86483 APRIL 2014 • Number 139 Sluggish Postcrisis Growth: Policies, Secular Stagnation, and Outlook Otaviano Canuto, Raj Nallari, and Breda Griffith In the aftermath of the recent global financial crisis, advanced economies have continued to experience sluggish growth. Is this slow postcrisis growth the result of a policy response that was overly reliant on monetary policy, which ran into the zero interest rate lower bound before growth was restored? Looking deeper, is secular stagnation,1 which is related to the zero lower bound and was recently brought to the fore by Larry Summers, another potential cause for advanced econo- mies’ failure to return to precrisis growth levels? This note seeks to answer these questions as well as identify what alternative policies might be pursued by advanced economies to escape secular stagnation, should stagnation propo- nents be proven correct. After a brief review of secular stagnation, Summers’ hypothesis is tested through a review of academic literature and opinion pieces. However, the secular stagnation theory is not without its critics; moreover, there is a debate between “Keynesian versus Schumpeterian” economists, which could help to shed light on the medium-term postcrisis outlook. Policy makers in advanced economies at the center of the masked by asset bubbles and the like before the crisis became global financial crisis can claim to have prevented a new apparent? If such stagnation does exist, does this reflect de- “Great Depression.” However, recovery since the outbreak of mand or supply side factors, and what different implications the crisis more than five years ago has been sluggish, just bare- would either have for policy?2 This third question has ly keeping pace with population growth and normal produc- launched an unfinished, critical debate between “Keynesian” tivity in the United States, and faring much worse in other and “Schumpeterian” economists that has yet to be resolved, industrialized countries. Despite recent signs of incipient re- with the outcome likely to have a major role in the views on covery, the current economic environment appears to be char- medium- to long-term advanced market growth prospects. acterized by insufficient aggregate demand, with below target Sluggish Postcrisis Growth inflation rates and persistently low interest rates across indus- trialized economies. Several key features help outline the ongoing recovery in ad- This raises a number of key questions: first, to what ex- vanced economies (figure 1). First, the precrisis aggregate tent does the sluggish postcrisis growth performance in ad- growth trend has disappeared, either because it was not sus- vanced countries reflect the policy choices made during and tainable to begin with, and/or because trend growth has de- in the wake of the crisis? In particular, has policy been overly clined postcrisis. Second, although a new “Great Depression” reliant on monetary policy accommodation? A second, deep- has been avoided, actual gross domestic product (GDP) re- er question is to what extent does the poor growth perfor- mains subpar, having fallen about 13 percent relative to pre- mance reflect an underlying secular stagnation, previously crisis growth trends. Growth has also fallen relative to the lat- 1 POVERTY REDUCTION AND ECONOMIC MANAGEMENT (PREM) NETWORK    www.worldbank.org/economicpremise Figure 1. Aggregate G4a GDP, Potential, and Trend ure 1. On the other hand, based on the size and persistence of 120 actual GDP the gap between actual and potential GDP exhibited in figure consensus forecast with 1, one may question whether such a transition might have 115 90% confidence interval been faster with appropriate macroeconomic policies. After 110 average of potential output estimates all, while economists often assume that, no matter where po- 105 log-linear trend tential GDP might be, actual GDP will eventually move to it, 100 convergence can also be in the reverse direction, with potential 95 GDP growth falling to meet actual growth. For example, losses associated with prolonged periods of significant output gaps, 90 for example, labor de-skilling, foregone research and develop- 85 ment (R&D) efforts, and resource idleness could become per- 80 manent, effects that are also known as “hysteresis effects.” 2000 2002 2004 2006 2008 2010 2012 2014 Source: Davies 2013. A “One-Handed” Policy Response a. The G4 includes the eurozone, Japan, the United Kingdom, and the United States. Kose, Loungani, and Terrones (2013) point out that the re- est International Monetary Fund (IMF) and Organisation for covery in advanced economies may well reflect peculiarities Economic Co-operation and Development (OECD) estimates of the policy mix adopted in response to the recent economic for potential output. Finally, despite the possibilities of a GDP crisis, compared to those implemented during previous finan- catch-up in two years, as outlined in the central GDP projec- cial crises. While fiscal and monetary policies implemented in tion, success depends upon policy makers accurately calibrat- tandem in the same countercyclical direction were successful ing their responses to the wide range of idiosyncratic chal- in promoting recovery in past recessions, this time such poli- lenges ahead (Canuto 