The Pak Banker

What explains the great global slowdown

- Vivek Dehejia

WHO would have thought that a somewhat arcane economics concept from the 1930s would occupy centre stage in economic policy debates today? Yet, along with "financial instabilit­y", "secular stagnation" is now well on its way to becoming a household term. It befits an era of economic volatility in a global economy which is yet to recover fully from the great financial crisis of 2007-10.

Coined originally by Harvard economist Alvin Hansen in the wake of the Great Depression, the term in recent years has been given new currency by another famous Harvard economist, Lawrence Summers. Most recently, writing in the influentia­l journal, Foreign Affairs, Summers argued that secular stagnation holds the key to understand­ing the current global macroecono­mic situation

But most simply, secular stagnation refers to a situation of insufficie­nt aggregate demand, or, equivalent­ly, a situation of excess aggregate supply. While these two definition­s are equivalent, the first points to the demand side, and the latter to the supply side, as the source of the problem.

Yet another equivalent, demand-side, definition is to say that secular stagnation reflects an excess of savings over investment. This is, as a matter of accounting, the flip side of insufficie­nt demand for goods and services: as every student who has been taught the circular flow of goods and services in a first-year prin- ciples of economics class will know.

A somewhat more technical definition of secular stagnation is that it is a situation in which the "natural" or "neutral" real rate of interest is so low that it is impossible to achieve at a positive, zero or even slightly negative nominal interest rate. Recall that the natural or neutral real interest rate, a concept originated by Swedish economist Knut Wicksell, is that real interest rate which balances aggregate demand and aggregate supply at full employment. While small negative nominal interest rates are theoretica­lly and practicall­y possible, contrary to what is sometimes believed, the nominal interest rate required to equilibrat­e aggregate demand and aggregate supply in a situation of secular stagnation is so large and negative that it would be impossible to achieve using convention­al monetary policy.

The key reason is that depositors may tolerate a small negative interest rate as a convenienc­e charge, but, facing a large enough negative interest rate, it would be cheaper to hold money in cash, even if one has to pay for storage and security. In theory, the government could directly tax currency holding at whatever rate it wishes, which would push even lower a sustainabl­e negative nominal interest rate, but this seems impractica­l and politicall­y difficult.

Summers argues that the current global macroecono­mic picture is entirely consistent with a situation of secular stagnation. He writes: "Real interest rates are very low, demand has been sluggish, and inflation is low, just as one would expect in the presence of excess saving. Absent many good new investment opportunit­ies, savings have tended to flow into existing assets, causing asset price inflation." As evidence in favour of the hypothesis, Summers points to declining estimated neutral real interest rates and a body of research which documents a range of factors behind rising savings rates and declining investment rates.

To quote Summers again: "Greater saving has been driven by increases in inequality and in the share of income going to the wealthy, increases in uncertaint­y about the length of retirement and the availabili­ty of benefits, reductions in the ability to borrow (especially against housing), and a greater accumulati­on of assets by foreign central banks and sovereign wealth funds. Reduced investment has been driven by slower growth in the labour force, the availabili­ty of cheaper capital goods, and tighter credit (with lending more highly regulated than before)."

Stemming from his diagnosis of the global economy's current woes, Summers' policy prescripti­on is a return to the centrality of fiscal policy, which has been neglected as of late. For a decade and a half before the financial crisis, the consensus view in the economics profession was that monetary policy, as delivered through inflation targeting, would suffice to fine-tune the economy and keep it close to its long-run potential level of output and employment, while at the same time overcoming, or at least mitigating, the ebb and flow of the business cycle.

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