which the central bank cannot create. But there is an opposite example. Japan has been piling up public debt for decades, and the central bank has been buying up debt, with few apparent ill-effects.

So how do you know whether you are Japan or Argentina (and no doubt Argentina looked like Japan once)? The first, obvious, difference is that Argentina has had a current account deficit for some time, while Japan has generally been in surplus. That means that Argentina is importing more than it exports and requires financing by foreigners – who are less likely to be happy to take payment in domestic currency. Current account deficits usually flow from budget deficits – though not always, as the recent crisis in Spain showed. That would be a bad sign for countries like Britain that also have a current account deficit. But Britain’s standing in international markets looks a lot more like Japan’s than Argentina’s. The government has no trouble in borrowing in sterling, and the same goes for most British businesses.

So why are we in Britain so worried about budget deficits and debt? One explanation is that we have been persuaded into this view by malign political forces who use the analogy of household financial management to make their case. But there are deeper worries. The first is how do you tell when you have gone far enough with budget deficits and need to stop? The traditional economists’ answer is when inflation starts to take hold. But it might be too late by then, and anyway it is not so clear that in a modern, globalised economy inflation works in quite the way economists think. You know it is too latewhen there is a rush of people trying to change domestic currency into foreign, creating a panic and to people, including the government, having to borrow in foreign currency. That can happen without inflation.

The problem behind that is the politics of it. Opening up the possibility of more government spending is a huge boost to the power of central government politicians, who do not have strong incentives to apply the brakes when they need to – any more than those bankers did before the crash of 2008. It is too easy to believe your own hubris. I think this happened to the Labour government in the mid 2000s when the government should have started to tighten spending but decided not to. This didn’t cause the financial crisis, but made it harder than it should have been to manage. Even now, though, it is impossible to get anybody on the political left to accept that. It’s the one thing that unites Jeremy Corbyn with Tony Blair.

Still, we should be able to find ways increasing government borrowing that helps stimulate demand more sustainably. Building public housing is one idea. Other infrastructure policies should help (but not all of them). There’s also a case for taking a longer view on some public spending, like education , community policing, mental health services and public health that heads off future trouble. But not building more navy frigates or, even, hospitals. We might need these, but they need to be securely funded by current taxes. The trick politically is to create a system of checks and balances that lets you invest productively and not let central government managers run away unchecked.

Behind this lies an important but rarely acknowledged idea. It is that, in the 2010s and onwards, public investment is often more productive than private investment. And that, I think, is one of the causes of secular stagnation. So in the developed world we need more public investment, and that we can afford to borrow much more to pay for it than most people think. And we need less private investment, much of which is wasted on asset recycling schemes that will end in tears. It may well take another financial crisis before we start to realise this.


13 thoughts on “Secular stagnation: the curse that still haunts developed economies”

  1. Secular stagnation, with an excess of savings over investment opportunities being associated with low financial returns and hence low productivity growth, seems an interesting concept. I would blame it on some but not all of the factors you mention, Matthew. In particular, inequality leads to low demand and hence lack of investment opportunities because the poor spend more of their income than the rich; and the nature of recent growth industries- not needing much capital – seems clearly to have an effect, with this latter being associated with the switch to service industries including health care.

    A practical question is that of the ‘checks and balances’ needed to enable badly needed public investment to flow without being open to abuse by politicians and managers subject to populist pressures. I would recommend reforming the PSBR definition so as to exclude public borrowing for investment which generates income, provided that those public sector managers making the investment were subject to a duty to break even on their investments. Thus for example, we could put local authorities under an obligation to break even on their housing accounts (many make a loss, I have read), and then exclude local authority borrowing to finance new housebuilding from the PSBR totals. Institutionally the creation of Government agencies seems to me to have been a success – eg the vehicle licensing centre operates efficiently with the investment it needs , no doubt enabled to access borrowed money by the revenues it receives.

    And what about social care? A pity that all those reforms of our NHS systems have not produced some such solution there! – eg perhaps a break even regime subject to specific Government subsides attaching to those with inadequate pensions.

