Secular Stagnation, Then and Now

THE FINANCIAL CRISIS, and the great recession it engendered, is pushing mainstream economists to the left. Hyman Minsky, during his life a marginal figure, is now quoted everywhere from the Wall Street Journal to IMF working papers. Martin Wolf, probably the most influential financial journalist of our era, actually argued for monetizing the debt, a policy traditionally associated with Weimar Germany or Robert Mugabe’s Zimbabwe. Ten years ago, it would have been as unthinkable for the Financial Times to advocate printing money to pay off government bonds as it would be for the Pope seeing the upside in abortion.

Perhaps the most significant transformation has been that of Larry Summers: protégé of Goldman Sachs’ Robert Rubin; Treasury Secretary under Clinton; senior economic advisor to Obama; despised by the bien pensant left for his sexist comments as Harvard president, his role in deregulating finance, and his millions made consulting on Wall Street. When President Obama hinted he favored appointing Larry Summers Fed chairman, the progressive wing of the Democratic Party erupted in fury.

And yet, out of government, Larry Summers has voiced a radical explanation of our economic travails. In a speech at the IMF, Summers suggested something more heterodox economists have been saying for over twenty years — that demand has become so fragile, our economy requires asset price bubbles in order to enable growth. He used the expression “secular stagnation,” a phrase invented during the Great Depression, to characterize our malaise. Now VoxEU has published an ebook, Secular Stagnation: Facts, Causes, and Cures, with heavy hitters such as Paul Krugman, Barry Eichengreen, Richard Koo, and Joel Mokyr contributing chapters. It is perhaps the best explanation why the economy continues to disappoint.

Summers begins by praising policymakers for staunching the financial crisis. Within less than a year, he reminds us, they reassured markets, stopped the meltdown, and brought the world economy back from the brink of disaster. In normal times, that would have sparked a recovery. But five years later, the economy still hasn’t returned to its pre-crisis trend line. Despite recent good news on unemployment, UK median real wages remain 10 percent below their peak. The US economy is 15 percent smaller than was expected in 2007, and median household income is lower than it was 15 years ago.

And the boom wasn’t all that great. Summers notes that, even before the bust, growth was anemic and inflation almost nonexistent. According to standard macroeconomic theory, a massive speculative bubble and the ensuing money creation it engenders should have caused the economy to overheat, sparking inflation. That dog didn’t bark; Summers suggests the reason our economy remains stagnant is a profound imbalance between our collective desire to save and our desire to invest.

Balancing the desires of savers and investors is traditionally the task of monetary policy. Cut interest rates and saving becomes less attractive. We are less tempted to put money in the bank if it earns 0.5 percent instead of 7 percent. Meanwhile, lower interest rates make investing more desirable both by making it less expensive and by increasing the present value of future cash flows. At lower interest rates, an investment can generate less revenue and still be profitable, making capital improvements more likely. To balance savings and investment merely requires finding the appropriate interest rate. Before the bust, most economists assumed that monetary policy was so powerful that it could cure all macroeconomic dilemmas.

The problem today is that our desire to save so exceeds our desire to invest that even rates barely above zero cannot bring them into line. Summers suggests that this has been true for some time and is not likely to change. Part of the problem is cyclical. When entrepreneurs notice their inventory sitting on the shelf, gathering dust, they see little reason in investing in expanding productive capacity. Why build a new and modern widget factory when you can’t sell all the widgets you already make? Cyclical downturns are relatively easy to cure. Once demand rises and consumers desire more goods than corporations are able to supply, investment in productive capacity again becomes sensible.

The deeper worry is that our current problem is secular, that is to say, built into the structure of the economy. Summers borrowed the phrase “secular stagnation” from a speech the great American Keynesian Alvin Hansen gave to the American Economic Association in the midst of the Great Depression. In 1938, Hansen suggested the reason the world was operating below capacity was a lack of interest by the private sector in investing in capital goods. He feared a declining population, the closing of the frontier, and a reduced need for capital goods would permanently dampen need for investment, making full employment a chimera.

