Secular stagnation and post-scarcity

Secular stagnation and post-scarcity

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“Many people think monetary policy was too easy [before the crisis], everybody believes that there was a vast amount of imprudent lending going on and almost everybody believes that wealth as it was experienced by households was in excess of reality. Was there a great boom? Capacity utilisation wasn`t under any pressure, unemployment wasn`t at any remarkably low level and inflation was entirely quiescent. Somehow even a great boom was unable to produce any excess in aggregate demand…

Suppose then that the short term real interest rate that was consistent with full employment had fallen to negative two or negative three percent. Even with artificial stimulus to demand you wouldn`t see any excess demand. Even with a resumption in normal credit conditions you would have a lot of difficulty getting back to full employment.”

Larry Summers - November 8, 2013

Larry Summers’ speech given at the IMF Economic Forum has prompted a lot of interesting discussion over the concept of secular stagnation. The idea, as Summers spells out above, is that the bursting of the housing bubble from 2007 was merely the proximate cause of the Great Recession. Underlying it was a structural trend towards secular stagnation that has stretched back decades.

While there will be fevered debate over the possible causes of secular stagnation one thesis I would like to advance is that of over-supply. Summers suggests that in order to soak up idle resources in developed economies policymakers have had to make a habit of pumping up asset bubbles. Yet he notes they have apparently done so without stoking rampant inflation.

A possible answer to this puzzle is that inflation has remained constrained because of increases in the productive capacity of developed economies that have far exceeded growth in aggregate demand. Over the boom period inflation is kept low as supply is always ready to respond to (or over-meet) any increase in demand. No matter how large the bubble grows inflation fails to respond even with unemployment below a level that would have been assumed to start exerting upwards pressure on prices.

This is not a problem as long as the bubble persists. Unfortunately that same over-supply can also hold back recovery.

In a post-scarcity economy the expected risk-adjusted return on investment is already sharply reduced in competitive markets as profits are brought down closer to marginal cost. The only way to extract significant profit is either through increasing scale or (related) anti-competitive practices.

The combination of asset bubbles and low profit margins make the system more vulnerable to cyclical crises. In response to an expected fall in demand firms quickly cut employment and investment, which helps to maintain or even increase profit margins in the near term. But as Krugman and Eggertsson have pointed out what might make sense for an individual or a single company becomes disastrous over the economy as a whole. If it persists higher unemployment and stagnant wages constrain the ability of consumers to keep up their spending, causing further erosion in the demand outlook (the so-called Paradox of Thrift).

Conventional theory tells you that under these circumstances prices would adjust to find a new equilibrium. Unfortunately recent history suggests they have struggled to do this because of one of the few sectors in which chronic undersupply remains a problem – energy. After the oil price shock of 2008 prices have failed to return to their long run average (see chart below) and companies are now more exposed to movements in energy prices – meaning even relatively small shifts in prices hit their bottom line much more quickly than in the past.

Brent Crude USD/BBL

As a consequence the perceived value of adding to fixed business costs through hiring permanent employees is much reduced and the threat of further demand erosion diminishes the appeal of long term fixed capital investment in increasing productivity. Firms are instead incentivized to hire workers on short term contracts and extract as much value as possible out of existing assets, in a vain attempt to reduced input costs to meet demand reduction (see Eggertsson’s Paradox of Toil).

So productivity gains facilitated by the boom period become a liability in the downturn as it increases labour market slack and economies struggle to reach full employment. This in turn means that even during a recovery the impact of rising employment on prices is swamped by efficiency gains (machines are turned back on) breaking the Phillips curve relationship between inflation and falling unemployment as the data has been suggesting.

This helps explain why even cash heavy firms like Apple have struggled to find uses for their surplus capital. If the expected return on investment over the short term is presumed to be lower than the cost of holding cash then even pushing interest rates to zero will have little effect. That is, if you cannot push real interest rates below the so-called short run natural rate you will struggle to bring forward future consumption, blunting the short run effectiveness of monetary policy.

Moreover, if you fail to bring it below the long run natural rate there is a strong disincentive to increase fixed capital investment and a consequent preference to hold cash or cash-like instruments in an attempt to mitigate risk. This could cause longer-term hysteresis effects and reduce an economy`s potential output.

A paper by Christian Upper and Andreas Worms for BIS suggests that the long run natural rate may well be falling across developed economies and, worryingly, policymakers may be losing the ability to influence them (possible pointing towards a structural over-supply thesis).

The charts above illustrate that the overall picture is clearly one of falling long-term interest rates. As the authors say:

“[The] importance of monetary policy for long real rates appears to have diminished since the late 1990s… This is consistent with evidence that monetary policy has become more synchronised across countries, leaving less room for national real interest rates to diverge.”

This is what you would expect to see in a post-scarcity economy, though it is not to say that there are no projects that can deliver a real return on investment. Rather under post-scarcity conditions firms cannot have confidence in the existence of a market that can absorb all of their goods or services – so the risk adjustment of expected returns has to be larger. As such in order to get firms to part with their capital you would need to either set strongly negative nominal rates to force corporates into action or expand fiscal policy sufficiently to make it bear the investment risk that the private sector is refusing to take on. If Summers is right, however, it remains unclear whether even these measures would be sufficient to break developed economies out of secular stagnation.

Further Reading

Real long-term interest rates and monetary policy: a cross-country perspective - Christian Upper and Andreas Worms, BIS

Secular Stagnation, Coalmines, Bubbles, and Larry Summers - Paul Krugman, New York Times

The implications of secular stagnation - Gavyn Davies, Financial Times

Debt, Deleveraging, and the Liquidity Trap - Gauti B. Eggertsson (NY Fed) Paul Krugman (Princeton) 


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