  2. Regular contributor Peter Martin tried to post the following comment but the system wouldn’t let him:

    “The problem for Argentina is that its monetary system has been mismanaged for so long that much borrowing, public and private, has to be in foreign currency, which the central bank cannot create.”

    Only if the Govt targets a particular exchange rate is borrowing in a foreign currency necessary. This is just as true for Argentina as the UK. If a big net exporter wishes to run a surplus against either Argentina or the UK they should be given the take-it-or-leave-it choice of balancing up the country’s inevitable current account trade deficit with surplus in the capital account by buying up peso or pound based securities.

    It’s then their call. If they leave it trade will have to balance and there’ll be no need for any borrowing in any currency. If they take it then borrowing will be in the local currency.

    This means that the Government will then have to knowingly recycle the inward capital flow into its economy with a deliberate policy of running a budget deficit. Any fight against that, by trying to reduce spending or raise taxation is going to be counterproductive. Any fight against that by deliberately pushing the borrowing on to the private sector, as we’ve seen happen, will also be counterproductive. We’ll see just why shortly – I expect.

    1. We conversed about this before. In Argentina it’s quite easy to see how your argument breaks down. Unless tied firmly to the dollar (which it was for a while) the Peso was (and still is) regarded as a terrible store of value. (And incidentally when it the Peso was tied to the dollar the locals often treated the two currencies as indistinguishable – I remember this when visiting the country at the time). Nobody, whether Argentina or foreigner wants to risk holding it. The “take it or leave it” argument on how you pay for imports belongs clearly to the seller. They don’t consider it worth the business to deal in local currency. And remember it is businesses and individuals who take these decisions, not the managers of the macro-economy. They couldn’t give a damn whether their country is running a surplus or deficit, and that simply doesn’t feature in the decision making process. Governments have few tools to force people to choose the currency they want without exchange controls which are often hard to enforce.

      1. Argentina shouldn’t force anyone to use any currency. People can use Vietnamese dongs if that’s what they prefer! But it certainly should imposes its taxes in pesos. Everywhere that countries have both a productive base and are properly run the currency demanded in taxation becomes the unit of account in that jurisdiction.

        Now I’m sure we both agree that Argentina hasn’t been properly run in the past. But that doesn’t mean it has to tie its currency to the dollar. That’s no substitute for doing things properly. It’s possible it might work in the short term but inevitably the same thing will happen all over again as it did in 2001.

        It’s quite possible that you’re right that no-one, just now, will want to hold pesos for any length of time. So if I’m an exporter and I want to sell to Argentina does that mean I demand US dollars only? Well I could – but it really doesn’t make any difference if I take pesos providing I have a working calculator and can convert between one and the other at the current rate of $1.00 = 24.58 pesos. I take the pesos and then change them straightway into dollars or whatever other currency I like.

        There’ll always be someone who wants to swap US dollars for pesos if for no other reason to pay their taxes. And certainly the Argentinian Govt needs to do what is necessary to properly collect imposed taxes. If no-one outside the country, at the moment, wants to hold pesos then trade will have to balance or possibly be in surplus if there is a net capital flow out of the country.

        1. Just an additional point about Argentina. Its National Debt is a relatively low 54% of GDP. If no-one wants to hold your currency you can’t run deficits (either budget or current) without borrowing in a foreign currency which is very much to be avoided.

          So the fact that we can run both, in the UK, is sign of international confidence in our economy. Maybe everyone doesn’t think we’ll fall off the proverbial cliff next March!

          1. Yes but it doesn’t take much to guess what the Treasury mandarin’s reply to that would be. It’s only because HMG has a reputation for prudent finance (aka austerity) that the country has international confidence.

          2. Peter’s having technical problems posting. Here’s his response:

            The Treasury mandarin has probably had the disadvantage of a neoliberal based economics university ‘education’! We have to make allowances. ?