Hansen reminded the assembled economists at the 1938 meeting that current technology required far less capital that it did back in the 19th century. In those days, railroads and steel mills absorbed billions of dollars of investment before they were able to produce a dime of profit. Our modern corporate bond market emerged because no individual or group of individuals could mobilize sufficient capital to build a railroad. Societal savings needed to be bundled together if the great 19th-century inventions were to be realized.

The 19th century was called the “capitalist period,” Hansen noted, because of its “prodigious growth in capital formation.” Back then, unemployment was merely cyclical, as rapidly rising levels of investment created jobs for everybody that wanted one. With so much less investment required in 1938, Hansen feared full employment could become unattainable.

Today, our need for capital is even lower than in Hansen’s day. When J. P. Morgan built railroads, and when Henry Ford built car factories, they required massive amounts of money in order to realize their dreams. When Mark Zuckerberg created Facebook, all he needed was a rented house, enough money to pay a handful of software engineers, and a few servers. Even non-digital industries have become more productive. Everything from steel mills to telecommunication equipment to movie production gear have become considerably cheaper, requiring less of a capital investment to produce the same quantity of goods. Continuous technological advances and their ensuing productivity gains have reduced the need both for capital and labor.

According to Max Weber, it is the thrifty Protestant burgher, forgoing sumptuous consumption in order to invest in productive activity, that is the original hero of capitalism. We retain a deep-seated respect for savers, but that regard may well be atavistic. Finance textbooks assert that capital markets exist in order to mobilize societal savings so that firms can build factories and buy machinery, allowing workers to become more productive. Today, financial markets work in the opposite direction. For the past thirty years, through stock buybacks and dividends, the US equity market funneled corporate profits to rich households rather than steering societal savings into the most productive investments.

Excess savings is pernicious because it reduces aggregate demand. Saving, whether putting money under a mattress, buying government bonds, or depositing it into a bank account, sterilizes money. It only adds to demand when it is used, either for consumption or investment.

Today, we save too much, and invest too little. That is the implicit message of our microscopic interest rates.

Breaking secular stagnation, both today and in 1938, requires policies that encourage investment or discourage savings. Creating asset price bubbles, as we have done for the last thirty years, is inequitable and risks further financial turmoil. Increasing the inflation target could force real interest rates down, but creating inflation may be harder than it looks.

It is worth remembering how secular stagnation was defeated last time: World War II, or more accurately, the huge government deficits that the warrior nations incurred to finance the war. Everybody knows it was World War II that ended the Great Depression, but it is vital to remember it wasn’t slaughtering soldiers and firebombing cities that cured the economy. It was government deficit spending, hiring workers previously unemployed, and building factories in which they could work that reinvigorated the world economy.

Today, mostly because technological advances have made the creation of capital goods so much cheaper, private sector investment is ever less likely to soak up societal savings. Nonetheless, investing for the future remains vital. We need better schools, better roads, better infrastructure. With the private sector unwilling to invest, the government needs to become the investor of last resort. The public sector has a much longer time horizon than even the most forward-looking firm. With unemployment high and interest rates low, this is the perfect moment to build homes, build schools, build roads, build parks, build free Wi-Fi everywhere, invest in our collective future. Public sector investment creates demand today and improves supply tomorrow. It is a free lunch.

Unfortunately, while economists have been moving left, public discourse has not. Politicians and much of the media remain enchanted with austerity, discredited by Keynes more than eighty years ago. It has been seven years since the onset of the financial crisis. Seven years after 1929, the economic world was awash with ideas as to how to cure capitalism. We have been slower off the mark this time, but secular stagnation finally gives us a framework to understand what is wrong and so how to cure it.

Keynes told us ultimately ideas rule the world. Let’s hope he is right.


Tom Streithorst has been a union member, an entrepreneur, a war cameraman, a commercials director, a journalist.