Monday, July 20, 2015

Secular stagnation and prospects for a new growth compact

Overcoming secular stagnation (SS) is arguably one of the biggest challenge facing developed economies. The phrase, first propounded by Alvin Hansen in the context of the Great Depression and revived in 2013 by former US Treasury Secretary Lawrence Summers to describe the present times, essentially means “chronic excess of savings over investment” which serves to keep real interest rates low for a prolonged period.

It has been construed that these countries may have entered a phase of lower trend economic growth, a new normal, driven by "persistent shortfalls of demand". The most compelling argument in favor of its demand-side origins come from the fact that even a large asset bubble fuelled economic boom in the last decade was not accompanied by inflationary over-heating.

Supporters of SS hypothesis point to multiple reasons for excessive savings - rising share of incomes going to those with "high savings propensities"; increased uncertainty, greater indebtedness, and expectations of lower returns encourage people to save more; and the burgeoning surpluses of emerging economies and oil exporters which find their way to the safety and liquidity of US Treasuries. On the investment side, they point to the substantial reductions in the relative price of capital goods as well as capital intensity, reflected in the declining share of investment goods in the GDP. This is most evocatively captured in Larry Summers’ example of "WhatsApp, worth $19 bn, with 55 people in a big room with Sony, worth $18 bn, and owning lots of factories and office buildings and the like".

Then there is the challenge posed by demographics. Demographic trends affect both investment and savings. A lower population growth reduces potential output, and limits the scope for investments. An aging population means people save more to fund their retirements. A combination of excess savings, amplified by the accumulating surpluses in emerging economies, and limited investment opportunities keeps interest rates low, even negative in real terms.

Finally, there is the productivity explanation, best captured by Tyler Cowen's best-selling book, The Average is Over - all the low hanging fruits from technological and process innovations have been plucked and large productivity enhancing innovations are very difficult to come by. The combination of all these factors point to the difficulty of operating at full employment and potential output without inflating destabilizing asset bubbles. Critics though dispute the SS hypothesis pointing to the remarkable ongoing economic recovery in the US.

The conventional wisdom on responding to SS has been either monetary accommodation, using unconventional approaches like quantitative easing, or fiscal spending on infrastructure. But the former engenders resource misallocation and ruinous asset bubbles, whereas the latter is constrained by fiscally strapped governments. It is in this context that the international dimension assumes significance.

A striking feature of the SS hypothesis is its "closed economy" assumption. Since the low hanging fruits from technological innovations have been plucked, developed countries, and their firms, face a future of declining gains in productivity. Their companies, exemplified by the cash hordes at two iconic firms Apple and Google, have limited investment opportunities. The income stagnation at all but the highest income levels boosts savings and limits consumption demand. All these trends are confined to developed economies and tend to assume them living in isolation from the rest of the world.

Faced with declining investment opportunities and lower returns to capital, Econ 101 teaches us that the natural response would be to expand trade and other economic linkages. The developed economies have the technologies, businesses, and even capital, all searching for opportunities. It also faces an aging population and therefore diminished supply of labor. In contrast, emerging economies have rising productivity, remunerative investment opportunities, growing consumer demand, and a large pool of labor. The complementarity could not have been any more mutually beneficial. The scope for a new growth compact between the two economic groups could not have been more opportune.

So far, the operations of multi-national corporations has been focused on selling products produced in developed to consumers in developing countries. Imagine the potential of a market for goods and services that are essentially needed for the developing countries. What if the firms from developed countries are able to realize increasing gains in productivity by making products for developing countries? What if there are remunerative investment opportunities in developing countries? As capital flows out from developed economies, their depreciating currencies would boost exports.

Such innovation opportunities and incentives abound – massive savings in infrastructure investments from efficient construction technologies, low cost medical technologies could dampen rising health care costs, on-line instruction technologies can transform education and health care markets, and so on. The "jugaad" innovations that characterize many breakthroughs by Indian firms are an example of such opportunities. 

Developing countries are estimated to invest trillions of dollars in their physical infrastructure over the coming decade. They include investments in electricity, mass-transit, telecommunications, and urban utility systems. The potential for technological innovations to optimize cost-effectiveness in their construction, reduce various forms of operational inefficiencies, and enhance environmental sustainability is enormous.

Consider the potential for transformational change from the recent advances in data science on governance itself. Arguably the most critical governance challenge in developing countries is with translating policies and programs into their desired outcomes during implementation. An important contribution to bridging this implementation deficit can be a right combination of analytics and visualization delivered through a variety of hand-held devices. The cash hordes of the likes of Google could transform governance in developing countries in a mutually beneficial partnership.

Finally, there is the channel of migration. It is no coincidence that Japan, with the most restrictive immigration rules, is the worst affected by secular stagnation, and US, with the least restrictive immigration rules, looks the least affected by secular stagnation. Liberalizing immigration rules could be another important contributor to alleviation of SS, especially in countries facing adverse demographic shifts like Japan and Germany.

We should therefore strive to see the current problems in the developed world as a great opportunity to construct a new paradigm of economic and social co-operation between the developed and developing countries driven by mutually beneficial imperatives.

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