            ‘Prudent finance’ from a Government’s perspective doesn’t equate to austerity. That’s applying household economics. The level of inflation would be a factor in international confidence. But we’ve had much higher levels previously than we do now. The level of interest rates paid out on gilts would be another one. So would the status of the pound as an independent currency.

            But ultimately its about political stability and having an economy which is capable of making the pound worth something. We’ve always had a high level of inward capital flow. I would argue too high, at times, for it to have been a benefit to the real economy. That was true long before the word ‘austerity’ became part of the everyday economic lexicon.

            If austerity was the key, then Italy, Greece, Spain and Portugal would have much more international confidence than the UK. They have lots more than us. But, apart from the ECB, who wants to lend to them?

            There’s no reason why trade has to be done via real US dollars. The economies of Canada and the USA are very similar in terms of trade and budget deficits. There’s no evidence that the USA is getting any special extra advantage from its own dollar.

            If I want to buy oil, which is priced in dollars, I only need pounds. The bank doing the transaction doesn’t need any dollars either. It just takes my pounds, multiplies by 1.3, or whatever, and credits the seller’s account with so many dollars. Only, if the seller wants to buy dollar securities, for example, does the bank need to find real dollars from its reserves.

            If the seller wants to end up with euros then the bank simply switches the dollars (which have never actually existed in the way we might imagine) into euros. So what really matters is the currency the seller wants to end up holding rather than the currency in which any commodity is priced.

          3. The Treasury’s understanding of “prudence” goes back way before neoliberalism. It was alive and well in Gladstone’s day, visible in its last ditch defence of the Gold Standard. And onwards. Only war seems to break it. Neoliberal arguments are used to justify a way of thinking that has deep cultural roots. As you know, I have more sympathy for neoliberalism than you, but my rather late academic Economics education isn’t really a factor in that – indeed it allows me to better understand the alternatives. It’s long been said that the problem with neoliberal dogmatism isn’t the trained economists, its the hangers on in senior political and civil service positions. Treasury mandarins completely understand the arguments about the differences between national and household economics, but that doesn’t affect their views; they just look in different places for justification. Incidentally the bond yields for Italy, Greece, Spain and Portugal are remarkably low, given the long run history of these countries – certainly lower than they were when they were independent countries with their own currencies. Which isn’t to say that they might no be in better shape if there was less austerity. But the choice seems to be austerity + economic reform or looser finances + no reform. The option of looser finance + reform doesn’t seem to be on the table, alas. And it isn’t just the fault of the Eurozone masters; local democratic politics is just as much to blame.

            Alas I think you are completely wrong about the dollar. It is the lynch pin of international finance, which makes US financial sanctions so powerful. Almost every international transaction seems to go via the dollar at some point. The Euro hasn’t even tried to challenge this (according to Wolfgang Munchau in today’s FT that was deliberate: the Germans feared the the currency being too political). The Trump regime’s throwing its weight around will no doubt change that in time, but it will take a long time for the financial infrastructure to change to make that feasible. The US Government could halt the Canadian economy dead in its tracks if it wanted to. Canada has not the slightest power to do the same anywhere.

          4. Alas Peter is still havoing problems posting comments directly. Here the next bit of the conversation:

            I’d just make the point that the yield on Greek, Spanish, Italian bonds is entirely controlled by the ECB and its QE program. The ECB can deal the speculators out of the game effectively and completely.

            I’m sure economic commentators must know this but they are still fixated on the spread between German bond yields and the rest. They are exactly what the ECB wants them to be for political purposes. You could probably make lots of money, and I’m sure its a nice little earner for some, by borrowing in German euros and buying up Greek bonds. The ECB is in charge so what’s the risk?

            The Greek Govt will be well aware that if it doesn’t toe the line the interest it needs to pay on its bonds will rise as the ECB cut back on their buying. If the ECB didn’t do this no-one would want to lend to Greece, or Italy, or Spain at anything like an affordable rate and they would have to leave the eurozone. The euro would collapse. Strictly speaking this is against the terms of the Maastricht Treaty and everyone knows that. Some German right wingers are determined to have the matter brought before the courts but its politically impossible for the law to be upheld.