2014). cies have been ineffective. Moreover, as shown by Kose, Loungani, and Terrones Monetary policy has been very accommodative. As poli- (2013), the ongoing recovery in advanced economies has cy interest rates approached the zero lower bound, some cen- been sluggish and fragile compared to three previous reces- tral banks, most notably the U.S. Federal Reserve, headed by a sions. Real GDP per capita returned to ascending trajectories chairman well versed in the mistakes made on the monetary soon after temporary inflections during past downturns, policy front during the Great Depression, expanded its bal- whereas for the recent crisis, it not only started decelerating ance sheets rapidly and followed other unconventional mon- prior to the global recession year (2009), but has not yet fully etary policies (Canuto 2013a). Figure 2, which compares recovered its peak levels. short-term interest rates during previous economic down- At first glance, this is not surprising given the nature of the factors underlying the crisis: the pervasiveness and magni- Figure 2. Short-Term Interest Rates during Global Recessions and tude of asset booms and busts; the design flaws of the euro- Recoveries for Advanced Economies (%) zone that only fully revealed themselves as the crisis unfolded; the degree of synchronization of individual country reces- 14 sions; the policy uncertainty resulting from a loss of confi- 12 dence on the sufficiency of established policy blueprints; and more. Moreover, any transition from a previously booming 10 economy to a “new normal” would necessarily entail a signifi- cant reallocation of resources, with creation/destruction of 8 jobs and productive assets. As remarked by Rajan (2013): The bust that follows years of a debt-fueled 6 boom leaves behind an economy that supplies too much of the wrong kind of good relative to 4 the changed demand. Unlike a normal cyclical recession, in which demand falls across the 2 board and recovery requires merely rehiring laid-off workers to resume their old jobs, eco- 0 nomic recovery following a lending bust typi- -4 -2 0 2 4 cally requires workers to move across industries Source: Kose, Loungani, and Terrones 2013, 34. and to new locations. Note: Zero is the global recession year. Each line shows the PPP-weighted average Taken together, these factors mean that trend growth like- of the countries in the advanced economies. The red line refers to recovery from the Great Recession; the blue line refers to the average of previous recessions ly followed something similar to the dotted orange line in fig- (1975, 1982, 1991) and the grey vertical line refers to the global recession year. 2 POVERTY REDUCTION AND ECONOMIC MANAGEMENT (PREM) NETWORK    www.worldbank.org/economicpremise turns and the most recent episode (the “Great Recession”), il- eurozone countries had far more room for fiscal expansion lustrates the extremely accommodating nature of monetary than they ultimately used. policy. This new policy mix no doubt contributed to the current Conversely, while previous recoveries were supported by sluggish postcrisis recovery. In crisis conditions, and in situa- expanded public spending, this time fiscal policy has moved tions where fiscal retrenchment is employed in a synchro- in the opposite direction (figure 3). This shift was made de- nized manner, fiscal multipliers tend to be much higher than spite the low costs of borrowing, which would presumably usual (IMF 2012). Fiscal retrenchment, therefore, is likely a have allowed large-scale public investment projects with high- contributing factor to the currently slow recovery. er returns than initial costs. The fiscal stimulus implemented But what about monetary policy? There is no doubt that in the United States at the outset of the downturn was re- the early and sharp reductions in interest rates helped. How- versed not long after, followed by fiscal contraction. In the ever, once the zero lower interest rate bound was reached, cen- eurozone, fiscal austerity policies were implemented as finan- tral bankers were forced to rely on more unconventional mon- cial havoc morphed into fiscal unsustainability among its cri- etary policy measures. These measures certainly helped, and sis-ridden members. Austerity has also been favored in the the U.S. Federal Reserve has, for example, estimated that in- United Kingdom. terest rates fell along the yield curve in the wake of its balance Why has the fiscal and monetary policy mix been so dif- sheet expansion. But the size of the effects of such policies is ferent this time round? On the fiscal policy side, as shown by “very limited and uncertain” (Blanchard 2013). Kose, Loungani, and Terrones (2013), public debt levels in Moreover, the scope for engaging in a long period of advanced economies were much higher than in past macro- quantitative easing (QE) is limited, because QE expands cen- economic downturns. Public deficit levels had soared in the tral bank balance sheets to levels that are risky and may lead to run-up to the recession, given the scale of financial support political resistance, while the availability of appropriate in- measures and substantial revenue losses. However, the use of struments for purchase is limited. This means that ongoing austerity as a policy