Talk to Comview conference, Melbourne, Tuesday, December 3, 2019
You’ve probably seen me writing a lot lately about “secular stagnation”, how it applies to all the advanced economies – the US, Europe, Britain and Japan – and how, particularly since the marked slowing in our economy since the September quarter of 2018, it’s now clearer that Australia, too, has long been caught in the same long-lasting period of stagnation. This is true even though none of our political leaders or econocrats have used the term, and they persist in forecasting that, within the next year or two, the economy will return to trend growth or better. It’s true, however, that Reserve Bank governor Philip Lowe has on several occasions acknowledged the phenomenon of a savings glut which is at the heart of secular stagnation, and is evident from the fall in world interest rates to unprecedented lows.
What I’ll do today is give you a bit more of the context and background to the secular stagnation hypothesis – more than it’s possible to include in a newspaper column and, probably, more than you’ll feel needs to be passed on to your students. I’ve always believed that teachers need to be equipped with more understanding of a concept than they see fit to pass on to their students. I often write that the world’s economists are still debating the causes of secular stagnation and, hence, the main things governments should be doing to get our economies moving again. Today I’ll outline some of the main issues they are debating - without, let me warn you, offering any resolution of that debate.
Meaning and origins of the term
Secular stagnation means a prolonged period of weak economic growth caused by change in the underlying structure of the economy. “Secular” is the old word for “structural” – as opposed to short-term weakness caused by the business cycle. “Stagnation” could mean no growth at all, but usually refers to growth persistently weaker than an economy’s “potential” growth rate, as estimated in the conventional way.
The term was first re-introduced to the debate in 2013 by the leading American economist, Laurence Summers, of Harvard, a former US Treasury Secretary in the Obama Administration. Summers was reviving a term first used by the famous American economist, Alvin Hansen, who argued in 1938, after the end of the Great Depression, that the US economy had entered a period of protracted weak growth. Since the advanced economies grew strongly in the 1940s and the post-war period, most economists believe Hansen’s theory was wrong. Summers’ retort is that, since it took another world war to lift the US economy out of the doldrums, that just shows Hansen was right. A point worth remembering is that, once the war was over, many economists feared the economy would lapse back into weak growth. Instead, it enjoyed a 30-year-long post-war “golden age” of technological advance, strong growth, full employment and rapidly rising material living standards. So accepting the reality of secular stagnation at present doesn’t necessarily imply accepting that nothing could occur that returns us to more healthy rates of growth.
In a recent speech to the IMF, the former governor of the Bank of England, Mervyn King, essentially accepted the reality of secular stagnation, but preferred to say that, since the Great Recession of 2008-09, we’ve entered the Great Stagnation and are "stuck in a low-growth trap".
This looks like another macro paradigm shift
The fact that we’re in a period of confusion and furious debate between economists about the causes of the “low-growth trap” we’re caught in, and what we need to do to escape it, may be disturbing to you, but I feel like I’ve seen this movie before – and know it will end satisfactorily . . . eventually. Why? Because I became an economic journalist in 1974, immediately after the first OPEC oil shock and just before the world recession it precipitated, which saw the advanced economies caught in “stagflation” – the combination of high unemployment and high inflation that Keynesian economics and the Phillips curve said couldn’t happen. The world’s economists fell into furious debate between Keynesians and monetarists, which took about a decade to be resolved into the new macro management policy orthodoxy that today we find under challenge: the main instrument used to manage demand should be monetary policy, not fiscal policy. The conventional wisdom among the economic managers abandoned Keynesian demand management and reverted to a neo-classical macro-economics which gave primacy to the supply (production) side of the economy.
Which side is the bigger problem: demand or supply?
This is where I advance my own theory. The concept of a macro economy that needs to be managed by the authorities goes back only as far as the Great Depression of the 1930s and the utter confusion among economists about why it had happened and what should be done about it. At the time, neo-classical economics, which was preoccupied with micro, used Say’s Law – supply creates its own demand – to assume the overall economy was always at full employment and so needed no meddling by governments. That is, it said depressions couldn’t happen. Keynes wrote the General Theory to explain why it had happened – deficient demand – and, since what today we call monetary policy was caught in a liquidity trap, why the answer was for government to create demand by its own spending. Hence the post-war orthodoxy that the big problem in achieving full employment was recurring deficiency of demand – growth in the economy’s supply side, potential production capacity, could be left to its own devices – and the best instrument to use to ensure adequate demand was the budget.
After the arrival of stagflation in the mid-1970s, economists eventually decided that, with so much inflation, demand could hardly be said to be deficient, and the big problem was on the supply side: getting productive capacity to grow faster and keep up with demand. The reversion to a form of neo-classical macro-economics fitted with this analysis. Over the medium term, the rate at which the economy could grow was determined by the supply side – the growth in potential output – which, in turn, was determined by the growth in the three Ps: population, participation and productivity. If we wanted faster growth in supply, the answer was micro-economic reform to reduce the government interventions that were inhibiting growth in participation and productivity. Macro management of demand could do nothing to hasten supply-determined growth over the medium term. Over the short term, however, monetary policy was the best instrument to use to dampen the impact of either inadequate or excessive demand which can cause fluctuations around the growth path as determined by supply. Otherwise these fluctuations would result in the new problem of excessive inflation (which was assumed to be purely “demand-pull” inflation) or, alternatively, a temporary rise in unemployment.