            The correct way to understand the US dollar and all currencies is to think of them as units of measure. You don’t actually need real inches or real metres to measure anything out. You just look at the lines on a ruler. So, you or I or any bank, can conduct a financial transaction in any currency we choose. Like Thai Baht for example. We don’t actually need any IOUs from the Thai central bank to be able to do this providing we have enough financial wealth to be able to make good our IOUs on demand.

            Futures traders play this game all the time. They don’t need to own any cocoa or coffee to trade in the futures market. They just need sufficient financial ability and credibility to be able to come up with an amount if they really have to.

          5. I don’t think so Peter. The ECB has limited discretion in which nation’s bonds it can buy and in which proportion. Apparently one constraint on its bond buying is the shortage in supply of some countries bonds. The ECB cannot ignore German pressure altogether, and the Germans are worried about the ECB buying bonds from the dodgier countries; its all very bound by rules. I think they can exclude countries that are deemed non-compliant, so the element of threat and leverage you mention does apply – but the spreads between countries does convey more information that just the vagaries of ECB politics. In any case my point was that if Italy was outside the Euro its interest rates would be much higher.
            Also what I read about the way financial markets actually work suggests you are wrong about currencies. They are more than just measuring sticks. For small values I’m sure you can transact in any currency you want to, though the cost is often high. Anything else depends on how the real stuff flows. The Eurodollar markets couldn’t get going until the Vietnam war caused the American to pump the world full of US dollars to pay for imports. The Yuan/Renminmbi is very hard to transact in at scale internationally. In practice most cross currency trade has to be done via the USD. The cost of maintaining so many small cross-currency markets is prohibitive – especially since the crash has forced banks to tighten up on free currency positions which are needed to maintain liquidity. If I want to buy a serious amount of Thai Baht, it is less likely that a bank will have that amount to sell to me without trying to dig out a seller by pushing the price up. Don’t believe all the hype you read about the depth, efficiency and fluidity of financial markets. There’s much more friction in practice than most let on.

        2. I think selling in Pesos (say) and the converting to home currency works better in theory than practice. Markets may be illiquid giving rise to big and variable spreads, which could eat into profit margins very quickly (or render your product uncompetitive). One issue is that most excahnge markets work by changing via the US Dollar, which adds an extra level of cost and risk if that isn’t your home currency (one of the reasons that the US has so much clout in financial markets).
          But there’s an even bigger problem. Most export-import is done business to business, and most of that on credit. If you are being paid in advance in Pesos then you can minimise currency risk. If it’s a couple of months down the line and subject to other vagaries then it’s a different matter. Trade credit is one of the things that keeps the wheels of commerce oiled – but lending money to somebody in a currency other than your own is an unappetising prospect, especially if that currency is subject to high inflation.

  3. “….in the mid 2000s…. the government should have started to tighten spending but decided not to. This didn’t cause the financial crisis, but made it harder than it should have been to manage. Even now, though, it is impossible to get anybody on the political left to accept that.”

    I don’t believe it’s anything to do with left or right. In the 00s the economy was far too heavily reliant of private credit to create growth. It’s not much different now so we are slow learners in that respect.

    So, we are saying that monetary policy should have been tighter. There shouldn’t have been an almost complete deregulation of the banking industry. But, if you want the same level of growth you can’t tighten both monetary and fiscal policy simultaneously. Fiscal policy should have been looser to compensate.

    1. Rather a good argument that! Monetary policy was clearly too loose and banking was running riot. The argument at the time was that there was little in practice the government could do about loose monetary policy because there was too much savings sloshing around in the world economy (thanks to the Chinese and oil exporters). An increase in interest rates would have forced up the currency and pushed exporters out of business; looser fiscal policy wouldn’t have stopped that, in the short run anyway. But the government could have done a lot more to curb the banking industry, so this does break down a little. I would still hold that it was a serious mistake to keep cutting income tax rates. That made austerity inevitable when the bubble burst since tax receipts fell off a cliff as they were too tied to the bubble economy.

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