A tale of two the­o­ries

Financial Mirror (Cyprus) - - FRONT PAGE -

In the eu­ro­zone, growth in the latest quar­ter was un­der­whelm­ing. Ja­pan has re­turned to neg­a­tive ter­ri­tory. Brazil and Rus­sia are in re­ces­sion. World trade has stalled. And China’s eco­nomic slow­down and mar­ket tur­moil this sum­mer have cre­ated fur­ther un­cer­tainty.

True, there are bright spots: In­dia, Spain, and the United King­dom are beat­ing ex­pec­ta­tions. The United States’ re­cov­ery is solid. Africa is do­ing well. But, over­all, it is hard to deny that the global econ­omy lacks mo­men­tum.

This is partly be­cause trees can­not grow for­ever: China’s econ­omy could not con­tinue to get 10% big­ger ev­ery year. And in part, it is be­cause growth is not un­con­di­tion­ally de­sir­able: Cit­i­zens may be bet­ter off with a lit­tle less of it, and more clean air.

But many coun­tries are still poor enough to be en­dowed with strong growth po­ten­tial, and many oth­ers, though rich, have not yet re­cov­ered from the global fi­nan­cial cri­sis. So there must be some­thing else hold­ing growth back.

There are es­sen­tially two com­pet­ing ex­pla­na­tions. The first, the Sec­u­lar Stag­na­tion Hy­poth­e­sis, has been pro­posed by Larry Sum­mers. Its key premise is that the equi­lib­rium in­ter­est rate at which de­mand would bal­ance sup­ply is cur­rently be­low the ac­tual in­ter­est rate.

This seems para­dox­i­cal, be­cause in­ter­est rates are close to zero in most ad­vanced economies. But what mat­ters is the real rate of in­ter­est, that is, the dif­fer­ence be­tween the mar­ket rate and in­fla­tion. Ag­gre­gate eco­nomic bal­ance may re­quire a neg­a­tive real in­ter­est rate; but with in­fla­tion at an all­time low – the IMF ex­pects it to be neg­a­tive this year and next in the ad­vanced economies, and zero in the emerg­ing economies – this is not fea­si­ble.

There are sev­eral rea­sons why the equi­lib­rium in­ter­est rate could have reached neg­a­tive ter­ri­tory. Some are struc­tural: sav­ing is high glob­ally, es­pe­cially in Asia but also in Europe, where ag­ing coun­tries like Ger­many put money aside for re­tire­ment. At the same time, the new dig­i­tal econ­omy is less cap­i­tal-in­ten­sive than the old brick-and­mor­tar econ­omy. This may be ac­cen­tu­ated in the fu­ture by the ad­vent of the so-called shar­ing econ­omy.

Other fac­tors are tem­po­rary. In sev­eral coun­tries, debt-fi­nanced hous­ing booms have left house­holds and com­pa­nies over­lever­aged; and gov­ern­ments have re­duced deficits to con­tain their own debt. As a re­sult, there are likely to be too few in­vestors and too many savers.

The Sec­u­lar Stag­na­tion Hy­poth­e­sis is wor­ry­ing, be­cause it gives few rea­sons to be­lieve that things will im­prove by them­selves. True, debt delever­ag­ing is not with­out lim­its. But it is im­peded by slow growth and, thanks to high un­em­ploy­ment and weak global de­mand, per­sis­tently low in­fla­tion. Worse, over the longer term, low in­vest­ment un­der­mines pro­duc­tiv­ity, while pro­tracted un­em­ploy­ment de­stroys skills. Both re­duce fu­ture po­ten­tial growth.

A vi­cious cir­cle, it seems, is at work. The way to break it, ac­cord­ing to Sum­mers, is to sus­tain mon­e­tary stim­u­lus and boost de­mand ag­gres­sively through fis­cal pol­icy.