option was exercised: in the cases of the QE could begin to dominate, rather than just influence, some United States and the United Kingdom, financial markets private sector markets; short-term QE can only achieve so were not signaling the need for the short-term fiscal retrench- much. As Summers argued (2013b), “whereas you can keep the federal funds rate at a low level forever, it’s much harder to ment that was adopted. Likewise in the eurozone, some fiscal do extraordinary measures beyond that forever, but the un- adjustment was unavoidable in crisis-ridden members, yet its derlying problem may be there forever.” pace could have been more measured had higher financial support from outside been made available. Furthermore, core What If a “Secular Stagnation” Trend Has Been at Play? Which One? Figure 3. Real Primary Expenditure of Advanced Economies The role of asset bubbles in pulling up the precrisis growth (index, PPP weighted) trajectory depicted in figure 1 is now widely acknowledged. In 130 the case of the United States: The liquidity-generating machine inflated U.S. 120 asset values and fed the exuberant growth of U.S. household spending. U.S. consumers have 110 accounted for more than one-third of the growth in global private consumption since 100 1990. Increasingly, their spending was made possible by the wealth effect generated by the 90 rising prices of housing and household financial assets and stocks, whose values were in turn ex- 80 pected to more than outstrip those of house- hold debt. It was this upswing in consumption 70 by U.S. households and others as debt-based consumers-of-last-resort in the global economy 60 that essentially made possible the extraordinary -4 -2 0 2 4 structural transformation and productivity in- Source: Kose, Loungani, and Terrones 2013, 33. creases experienced by some manufacturing Notes: Dashed lines denote World Economic Outlook forecasts. Figures are exporters and commodity producers among de- indexed to 100 in the year before global recession. Zero is the global recession year. Each line shows the PPP-weighted average of the countries in the advanced veloping economies (Canuto 2009). economies. The red line refers to recovery from the Great Recession; the blue line refers to the average of previous recessions (1975, 1982, 1991) and the grey A similar bubble-led growth process was found within vertical line refers to the global recession year. the eurozone, beginning with the downward convergence of 3 POVERTY REDUCTION AND ECONOMIC MANAGEMENT (PREM) NETWORK    www.worldbank.org/economicpremise perceived risks and interest rates throughout the zone after ployment—could be seen as underlying the evolution shown the introduction of the new common currency. Countries in figure 4. that are currently under stress were able to sustain domestic Wolf (2013) offers a detailed account3 of why the Sum- absorption much above domestic production capacities for a mers hypothesis may make sense. Wolf agrees that the finan- long period, easily financing the difference because of fallen- cial excesses prior to the crisis masked structural weaknesses from-heaven domestic asset value appreciation. The underes- that are now obvious in the postcrisis world. The structural timation of fiscal risks can also be seen as a manifestation of weaknesses are, according to Wolf: (i) the global savings glut such euphoria. Asset-price dynamics are now considered a (figure 5) and, relatedly, (ii) global imbalances. The global key area to be addressed by policy makers, and macropruden- economy has generated more savings than businesses wish to tial policies are now a component of the macroeconomic sta- use, even at very low interest rates, which would usually tend bilization toolkit (Canuto 2013b). to stimulate such investment. The global savings glut, or its However, enhancing the policy framework by revamping counterpoint, the investment dearth, has low real interest financial regulation and supervision and combining mone- rates as its counterpart. Relatedly, the large current account tary and prudential policies to ensure both financial and mac- surpluses of some East Asian emerging economies, including roeconomic stability may not be enough if some underlying China (although to a lesser extent than before the crisis), as secular trend of stagnation is at play. If the precrisis growth well as several high-income countries such as Germany and trend in figure 1 was inextricably dependent on the over- large oil exporters, has meant that these economies became spending induced by the financial frenzy—credit and house net suppliers of savings to the rest of the world. Prior to the bubbles—running its course, avoiding future asset price recent crisis, the United States absorbed most of these global booms and busts might simply lead to stability around low savings, albeit in investments that were often unproductive, growth rates. This view underlies the possibility of a “secular as evidenced by the precrisis housing and investment bubbles. stagnation” trend, as raised by economists Krugman (2013b) The fact that desired investment has fallen in the wake of the and Summers (2013c): crisis only exacerbates the effects described by Summers Manifestly unsustainable bubbles and loosen- (2013c). ing of credit standards during the middle of the Fatás (2013b), in a recent blog post, also considers the past decade, along with very easy money, were savings glut and investment dearth and argues that that the sufficient to drive only moderate economic only way to validate the savings glut hypothesis was if the in- growth. (…) short-term interest rates are severely vestment curve was shifting inwards, as in figure 6. This is constrained by the zero lower bound: real rates consistent with the fact that investment fell rather than rose, may not be able to fall far enough to spur enough as would have been the case if a rightward shift of the savings investment to lead to full employment (Sum- mers 2013c). Figure 4. U.S.