Which brings us to the present era of secular stagnation. Inflation is almost non-existent and interest rates are hovering above the “zero lower bound” but, though employment growth is strong and unemployment isn’t particularly high, economic growth is weak, real wage growth is weak and living standards have stopped improving. Advocates of the secular stagnation hypothesis say the problem is deficient demand and that the answer is for governments to generate some demand, particularly via government spending on such things as infrastructure. This is especially so since monetary policy now has no room to move. It’s comparative advantage relative to fiscal policy is controlling inflation, not stimulating demand when the economy is again caught in a liquidity trap.
Are you starting to detect a pattern here? In the 30-odd years after World War II, the problem was perceived to be deficient demand not deficient supply, and the right macro instrument was seen to be fiscal policy. In the 30-odd years following the emergence of high inflation, however, the problem was perceived to be deficient supply not deficient demand, and the right macro instrument was seen to be monetary policy. Since the global financial crisis and Great Recession roughly 30 years later, however, the economy has fallen into a “low-growth trap” and the leading thinkers are defining the problem as deficient demand not deficient supply, with the right instrument being fiscal policy. If so, we’re seeing unfold before us the emergence of another paradigm shift in macro management.
Symptoms of secular stagnation
In the decade or more since the Great Recession, the advanced economies’ performance has been characterised by weak growth in consumption and business investment, plus unusually low rates of productivity improvement, adding up to persistently weak economic growth overall. Inflation has been consistently below-target everywhere – itself a sign of weak demand. It’s thus not surprising that nominal wage growth has been low, but real wage growth has also been unusually low. The US economy has been stronger than most other economies, but it’s had a temporary benefit from the “sugar hit” delivered by Donald Trump’s pro-cyclical cuts in corporate and personal income tax.
The bit that doesn’t fit this story of universal weakness is surprisingly strong growth in employment and, in consequence, falling unemployment. We know that’s happened in Australia, but it’s also happened in most other economies. The strong growth in employment at a time of continuing weakness in real wage growth has prompted many of the advanced economies to revise downward their estimates of their NAIRU – non-accelerating-inflation rate of unemployment – that is, full employment. The Reserve has cut ours from “about 5 per cent” to “about 4.5 per cent”, but it’s probably lower and, in truth, no one can be sure how low.
With the sharp slowdown in Australia’s economic growth in the quarters following the June quarter of 2018, it’s become much easier to see that we, too, have been caught up in the stagnation affecting the other advanced economies. Using the three Ps, Treasury and the Reserve Bank estimate the economy’s forward-looking “trend” or potential rate of growth to be 2.75 per cent. Over the seven financial years to June 2019, that figure has been touched just twice, the economy achieving a simple average growth rate of 2.5 per cent. It’s important to note that this below-trend growth has happened despite unusually strong growth in the population – much higher population growth than in the other advanced economies. So whereas over the seven years to June 2019 real GDP grew by 19 per cent, real GDP per person grew by a pathetic 6.4 per cent. This doesn’t mean the economy is on the edge of recession. Rather it means that mere population growth accounted for two-thirds of the overall growth, leaving the other two Ps – participation and productivity – accounting for just a third.
Treasury and the Reserve have gone year after year forecasting an early return to above-trend growth, only to fall short of their forecasts, particularly for nominal wage growth. By now, it’s hard not to believe that they are merely cracking hardy, refusing to accept that something fundamental in the economy has changed.
But at the heart of the secular stagnation hypothesis is the remarkable decline in world interest rates. It’s not surprising that, with the advanced-economy-wide fall in inflation rates, nominal interest rates have also fallen. But Summers and others have demonstrated that the world real interest rate – on long-term government bonds – has been falling since long before the GFC and now is at record lows. As Phil Lowe has noted several times, this fall in interest rates can be explained only by the supply of “loanable funds” made available by savers exceeding the demand for funds from real and financial investors. Obviously, the interest rate is the price that equilibrates the supply of funds with the demand for funds. Note that this process happens on the financial side of the economy, not the real side.
Rival explanations of secular stagnation
Globalisation and the digital revolution. We know that the digital revolution is working its way through the economy, industry by industry – the entertainment and news media, retailing, accommodation, taxis, motor vehicles and many others – destroying traditional business models and leading to much uncertainty. This usually benefits consumers, bringing lower prices and new or improved services, but doing so at the expense of industry incumbents and their workers. In Australia, our retailers in particular are being put through the wringer, and it may be that this is a big factor in holding down inflation and making firms reluctant to invest. If so, this would be more in the nature of a once-only adjustment spread over a number of years, rather than permanent source of weak demand.
