Permanent Secular Stagnation?

ARE THE WORLD’S ADVANCED ECONOMIES LOCKED INTO A PERMANENT STATE OF SECULAR STAGNATION?

SUGGESTING FOR THE U.S. CONTINUED SLOW GROWTH, HIGH UNEMPLOYMENT AND A FALLING STANDARD OF LIVING FOR THE 90%, MAKING IT IMPOSSIBLE FOR THE FED TO WITHDRAW MONETARY STIMULUS AND “NORMALIZE” INTEREST RATES.

The disturbing idea of “secular stagnation” was first raised by Harvard’s Alvin Hansen, in his 1938 presidential address to the American Economic Association, at a time when the Great Depression was stubbornly dragging on. Hansen suggested that the high unemployment of that time might continue for many years as the permanent condition of the economy. He attributed his “secular stagnation” hypothesis to a decline in the birth rate and an over-supply of saving by the aging population. The excess saving meant that there was too little aggregate demand to spur investment, production and employment, and thus no natural forces to return the economy to full employment.

Shortly afterwards there was a huge increase in government spending as America began to prepare for war, and after the war a “baby boom” that increased the population, the economy prospered and economists forgot about the problem. After 1995 the mild deflation of the Japanese economy stirred interest in the question of secular stagnation again, but that was attributed to Japan's rapidly aging population and other special circumstances of that economy. Now, however, the persistent slow growth and high unemployment of the U.S. and Europe five years after the Great Recession is bringing the question to the forefront once more.

Only last year, Larry Summers wrote an article for the Financial Times titled, “Why Stagnation Might Prove to be the New Normal.” In the article Summers suggested that the crisis of 2008 may have ushered in an era of “secular stagnation” in much the same way as Alvin Hansen had described in 1938. He suggested it might even have started sooner only to be hidden by the housing bubble. Numerous others picked up on the theme in a flurry of commentary, including Krugman, Taylor and DeLong, but no one had presented it in the form of a substantive theoretical model until Gauti Eggertsson of Brown Univ. and Neil Mehrotra of Columbia Univ. took a first stab at it in the linked paper released 11 days ago. The model constructed by Eggertsson and Mehrortra shows that a condition of permanent secular stagnation is possible as a result of a deleveraging shock brought about by a financial crisis in combination with slowing population growth and/or increasing inequality.

More importantly, the model shows that:

1. Absent a higher inflation target, the zero-bound interest rate policy of the Fed will be locked in place permanently because output will remain below the full employment rate and any increase in interest rates would further depress the economy.

2. With zero being essentially the lower bound for nominal interest rates, it would be impossible under conditions of secular stagnation for Fed monetary policy alone to achieve full employment and reach potential growth.

3. Under these conditions, full employment and maximum growth would require a continuous increase in debt financed government spending.

The authors have promised further consideration of the fiscal policy implications in a future elaboration of their model, as well as a consideration of the impact on asset prices which they believe will also be important.

It seems clear that we cannot sit idly back and expect the Fed and natural forces to “normalize” the situation and restore growth with full employment on their own. Fiscal policy will have to come into play. It may also be naive to expect that the Fed will be able to withdraw monetary stimulus and “normalize” interest rates anytime in the foreseeable future, not in 6 months after the end of QE, nor one year later, nor ever, without a new QE that targets inflation of at least 4%, if not higher, and/or a radical change in thinking about government spending and the national debt.



Link to: "A Model of Secular Stagnation"
http://www.econ.brown.edu/fac/Gauti_Eggertsson/papers/Eggertsson_Mehrotra.pdf