–Private Nonresidential Investment and Real Interest Under secular stagnation, and at the zero lower bound, Rates flexible wages and prices may not help because they may 14 end up exacerbating real debt burdens, which are already high for debtors, while falling prices can lead to postpone- 12 ment of purchases, further undermining demand. Sum- mers (2013a) categorizes this world as one in which re- 10 sources become increasingly concentrated in the hands of 8 those with high propensities to save and low propensities to invest, such as very rich individuals and reserve-accumulat- 6 ing foreign governments. Krugman, Summers, and others—referred to here as 4 “Keynesian”—economists have suggested an array of possible reasons for the U.S. economy and other advanced economies’ 2 demonstrated propensity for aggregate demand shortfalls, in the sense that, as a result of structural conditions, aggregate 0 Q4 Q3 Q1 Q1 Q4 Q4 20 4 Q3 spending would be enough to ensure full employment and Q 82 90 91 01 01 07 07 13 use of potential output capacity only in the presence of nega- 19 19 19 20 20 20 20 tive real interest rates. Such an “investment drought”—or, on private nonresidential investment (% of GDP) the flipside, a “savings glut” as measured by levels of noncon- real interest rate sumption expenditures required to sustain income at full em- Source: Fatás 2013a. 4 POVERTY REDUCTION AND ECONOMIC MANAGEMENT (PREM) NETWORK    www.worldbank.org/economicpremise Figure 5. Global Savings as a Percentage of GDP 40 35 30 25 % GDP 20 15 10 5 0 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10 12 14 19 19 19 19 19 19 19 19 19 19 20 20 20 20 20 20 20 20 world advanced economies emerging market and developing economies Source: IMF World Economic Outlook (WEO) Database, http://www.imf.org/external/pubs/ft/weo/2013/02/weodata/index.aspx, accessed February 21, 2014. curve was the main explanatory factor. Indeed, Fatás shows Krugman (2013c) invokes Hansen (1939), who, as a key that the aggregate investment rate as a percentage of GDP for architect of the secular stagnation hypothesis, suggested that advanced economies exhibited a clear downward trend from slowing population growth would mean low investment and 1980 to 2012. This also helps explain why growth and labor lower growth. While Hansen did not foresee the baby boom market performance have been sluggish since 2000 in some that ultimately resulted in the U.S. labor force growing at an advanced economies. average of 2.1 percent annually6 over 1960–85, accompanied Echoing these arguments, Drum (2013a) contends by full employment and sustained investment, Krugman sug- that there “simply aren’t enough promising real-world in- gests that “this time around the slowdown is here, and looks vestments available at current interest rates.” Some of the real.” He notes that the working-age population in the United reasons reviewed by Drum for the lack of investment oppor- States is projected to grow at an annual rate of just 0.2 percent tunities include Krugman’s view of demographics, the in- annually between 2015 and 2025, reflecting slower overall creased automation view (Drum’s 2013b) in which ma- population growth as well as population aging, and suggesting chines take over more work, resulting in fewer available jobs a new equilibrium in which both investment and growth are and less disposable income; Cowen’s (2011) theory of the both lower. Krugman (2013c) posits that the decline in popu- great stagnation;4 rising income inequality (CEPR 2013) lation growth may have reduced the natural rate of interest by that squeezes the middle class and their economic ability to an equal amount and that the secular stagnation in Japan may fuel the consumer economy (given that rising shares of in- well have resulted from its shrinking working-age population. come accruing to capital and the very wealthy tends to lead Summers (2014) argues that “our economy is held back to underconsumption); and Bernstein’s (2013) view that by lack of demand rather than lack of supply. Increasing ca- the culprit is the financialization5 of the United States and pacity to produce will not translate into increased output un- the world. less there is more demand for goods and services.” He strong- ly recommends establishing “a commitment to raising the Figure 6. The Savings Glut and Investment Dearth level of demand at any given level of interest rates through policies that restore a situation where reasonable growth and real interest rate reasonable interest rates can coincide.” If the argument pro- posing increased