By William Labasi-Sammartino, Reims Economic Society
Welcome to a new writing series from the Reims Economic Society! The Sundial has kindly given us a platform to write articles every now and then. We will provide a commentary on world economic affairs and also review ongoing discussions in the financial press and the economic blogosphere. We will shortly post a list of blogs and pages we highly recommend you read before coming here (some honest humility right here). To serve as an introductory post, we’ll discuss the current state of the world economy.
Today’s combination of low growth, low inflation, low interest rates, low labour participation, etc. has led some to call this the Age of Secular Stagnation or of Sclerotic Growth. The average annual growth rate during the 80s and 90s was 3.1 and 3.2% respectively. Since 2005, it’s been at a meagre 1.6%. This is especially alarming considering that countries hit by the Great Recession should have shown catch-up growth rates. In the graph below, we see the enduring gap between potential and actual output for the U.S. Notice how other countries don’t seem to be returning to trend either. Other major economies such as Japan and Europe have not seen nearly the same amount of growth as the U.S.
As a result, many commentators have come out with different explanations.
Secular Stagnation : a story of high saving and low investment
So-called secular stagnation has become one of the most popular — well, at least, it’s gotten the most attention. Larry Summers has led a group of economists who have argued that there is a chronic deficit in aggregate demand around the globe and that the Great Recession has only made matters worse. Summers points to global monetary policy which seems to being unable to reboot spending and low interest rates as being suggestive of a worldwide drop in demand to invest. Instead, there has been a rise in savings. All of this puts downward pressure on the natural rate of interest. Critically, even if economic conditions return to what they were before the crisis, monetary policy will be unable to reach the required interest rate which coincides with full employment. Hence, full employment may be elusive.
The graph shows an undeniable truth to Summers’ story : the natural equilibrium rate of interest has fallen. The last decade’s low inflation and low nominal income growth has been indicative that even if central banks target near-zero interest rates, it will have limited stimulative effect.
Stuck in a liquidity trap?Paul Krugman, on the other hand, has advocated for nearly a decade that we have entered a period of “liquidity trap economics”. The idea of the liquidity trap was notably developed in Keynes’ General Theory where it is said that monetary policy is ineffective when a central bank’s main instrument, the short-term nominal interest rate, has hit the zero lower bound (ZLB). The U.S. was in such a situation from 2008 to December of last year. Krugman has repeatedly argued in his NYT column that monetary policy is ineffective in such circumstances and that governments should therefore not solely rely on their central banks to get growth going again. Thus only expansive fiscal policy will manage to increase demand. As much as Krugman’s push for reigniting interest in an old-school Keynesian approach to macroeconomic policy has attracted a lot of attention, a long list of economists have argued that central banks still have a lot of “ammo” left. This issue will be covered in future articles ; however, it is worth mentioning now that the quantitative easing (QE) programs that the Federal Reserve, the Bank of England, Bank of Japan, and now the European Central Bank have undertaken are a testament to this view. Even if there is a lot of talk about monetary policy being powerless at the ZLB, this claim remains highly disputed.
Other significant headwinds
Another prominent position points to the supply-side in the sense that there is too much regulation which is holding down the world economy. Along with others, John Cochrane has espoused this view on his blog and in a string of articles. He claims that the low productivity growth has resulted in the real economy growing at below trend levels. He points to the excessive amount of regulation, complicated tax schemes, poor public schools, and policies promoting closed borders as the main culprits.
Particularly, but not exclusively to the US, urban centres may be over regulated. Combine unbearable zoning laws and construction regulations with slow population growth, cities can’t deliver the innovative and job growth that is necessary to keep the economy on trend. Increased regulation restricts the supply of housing thus leading to higher real estate prices which in turn hinders population growth and increases inequality.
Robert Gordon has famously been pessimistic on American productivity growth. He suggests that the IT-technology boom was a singular event and that we should settle for stagnation in technological progress. Furthermore, low population growth, rising inequality, and a poor education system all contribute to the current state of the US economy.
These reasons should not be ignored since important structural factors tend to matter much more in determining an economy’s long run performance.
Other narratives involve the astonishing growth in public and private debt around the world. Kenneth Rogoff has laid out this debt overhang hypothesis in a couple of (in)famous[i] papers in 2010[ii] and 2012[iii] where he argues that excessive amounts of debt can cause economies to grow at a considerably lower rate. Reinhart, Reinhart, and Rogoff (2012)[iv] shows that countries that demonstrate debt to GDP ratios above 90% experience, on average, 1.2% lower annual growth.
There has been a lot of debate around this issue since the world economy’s low growth has been quite puzzling. There seems to be a tentative consensus that many structural factors in industrialized economies are in need of reform in some way. Even Larry Summers has recently pointed to the US’ unfavourable climate for infrastructure development in a recent article for the Boston Globe[v]. The same can be said about housing regulation. Several commentators of different political stripes have found similar conclusions (see here[vi], here[vii], and here[viii]). A likely scenario is that supply-side issues will be resolved on a case-by-case basis after sufficient formal evidence is presented.
Demand-side and by extension short-run issues are, conversely, a bit more complicated. Being subject to elegant and elaborate macroeconomic theories, short-run economic policy has always been strongly debated and highly polarizing. This is why monetary and fiscal policy in the current world economy will be further discussed in future posts.
All time series come from the Federal Reserve Bank of St. Louis :
Graphics are author’s calculations.
[iii] “Public Debt Overhangs: Advanced-Economy Episodes since 1800” (with Carmen M. Reinhart and Vincent R. Reinhart), Journal of Economic Perspectives, Vol. 26, No. 3, Summer 2012
[iv] Carmen M. Reinhart & Vincent R. Reinhart & Kenneth S. Rogoff, 2012.”Debt Overhangs: Past and Present,” NBER Working Papers 18015, National Bureau of Economic Research, Inc.
[viii] Glaeser, Edward L. and Joseph Gyourko. “The Impact Of Building Restrictions On Housing Affordability,” FRB New York – Economic Policy Review, 2003, v9(2,Jun), 21-39.