The al­ter­na­tive ex­pla­na­tion for the per­sis­tence of weak global growth has been best for­mu­lated by the Bank for In­ter­na­tional Set­tle­ments, an or­gan­i­sa­tion of cen­tral banks. The BIS main­tains that ex­ces­sively low in­ter­est rates are a big rea­son why growth is dis­ap­point­ing.

This ex­pla­na­tion may seem even more para­dox­i­cal than the first, but the logic is straight­for­ward: Gov­ern­ments of­ten try to es­cape the hard task of im­prov­ing eco­nomic ef­fi­ciency through sup­ply-side re­forms and rely on de­mand-side fixes in­stead. So, when con­fronted with a growth slow­down caused by struc­tural fac­tors, many coun­tries re­sponded by low­er­ing in­ter­est rates and stim­u­lat­ing credit.

But cheap credit pro­motes bad in­vest­ment and ex­ces­sive debt, which bor­row­ers of­ten are un­able to re­pay. More fun­da­men­tally, in­vest­ment is a bet that can­not pay off if growth is struc­turally de­pressed. Ar­ti­fi­cial growth pro­mo­tion only ends in tears.

Fur­ther­more, the BIS claims that credit may well ag­gra­vate struc­tural de­fi­cien­cies. Hous­ing bub­bles and in­vest­ments in du­bi­ous projects re­sult in a waste of re­sources and a mis­al­lo­ca­tion of cap­i­tal that ul­ti­mately damp­ens po­ten­tial growth. The best ex­am­ple is per­haps Spain in the 2000s, where stu­dents left univer­sity be­fore grad­u­at­ing to take part in the real-es­tate frenzy. Amass­ing use­less con­crete and los­ing hu­man cap­i­tal, the coun­try lost twice.

So here, too, the logic points to a vi­cious cir­cle: Slower growth leads to ar­ti­fi­cial reme­dies and fur­ther ero­sion of long-term growth po­ten­tial.

The BIS ar­gues in fa­vor of fis­cal re­straint, debt restruc­tur­ing if needed, and swift nor­mal­iza­tion of mon­e­tary poli­cies – quite ex­plic­itly crit­i­ciz­ing the US Fed­eral Re­serve’s cau­tion and the Euro­pean Cen­tral Bank’s ag­gres­sive stance.

Both the­o­ries are in­ter­nally con­sis­tent. Both also fit only some of the facts.

The Sec­u­lar Stag­na­tion Hy­poth­e­sis ac­counts well for the mis­takes made in the eu­ro­zone in the af­ter­math of the global re­ces­sion, when sov­er­eigns at­tempted to delever­age while com­pa­nies and house­holds were un­will­ing to spend, and the ECB was keep­ing mon­e­tary pol­icy rel­a­tively tight. The BIS’s ex­pla­na­tion reads like a sum­mary of the woes of China, where growth has slowed from 10% to 7% or less, but the author­i­ties still push in­vest­ment amount­ing to al­most half of GDP and pro­mote all sorts of lowre­turn projects.

So which the­ory fits the facts bet­ter glob­ally? So far, it is odd to claim that ad­vanced coun­tries have stim­u­lated de­mand ex­ces­sively. Per­sis­tently low em­ploy­ment and near-zero ag­gre­gate in­fla­tion do not sug­gest that they have erred on the side of profli­gacy. True, fi­nan­cial reck­less­ness re­mains a risk, but this is why reg­u­la­tory in­stru­ments have been added to the pol­icy tool­box. So the BIS’s call for across-the­board mon­e­tary nor­mal­iza­tion is pre­ma­ture (though this does not mean that re­forms should wait).

In the emerg­ing world, how­ever, the mis­match be­tween growth ex­pec­ta­tions and ac­tual po­ten­tial has of­ten be­come a se­ri­ous is­sue that de­mand-side stim­u­lus and end­less debt ac­cu­mu­la­tion can­not cure. Rather, gov­ern­ments should stop bas­ing their le­git­i­macy on in­flated growth prospects.

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