demand as key to economic recovery is cor- savings (1990s) rect, then the prevailing postcrisis policy mix has been inap- savings glut propriate. Instead of relying single-handedly on ultra-loose monetary policy, the retrenchment of public spending—on real interest rate infrastructure, energy, and others—should be reversed where (1990s) there is fiscal space. At the same time, pro-active public poli- real interest rate investment (1990s) cies to ignite private investment spending should also be im- (2000s) plemented. investment dearth Summers (2014) cites three approaches to help avoid Source: Fatás 2013b. secular stagnation: 5 POVERTY REDUCTION AND ECONOMIC MANAGEMENT (PREM) NETWORK    www.worldbank.org/economicpremise • The first approach targets the supply side of the econo- Ball (2013) examines the implications of a 4 percent in- my—the skills of the workforce, firms’ capacity for inno- flation target and concludes that such a rate would ease the vation, structural tax reform, and sustainable entitle- constraints on monetary policy arising from a zero lower ment programs. This approach focuses on the long-term bound and ameliorate economic downturns. Indeed, Ball health of the economy and, despite its clear merits, is (2013) estimates that had central banks targeted a 4 percent unlikely to achieve anything significant in terms of gener- inflation rate in the early 2000s, average unemployment over ating higher growth over the next five years or so. More- 2010–13 could have been lowered by a full 2 percentage over, in the short term, there is the problem of insuffi- points. Ball also reviews eight recessions in the United States cient demand, and Summers (2014) cautions that raising since 1960 and suggests that of the three recessions that be- supply “could have the perverse effect of magnifying de- gan with inflation rates between 2 and 3 percent, the lower flationary pressures,” which brings with it debt deflation bound on interest rates was much more binding compared to problems, as already mentioned. the remaining recessions that began with inflation above 4 • The second approach is to continue with the current percent. He suggests that an initial inflation rate of 2 percent policy of lowering relevant interest rates and capital costs as will produce a bound of -1 percent on the real interest rate. much as possible and relying on prudent regulation to Krugman (2013b) addresses two of the main arguments ensure financial sustainability. Several central banks, against a higher inflation target, but dismisses both. First, to such as the U.S. Federal Reserve and the Bank of Japan those that contend “events like the current crisis almost never have employed QE to further lower the real interest rate happen,” Krugman responds that the costs are so huge, that and generate new investment demand. But, as noted, the they warrant different policies. Furthermore, the liquidity scope for sustained QE is limited. trap was on the horizon in the last three recessions, promul- • Summers most favors the third approach, which in- gated by private sector overreach and not U.S. Federal Reserve volves the commitment to raise the level of demand at any tightening. The most recent recession, Krugman argues, was given level of interest rates. He calls for expansionary similar to what has now become a regular pattern, not an un- fiscal policy to take advantage of the current slack in the expected exception. The second argument against a higher economy and low borrowing rates and to renew and re- inflation target is a credibility problem—the central bank an- build critical infrastructure. Increased demand would nounces a higher target and suddenly it’s a “slippery-slope” spur private investment, and Summers cites the un- issue. Ball (2013) finds no evidence for this fear, and Krug- tapped energy sector as an example of an area that man (2013b) concludes that “the conventional 2 percent tar- could benefit from private investment in fossil fuels get is a prejudice, nothing more.” and renewables. But the argument for a higher inflation target is highly This third approach is also what De Long (2014) termed controversial, even among those that believe something the first best solution in attacking the underlying market fail- should be done to address the secular stagnation. Indeed, De ures that have brought about secular stagnation. De Long first Long (2014) contends that undermining central banks’ track outlines the “very different fiscal policy” favored by Summers records on price stability by increasing the inflation target (2014), in which the U.S. government would take advantage risks undermining governments’ reputations, which could of the global savings glut to borrow and spend, and in combi- generate further financial instability. Kaminska (2014), in nation with the significant economic slack and low borrowing agreement with De Long,9 cautions against even modest in- costs that exist, resulting in the government successfully re- crease in inflation and underscores the importance of preserv- balancing its long-term finances and lowering its debt bur- ing trust in fiat currencies. According to Kaminska, it be- den.7 However, as acknowledged by De Long (2014) as well as hooves the central bank to do its job well and guard against