Mismeasurement. Many economists find it hard to believe that productivity growth, as measured, could be so weak at a time when the digital revolution is indeed revolutionising our lives and delivering so many benefits to producers and consumers. It’s probable that many of these benefits occur in our private lives and so aren’t measured by the national accounts. But Professor John Quiggin makes the broader point that the national accounting framework, which was developed about 80 years ago, was designed to measure an economy very different to the one we have today. It was designed to measure an economy dominated by the production of goods – farming, mining and manufacturing – whereas today’s economy is dominated by services, which are much harder to measure. If so, this suggest the economy is doing better in reality than the figures are telling us.
Demographic change. It’s widely believed that the ageing of the population – and, specifically, the greater proportion of workers getting close to retirement – helps explain why households are saving a higher proportion of their incomes (and thus devoting a lower proportion to consumer spending), on one hand, while the slow growing or even declining populations of most advanced economies have reduced the incentive for firms to invest in expansion. The retirement of the baby-boomer bulge has been expected to reduce the participation rate and thus make a negative contribution to the growth in potential production, though many older workers, particularly women, are staying in the workforce longer than expected. Just because people stop working doesn’t stop them consuming, of course.
Inequality. There is much evidence that globalisation and, more particularly, technological change, are “skill-biased”, favouring the growth of high-skilled occupations (eg managers and professionals), leaving some scope for growth in unskilled service occupations, but greatly reducing the demand for semi-skilled, routine jobs that are easily done by machines. Thus the middle of the workforce has been “hollowed out”. This implies that a much higher proportion of the growth in total wages is going to highly skilled and already highly paid workers. If so, a much higher proportion to wage growth is being saved rather than spent on consumption. It’s a demonstration of how increased income inequality is inhibiting economic growth. This is the reason former top econocrat Dr Mike Keating believes the best medium-term response to secular stagnation is a much great effort to ensure every level of our education and training system is helping our workforce adapt to employers’ changing demand for skills.
Debt. Phil Lowe argues that much of the weak growth in investment spending by households, companies and governments is explained by, variously, those sectors’ high levels of existing debt. In Australia, the inhibitor is much more housing debt than company debt or even government debt.
Market concentration. Some American economists believe weak growth in real wages, consumer spending, business investment and productivity can be explained partly by increasing “market concentration” as a few firms account for an ever-greater share of particular markets. The pricing power they acquire allows them to keep consumer prices higher than otherwise, limit wage increases, buy up new competitors and even limit productivity-enhancing investment. In other words, economic growth has been slowed by decades of successful rent-seeking by a small number of dominant firms – where rent-seeking means not just seeking favours from governments but also seeking out market situations when firms are able to charge prices that greatly exceed production costs (including “normal” profit). The big tech firms – Microsoft, Google, Facebook, Amazon and Apple – are classic examples of firms dominating their markets by early innovation, then buying out start-ups.
Arguments about real wages. Economists offer rival explanations for weak growth in real wages. Neo-classically inclined economists argue that real wage growth is weak purely because improvement in the productivity of labour is weak. Their solution is more micro-economic reform. But it’s by no means clear that the reforms they favour – eg lower company tax rates and further weakening of union bargaining power – would lead to higher labour productivity. Nor, at this point, is it as sure as we used to assume it was that the market economy contains some property which pretty much ensures all improvement in labour productivity is reflected in real wage growth. What if the mechanism through which that occurred was the industrial relations law’s previous balance of bargaining power between employers and unions, which IR “reform” – with its efforts to reduce collective bargaining and increase individual bargaining - has now shifted in favour of employers? Certainly, this is the union movement’s explanation for weak real wage growth. An alternative explanation is that technological change has most affected those jobs that been most unionised.
Arguments about business investment. There are various explanations for the weakness in business investment spending (or, in our case, non-mining business investment). Remember that business investment spending adds to demand in the short term and to supply – production capacity – in the medium term. One explanation is that the digital revolution has lowered the cost of capital equipment. If so, the weakness in spending isn’t as bad as it looks. Linked to this is the argument that the digital revolution has changed the nature of things firms want to invest in from expensive machinery and structures to less-expensive computer hardware and software. And linked to that is the argument that with services share of the economy ever-expanding at the expense of the goods share, meaning a shift from capital-intensive to labour-intensive production, the typical firm’s investment needs have been reduced. All these arguments imply that the weakness in business investment spending isn’t as bad as it seems, and thus not as damaging to continued expansion of potential production.
Conclusion: Although some of these explanations are mutually exclusive, it’s possible than many of them explain part of the slowdown. I’ll meet you back here in five or 10 years and tell you what economists have finally decided are the main causes, and the new conventional wisdom on how we should respond to secular stagnation. I’m pretty sure it will involve a return to worrying most about deficient demand and relying mainly on fiscal policy.
