On secular stagnation and the quest to lower real interest rates

Larry Summers' speech at the IMF conference, where he hints at the possibility of a long-period of post-1991 Japan-style stagnant economic growth in US and Europe, has generated great interest.

Briefly, the economy is stuck at the zero lower bound, where the equilibrium real interest rate is negative. Conventional policies become ineffectual. More worryingly, this may not be an aberration, but the new normal. In fact, but for a series of equity and asset market bubbles, this should have started binding since atleast the early nineties. In this period, despite fairly loose monetary policy and a steep rise in household borrowings, there have been very few signatures of aggregate demand overheating. Inflation has remained consistently low. Summers conjectures that the short-term real interest rate consistent with full employment has fallen to negative territory, and therefore the economy needs the financial excess from bubbles to sustain full employment. He invokes Alvin Hansen to describe this as a "secular stagnation" - permanent as against cyclical. He leaves us with a summary of the problem,

It is not over until it is over…We may well need, in the years ahead, to think about how we manage an economy in which the zero nominal interest rate is a chronic and systemic inhibitor of economic activity, holding our economies back, below their potential.

Paul Krugman attributes this stagnation to declining investment and widening output gap caused by a mix of lower population growth and slower pace of innovation. Miles Kimball points to the negative feedback from the declining share of population working (the labor force is estimated to grow by 0.5% annually in the 2012-22 period, half the rate in previous decade). Whatever the case, Krugman advocates that in such circumstances prudence is folly and spending is virtuous and the way out is to either introduce negative rates for deposits or raise inflation, by whatever means, and keep it there.

The diagnosis of a secular stagnation comes out as being plausible. In fact economists like Robert Gordon and Tyler Cowen have been arguing that the low hanging fruits from technological innovations having been plucked, we may now be in a period of technological stagnation. The related decline in productivity (output per worker in business sector rose by 3.6% per year in the 1997-2003 period, whereas it declined to just 1.6% in the 2003-12 period) when coupled with the declining population growth lends strong credence to a secular stagnation hypothesis. These are important long-term trends whose effects are certain to be profound.

Given the secular stagnation hypothesis, I am not sure whether the policy goal should be to attain the Great Moderation era "full employment" by seeking to lower the real interest rate. That would require continuing for an indefinite period the regime of quantitative easing and further monetary accommodation, as Krugman suggests, or deepening financial de-regulation, as Summers (may) be alluding to. Both are fraught with serious dangers of resource mis-allocation, incentive distortions, and structural problems (widening inequality and workers dropping out of the labor force).

There appears to be a distinct reluctance to accept the reality of a secular stagnation. Fundamentally, a sustainable pre-crisis trend recovery can happen only through the aggregate demand channel. But the aforementioned long-term structural trends are certain to keep aggregate demand muted. Therefore, instead of asking how to restore growth and employment back to pre-crisis levels, a more relevant exploration would be that of managing the economy given this new reality of a lower potential output. And that surely is not about seeking to lower real interest rates.

Update 1 (12/22/2013)
Lawrence Summers on secular stagnation as the new normal in developed economies. He argues that the US economy has been facing inadequate demand (as evidenced by low inflation and limited signs of over-heating even when growth was high) for some time now, and that this was the new normal. Further, under such conditions, the economy can get close to full employment only when supported by asset bubbles and unsustainable borrowing, as was the case in the nineties and first half of last decade. See also Paul Krugman here.

Update 2 (1/9/2014)

In order to avoid secular stagnation, and given the "new normal" of low interest rate regimes, Larry Summers argues in favor of large scale investments in infrastructure to help raise demand. Willem Buiter too feels the same, as also FT Alphaville. See also John Cassidy's summary on the secular stagnation debate here.

Update 3 (29/7/2014)

Larry Summers explains secular stagnation,

The question that this account leaves open so far is why, if there is a tendency for savings to exceed investment, why can’t lower but still reasonable interest rates balance things out? Here I think there are a number of answers both on the savings side and on the investment side. On the savings side, there’s a tendency towards increased saving because of greater wealth inequality and a rising share of profits increased the share of income going to those with high savings propensities; because increased uncertainty and greater indebtedness encouraged savings to repair balance sheets; because an expectation of lower returns leads to people or pension funds needing to put aside more money to prepare for their retirement or to send their kids to college or whatever their savings target is. All of that tends to lead to an excess of savings.

On the investment side, you have a tendency for substantial reductions in the price of capital goods, particularly those associated with information technology. You have a change in the capital requirements for starting a business. Contrast WhatsApp, worth $19 billion, with 55 people in a big room with Sony, worth $18 [billion], and owning lots of factories and office buildings and the like. Or think about Google and Apple, major leaders in scale on the stock market, but with vast cash hordes. That operates to reduce investment.

Update 4 (26/11/2014)

In 1938, following the persistent slowdown after Great Depression, Alvin Hansen described secular stagnation as "sick recoveries which die in their infancy and depressions which feed on themselves and leave a hard and seemingly immovable core of unemployment.” 

SS is a period of depressed growth due to a combination of weak demand and excess savings, coupled with slowing technological progress, which limits productive investment opportunities and makes conventional monetary policy blunt. An Economist article suggests another reason for the prolonged stagnation - demographics.

The primary channel through which demographics affects growth is by lowering potential output, which is dependent on both population growth and productivity. Now with both population growth and productivity stagnant or even declining, potential output has nowhere to go but down. Population patterns affect both investment and savings. The Economist writes,

Firms need a given capital stock per worker—equipment, structures, land and intellectual property—in order to produce a unit of output. If output growth is hampered by lack of workers, firms will need less capital. Ageing populations also mean that more people are saving heavily in order to fund their retirement, depressing consumption... businesses are buying less machinery because they have fewer workers to operate it and fewer technological breakthroughs to exploit.

Another possible contributor to SS is the rising inequality and stagnant wages. This assumes significance since the richer people are more likely to save and less likely to spend than those less well off. This would dampen consumption and therefore growth.

Its signatures are everywhere - cash hoarding by businesses, declining long-term bond yields, lowest net investment (gross investment minus depreciation) as a share of capital stock, slowing potential output growth, and so on.