Krugman (2013c), the political will is not there, so the second the slippery slope of inflation.10 Both Bernanke (2010) and best alternative needs to be sized up. Mishkin (2011) also subscribe to the slippery slope theory. The second best alternative, termed “Blanchardist” by De Bernanke suggests that inflation would become more volatile Long (2014) and “the solution that cannot be named”8 by above 4 percent, and inflation expectations would likely be- Avent (2013b), focuses on setting and aiming for a higher in- come less stable. In a similar vein, Mishkin (2011) noted that flation target. Since 2010, Blanchard, Dell’Ariccia, and Mau- inflation tends to keep on rising once it goes above 3 percent. ro (2010) have argued on the merits of a higher inflation tar- Wolff (2014) brings an international dimension into the pol- get to help alleviate the impact of the zero interest lower icy options. Beyond advocating improved investment condi- bound: it is much easier to generate negative real interest rates tions, Wolff argues for a better integrated international finan- at higher inflation. They also question whether the costs of cial system. He also suggests that emerging market investment inflation are really much higher at, say, 4 percent than they are demand may be part of the solution. For instance, the more at the current target range. China and India are integrated into the global economy, the 6 POVERTY REDUCTION AND ECONOMIC MANAGEMENT (PREM) NETWORK    www.worldbank.org/economicpremise more they should increase global investment demand, thus vanced countries need to focus on reviving in- helping to alleviate secular stagnation. novation and productivity growth over the me- dium term, and on realigning welfare promises Not Without Its Critics: with revenue capacity, while alleviating the pain The “Schumpeterian” View of the truly destitute in the short run. On the other side of the debate, there are those—called here Not Without Its Critics: More Views on “Schumpeterian”—economists who have offered supply side– Secular Stagnation based hypotheses of a long-run stagnation trend already on course for some time. Like Schumpeter, they emphasize the Beyond the Schumpeterian critiques, there are other valid role of growth in a process of “creative destruction” in which criticisms of the secular stagnation hypothesis. Although Tay- obsolete forms of resource allocation and wealth—jobs, fixed lor (2013) is in agreement with Summers and others about capital assets, technologies, and balance sheets—are replaced the weak postcrisis recovery, he is not convinced that a low by higher-value forms. Although accepting the eventual role equilibrium real rate of interest is at fault. Taylor contends of monetary policies in avoiding systemic financial melt- that bad policy decisions, rather than secular stagnation, are downs, these economists tend—also like Schumpeter—to be holding back the economy. He argues that lax enforcement of more skeptical of fiscal or other types of countercyclical stim- financial regulations before the crisis caused major problems. uli if designed in ways that impede the process of creative de- And, during and since the crisis, Taylor argues that new and struction. As for the postcrisis policy mix, even if it is ac- complex regulations, such as the Dodd-Frank act, and failed knowledged that fiscal policy may have moved prematurely to temporary stimulus packages, such as cash for clunkers, along contraction, ultimately public policy action to prop up aggre- with higher federal debt and a highly discretionary monetary gate demand is not considered to be a key component in the policy, have generated distortions and uncertainty, which are fight against stagnation under the Schumpeterian view: “If holding back economic growth. you are postulating a stagnation across the longer run, ulti- Cowen (2013) casts doubt on the assumption that the mately it will have to boil down to supply side deficiencies” equilibrium real rate of return is negative. He argues that, al- (Cowen 2013). The evolution of declining investments in the though real rates held on certain government securities, posi- context of lower interest rates, as shown in figure 4, would be tive rates still held on many other investments in the United stemming from disadvantageous rates of return not related to States. In Cowen’s view, a very negative real rate of return the pace of aggregate demand expansion. would not be a “natural” rate, and instead would be associated Gordon (2014) has for some time now proposed the hy- with negative economic growth and other problems. Looking pothesis that technological evolution can lead to stagnation further ahead, he argues that capital obsolescence, which re- trends. Nevertheless, his arguments regard the low productiv- quires new investment, would pull the economy out of secu- ity–raising features of current technological trajectories rath- lar stagnation over time. Cowen does, however, allow for the er than their supposedly dampening implications for aggre- fact that the real rate of return on capital could be positive, gate demand. Cowen (2011) has in turn approached but low, which would require very negative borrowing rates to stagnation as an outcome of the exhaustion of a significant set reflate the