Secular stagnation, bubbles & inequality
The big debate in global macroeconomics over the past week has been in response to Larry Summer’s IMF speech on ‘secular stagnation’, the idea that Western economies are set for years of low growth.
Summers asked if the US and other advanced economies could suffer the fate of Japan. As Miles Kimball has noted, the Japanese economy of 2013 is roughly half the size that economists of the 1990s would have predicted it to be.
The theory behind Summers’ concerns about secular stagnation revolves around the a declining natural rate of interest. As Paul Krugman has explained:
…[Summers] works from the understanding that we are an economy in which monetary policy is de facto constrained by the zero lower bound (even if you think central banks could be doing more), and that this corresponds to a situation in which the “natural” rate of interest – the rate at which desired savings and desired investment would be equal at full employment – is negative.
As Summers argued in the speech:
Suppose that the short-term real interest rate that was consistent with full employment had fallen to negative 2% or negative 3% sometime in the middle of the last decade.
The evidence for this fear, as shown in this chart from Gavyn Davies, is the performance of the G4 (UK, USA, Japan and Euro-area) economies since 2008.
That is certainly a rather concerning chart (‘rather concerning’ is used here in the traditional British sense and should be translated as ‘absolutely terrifying’).
As Davies notes:
Not only has GDP stagnated in absolute terms, it has of course fallen about 13 per cent below the long term extrapolated trendline, shown in red.
It is worth noting at this point that in the UK, we have become very used to pointing to US performance since 2008 (and the fact that GDP is some 5.5% above pre-crisis peak) as an example of a better economic performance. Whilst the US’s performance has no doubt been better than the UK’s own abysmal experience, it has been far from good.
The second part of Summers’ argument was on the role of bubbles as a way of growing the economy.
As Krugman writes (and apologies for the long extract but this really is crucial):
We now know that the economic expansion of 2003-2007 was driven by a bubble. You can say the same about the latter part of the 90s expansion; and you can in fact say the same about the later years of the Reagan expansion, which was driven at that point by runaway thrift institutions and a large bubble in commercial real estate.
So you might be tempted to say that monetary policy has consistently been too loose. After all, haven’t low interest rates been encouraging repeated bubbles?
But as Larry emphasizes, there’s a big problem with the claim that monetary policy has been too loose: where’s the inflation? Where has the overheated economy been visible?
So how can you reconcile repeated bubbles with an economy showing no sign of inflationary pressures? Summers’s answer is that we may be an economy that needs bubbles just to achieve something near full employment – that in the absence of bubbles the economy has a negative natural rate of interest. And this hasn’t just been true since the 2008 financial crisis; it has arguably been true, although perhaps with increasing severity, since the 1980s.
I think a similar point can be made about the UK economy over the last few decades. To use an old favourite, I’ve long argued that if one wants to understand the UK’s macroeconomic performance in one chart, then the place to look is the household savings ratio:
As we know, since I made that chart, the ratio has begun to fall and growth has picked up. The relationship still holds.
Indeed when one looks at the UK’s recovery over the past 12 months (falling household saving station, rise in household debt, a frothy London property market) then one can see further evidence for the Summers thesis around bubbles and growth.
Or, for an explanation, on what happened to balance sheets during the great moderation, it is worth once again to turning to Burrows’ and Barwell’s superb Bank of England Financial Stability Paper.
Various explanations can e offered as to the drivers of secular stagnation from Martin Wolf in today’s FT on the savings glut/dearth of investment, to Chris Dillow’s long running argument on a dearth of investment opportunities, Izabella Kaminska & Pieria on abundance , Krugman on demographic factors and Ryan Avent on the policy failure from (or rather the wrong targets for) central banks (that list link should be read in conjunction with this from Brad Delong).
There may well be something in all of these explanations. But I also wonder if there is a need to look deeper.
If we assume that that many Western economies have been plagued by some form of secular stagnation since the 1980s and that growth has increasingly relied on leverage and bubbles (in different sectors at different times) then it is worth asking what else has happened during this time?
A huge rise in inequality with the incomes of the top 1% detaching themselves from the rest, a falling share of investment in GDP, big rises in household debt and a slowing of wage growth for median earners and below.
The factors linking all of these outcomes is change in corporate behaviour since the 1970s. As Reuters’ James Saft wrote this week:
On one side stand households and investors who are responding to the very strong liquor which the Federal Reserve is putting in the punch. By buying up bonds and keeping rates low, the Fed encourages risk taking and drives prices for assets – real and financial – higher.
That’s leading to record prices for everything from art to social media companies to Manhattan real estate. This isn’t just a phenomenon for the rich, though the rich do get the cream. Real estate is going up fairly strongly in a wide variety of markets, as are the stocks owned in so many people’s retirement funds and accounts.
On the other side are corporate executives, who don’t seem to have read their economics textbooks. Rather than responding to high profit margins by investing and competing, they seem happy to milk their cows without adding much to their herds.
He does on to quote research from Andrew Smithers.
Smithers contrasts the early 1970s with today. Then companies invested about 15 times more in new equipment and ventures than they returned to shareholders via dividends. Now the ratio is less than two. As recently as the 1990s, this number was as high as six.
Why? The change toward ever greater executive pay, doled out in share options which are highly sensitive to short-term stock price movements, has changed how CEOs behave.
That, in combination with the market obsession with making quarterly earnings targets, has resulted in a corporate landscape in which legitimate long-term projects can’t get a hearing because they are not in the best interest of those making the decisions. Why fund a project which will only bear fruit when you, the CEO, are out of office and no longer getting huge yearly allocations of shares?
We have stumbled into a system whereby corporations are often run not for their own long term benefit but for the benefit of top staff. As Mariana Mazzucato has argued with are all too often rewarding value extraction rather than value creation.
Corporations are incentivised to focus on the short term leading to lower investment and weaker growth than would otherwise be the case. A greater share of the wage packet is grabbed by those at the very top and, as Ranciere & Kumphoff have convincingly argued there is an causual link between this rising inequality and the propensity for bubbles.
As they argued the decline in the bargaining power of labour seen in the 1980s allowed the large rise in inequality of the 1980s and 1990s. This has, in the authors’ model, two impacts. First, it creates a demand for credit from those lower down the income scale to sustain their standard of living. Second, and just as important, it creates a supply of credit to meet that demand. Those at the top of the income scale accumulate wealth, as they are more likely to save rather than spend additional income. In effect they build up financial assets, increasing the size of the financial sector and then boosting the availability of credit. As inequality rises, so too does the size of the financial sector and the amount of personal debt in the economy. This leaves the economy more vulnerable to financial crisis and makes recovery from recession harder as households have debt to service.
Take together the declining bargaining power of labour and the rising short termism of corporate run for their managers and you have a model that explains rising inequality, the propensity for bubbles, the declining investment share of GDP, the wage stagnation that has hit many and the rise in leverage.
Explaining the drivers of secular stagnation (broadly defined) helps get you towards a solution. This solution is firstly, as Krugman and other argue, a much larger role for public investment (which given interest rate is eminently affordable). But the real solution goes beyond this – it means tackling the route causes of short termism and rising inequality that have afflicted the economy since the 1980s. For me that means changes in corporate governance, banking, industrial policy and wage setting of the type I’ve long argued for.
Larry Summers’ speech is very important and reminds us yet again why we shouldn’t be so quick to think that the recent return of growth to the UK economy has made the underlying problems go away.