economy, given the high risk premium. of “low-hanging fruits” reaped in recent history, namely one- off supply side opportunities associated with postwar recon- Where Does This Leave Us? struction; trade opening; diffusion of new technologies in Postcrisis recovery has been unusually sluggish. This partly power, transport, and communications; educational attain- reflects the implementation of a poor policy mix—one overly ments; and others. Other supply side stagnation possibilities reliant on a monetary policy that had run into the zero lower recently suggested are associated with features of resource al- bound, and one that eschewed large-scale publicly funded in- location—for example, the oversizing of financial activities, as vestments financed at historically low interest rates. discussed by Canuto (2013c). But this sluggish growth may also reflect something deep- As outlined by Rajan (2012), speculation on stagnation er. Larry Summers recently invoked the secular stagnation hy- trends along this line suggests that: pothesis as a key reason for the unusually slow postcrisis growth The advanced countries’ precrisis GDP was un- rebound in the United States and other advanced economies. sustainable, bolstered by borrowing and unpro- In doing so, he dusted off a theory that first rose to prominence ductive make-work jobs. More borrowed in the late 1930s, associated with Alvin Hansen. Is secular stag- growth—the Keynesian formula—may create the illusion of normalcy, and may be useful in the nation likely to hold sway in the 21st century? If this theory is immediate aftermath of a deep crisis to calm a correct—that the equilibrium real interest rate could well be panic, but it is no solution to a fundamental negative due to large savings (associated with population aging) growth problem. If this diagnosis is correct, ad- and a dearth of investment demand—this is a new danger. 7 POVERTY REDUCTION AND ECONOMIC MANAGEMENT (PREM) NETWORK    www.worldbank.org/economicpremise The secular stagnation hypothesis has its critics. Most Competitiveness Practice at the World Bank Institute (WBI). He notably, so-called Schumpeterian economists maintain that has worked at the World Bank since July 1986 in various ca- supply side constraints explain sluggish growth, rather than pacities. Previously, he worked in the International Monetary demand side factors, and that reliance on stimulus mea- Fund Policy Development and Review Department from 2001 to sures—such as higher public investment—is not a recipe for 2003. He holds a PhD in economics from the University of success. Keynesian and Schumpeterian hypotheses of stag- Texas at Austin. Breda Griffith is a consultant for the Growth nation trends are based on not directly observable factors. and Competitiveness Practice at the WBI since 2005. Prior to Therefore, the struggle for the hearts and minds of the pub- 2005, she lectured on economics and entrepreneurship at lic and policy makers will likely remain unsettled. Dublin City University, Ireland. She has coauthored books on However, what if there is merit to the secular stagnation economic growth, poverty, gender, development, labor mar- view? What does this imply for policy? Policy prescriptions for kets, geography of growth, and competitiveness. She holds a such stagnation are either slow in bearing fruit—such as struc- PhD in economics from Trinity College, Dublin, Ireland. tural reforms to address supply side constraints—or do not Notes garner sufficient political backing, such as open-ended QE or fiscal stimuli concentrated on public investment. And the re- 1. Secular stagnation was introduced into the literature in the maining policy approach—increasing the official inflation tar- late 1930s by Alvin Hansen, who suggested that population get to reduce the impact of the zero interest rate lower growth would lead to low investment demand and low bound—has few proponents. growth. Even within these constraints, however, policy makers 2. The loosening of credit standards and the unsustainable could make improvements at the margin. First, regardless of bubbles in financial and housing markets in the precrisis pe- the size of public outlays, public action and spending should riod were associated with moderate growth at best, pointing be designed in ways that “maximize the bang for the buck” in to a weak, underlying sustainable growth trend. terms of overcoming obstacles to both secular stagnation and 3. These factors have already been detailed in this note. Wolf the process of creative destruction. Take the case of Japan: the (2013) summarizes these as: (i) weak growth despite expan- third arrow of Abenomics—on structural reforms of the ser- sionary monetary policies, referencing the U.S. economy’s vices sectors and others—will be necessary to achieve success- third quarter rate in 2013 that was just 5.5 percent bigger ful results from its fiscal and monetary arrows. In the Euro- than its precrisis peak and the continuing decline in U.S. real zone, timely restructuring/consolidation of “zombie” balance GDP relative to the precrisis trend; (ii) the bubble economy, sheets and companies, with a more pro-active stance taken by fed by rapid increases in leverage by the household and finan- monetary and financial authorities, should also facilitate the cial sectors that did not translate into above trend growth and/ trek out of the current stagnation. Second, regardless of or inflation; and (iii) despite strong global economic growth whether advanced economies are facing a demand or supply prior to the crisis, long-term real interest rates remained low, side stagnation trend, a major bet for the global economy to referencing the yield on UK long-term, index-linked govern- escape depends on the developing world’s economic transfor- ment liabilities (gilts) falling from close to 4 percent to about mation as a source of growth (Canuto 2011). However, for 2 percent after the Asian financial crisis, and then to negative that to happen, developing countries themselves need to face levels after the financial crisis. U.S. Treasury inflation-protect- their own country-specific agendas of structural reform (Ca- ed securities (TIPS) followed a similar course, albeit later. nuto 2013d). 4. Related to this, steep declines in the costs of durable goods— If Summers and other secular stagnation theorists are especially those associated with information and communica- correct, the issues facing Japan over the past decades could of- tion technology and/or outsourcing—would mean less spend- fer a glimpse of what lies ahead for many of the advanced ing associated with investment plans out of corporate savings. economies around the world. Certain policies can maximize Furthermore, the trajectories of technological evolution cur- the “bang for the buck,” allowing relief to flow from emerging rently unfolding would not carry an array of high-return in- market economies; however, relying on both these arrows vestment opportunities comparable to those in the past. may, in the end, fall short of what is needed. 5. Defined as the “relative growth of the finance sector.” (Ber- nstein 2013) About the Authors 6. Reflecting maturing baby boomers and increasing numbers Otaviano Canuto is Senior Advisor on BRICS Economies in the of women entering the labor force. Development Economics Department at the World Bank. He pre- 7. As Krugman (2013b) notes, servicing the debt by stabiliz- viously served as the World Bank’s Vice President and Head of ing the ratio of debt to GDP, in an environment of persistent- the Poverty Reduction and Economic Management (PREM) Net- ly negative real interest rates and positive, albeit moderate, work. Raj Nallari is the Practice Manager for the Growth and growth, has no cost. 8 POVERTY REDUCTION AND ECONOMIC MANAGEMENT (PREM) NETWORK    www.worldbank.org/economicpremise 8. Although as Krugman notes, “Actually, I’ve named it re- group-walking-on-the-wild-side-monetary-policy-and-pruden- peatedly; so have many others” (http://krugman.blogs.ny- tial-regulation/. ———. 2013c. “Finance as an Economic Cholesterol.” Huffington times.com/2013/11/19/monetary-and-fiscal-implications-of- Post, September 3, http://www.huffingtonpost.com/otaviano- secular-stagnation/). -canuto/finance-as-an-economic-ch_b_3860542.html. 9. De Long (2014) cites a hypothetical example in which a ———. 2013d. “Lost in Transition.” Project Syndicate, December 2, random investment bank (Schiff Medici Pomponius), in the http://www.project-syndicate.org/commentary/otaviano-canu- face of an increased inflation target (5 percent per year), de- to-reevaluates-emerging-economies--growth-prospects. cides to become involved in a liquid-safe-store-of-value busi- ———. 2014. “Calibrating 2014.” Huffington Post, January 2, http://www.huffingtonpost.com/otaviano-canuto/calibrating- ness. The bank will then construct a basket of durable, stor- -2014_b_4531942.html. able commodities to mimic the price level, fill containers with CEPR (Center for Economic and Policy Research). 2013. “Bubbles these, and store them. Then they will set up their own crypto- Are Not Funny.” November 16, http://www.cepr.net/index. currency and begin to trade in this, and thus take the seignior- php/blogs/beat-the-press/bubbles-are-not-funny. age business away from the 5 percent per year inflation gov- Cowen, T. 2011. “The Great Stagnation: How America Ate All ernments. the Low-Hanging Fruit of Modern History, Got Sick, and Will (Eventually) Feel Better.” Dutton Publishing, Penguin. 10. “If the store of value is based on a consumable or usable ———. 2013. “Are Real Rates of Return Negative? Is the “Natural” commodity or good, however, it’s going to be much harder to Real Rate of Return Negative?” Marginal Revolution, No- control the incentive to create ever more of it when the price vember 18, http://marginalrevolution.com/marginalrevolu- goes up” (Kaminska 2014). tion/2013/11/are-real-rates-of-return-negative-is-the-natural- real-rate-of-return-negative.html. 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The Economic Premise note series is intended to summarize good practices and key policy findings on topics related to economic policy. They are produced by the Poverty Reduction and Economic Management (PREM) Network Vice-Presidency of the World Bank. The views expressed here are those of the authors and do not necessarily reflect those of the World Bank. The notes are available at: www.worldbank.org/economicpremise. 10 POVERTY REDUCTION AND ECONOMIC MANAGEMENT (PREM) NETWORK    www.worldbank.org/economicpremise