‘The business cycle was par excellence the problem of the nineteenth century. But the main problem of our times, and particularly in the United States, is the problem of full employment. . . . Not until the problem of the full employment of our productive resources from the long-run, secular standpoint was upon us, were we compelled to give serious consideration to those factors and forces in our economy which tend to make business recoveries weak and anaemic and which tend to prolong and deepen the course of depressions. This is the essence of secular stagnation — sick recoveries which die in their infancy and depressions which feed on themselves and leave a hard and seemingly immovable core of unemployment.”
Thus wrote Alvin Hansen, a professor of economics at Harvard, in 1938. Slow population growth and the deceleration of technological progress, he argued, were leading to slow capital formation and weak economic growth. A program of public expenditures, though it had its dangers, was probably required to avoid this fate.
Hansen’s article was of course spectacularly wrong as a guide to the next few decades. Instead of suffering through stagnation we entered an extended, broad-based, and massive economic boom. In hindsight we can see that his analysis, while thoughtful and intelligent, was unduly influenced by the depression he was living through, and can see as well that the depression was the result of specific policy mistakes rather than inexorable trends. Recent research by Alexander J. Field shows that the 1930s were actually a time of exceptionally high productivity growth.
Hansen’s worry, some of his specific arguments, and his phrase “secular stagnation” are all making a comeback in our own day. Lawrence Summers, like Hansen an economics professor at Harvard, has sounded an alarm about the ability of industrial countries to achieve adequate economic growth. A new e-book, Secular Stagnation, includes chapters by Summers and other leading economists discussing the question.
The fact that Hansen was wrong does not prove that contemporary stagnationists are. In this case, though, history is repeating itself rather exactly. We do not pretend to know what the future path of economic growth in the United States will be. But the case for stagnation is weak — and, as in the 1930s, it is getting undue credence because of a long slump caused by policy mistakes.
Today’s stagnationism has several strands. Technological development, or at least the kind of technological development that improves living standards, is again said to have slowed down for the long haul. Slowing population growth is again said to portend economic decline. And new arguments have been added to these. Many economists worry that the sharp recession and weak recovery have dealt a long-term blow to our labor force. When people are out of work long enough, their skills degrade even if they eventually get another job — and some of them leave the world of work forever.
These arguments offer reasons for pessimism about the country’s potential output: both its future level and its future growth rate. Summers’s own argument is slightly different. It suggests that whatever the economy’s theoretical potential, it might frequently fail to meet it. The reason is that interest rates cannot fall to a rate that puts the economy at a full-employment equilibrium.
Central banks typically fight recessions by lowering interest rates, but they cannot practically lower them much below zero. So if the interest rate is already low when the economy falls into recession and needs to fall still further to revive the economy, central banks will find themselves unable to provide what the economy needs. It follows that we’ll have deeper recessions and weaker recoveries, as in Hansen’s forecast. And this theory is intertwined with the other lines of pessimism that descend from Hansen: The decline in population growth and technological development are among the possible causes that Summers lists for the decline in interest rates. The argument implies that the decline in real interest rates since the early 1980s might signal that the market thinks our prospects for growth have fallen.
#page#One solution to this problem Summers identifies would be for central banks to raise their target inflation rates. If the Fed aimed for 4 percent annual inflation rather than 2 percent, for example, nominal interest rates would rise two points, giving the Fed more room to cut them when needed. Summers mentions this possible response — which others have advocated — but also thinks it poses risks. He favors other methods of stimulating an economy even when interest rates are low, notably “public investment” (an answer that again echoes Hansen).
These overlapping arguments have inspired overlapping debates, with the liveliest concerning technology. Optimists argue that in fact we have recently seen and will continue to see quite a lot of innovation with positive economic effects — but that these effects may prove hard to capture statistically. They point to the increase in digitization and networked communications, advances in medicine, the growth of nanotechnology, the spread of 3-D printing, and the prospect of driverless cars and other smart machines.
Note, though, that some of these developments actually make GDP figures look worse. We used to separately purchase CDs, books, newspapers, cameras, scanners, voice recorders, radios, encyclopedias, GPS systems, maps, and dictionaries. These transactions were counted as part of GDP. Now these items can all be found on your phone as free apps and are not counted as part of GDP. In a recent study, Shane Greenstein and Frank Nagle attempted to quantify the unmeasured economic impact of the Apache HTTP Server, a free application used by more than half of all websites. They estimated its value as equal to almost 9 percent of the stock of sold software. Accounting for the value of other widely used free software would yield an even larger figure. It is plausible, then, that what looks like a decline in the economy’s trend rate of growth is in part an illusion: We’re underestimating how much economic growth is really occurring, and our estimates are getting more wrong over time.
There is also some cause for demographic optimism. The blogger Bill McBride has been pointing out that Millennials, who have their peak earning years ahead of them, are our largest age cohort. The share of our working-age population in the labor force may be shrinking, but the workforce will nonetheless keep growing as a result of this demographic fact. And working-age populations will be growing for decades in many parts of the world.
The strand of stagnationism that has inspired the least debate is its story about declining interest rates. Indeed, the introduction to Secular Stagnation, in reviewing nearly all the issues surrounding the concept, treats this decline as a fact accepted by all sides. But this factual premise, underlying a great deal of the conversation about secular stagnation, is simply wrong. The interest rate relevant to the conversation has not declined.
Stagnationists point to the real interest rate, which is calculated by taking nominal interest rates — the kind you usually see quoted — and subtracting expected inflation. So if the interest rate on a loan is 6 percent and inflation is expected to average 2 percent over its lifetime, the real interest rate on the loan is 4 percent. This real interest rate has been declining since the early 1980s.
But you need to make an additional adjustment. The quoted interest rate includes a “risk premium,” one that grew from the mid 1960s to the early 1980s as macroeconomic policy became more and more uncertain. That premium then slowly declined as policy improved. Subtract an estimate of the risk premium as well as the inflation rate from quoted interest rates, and the apparent trend of decline disappears. The real risk-free interest rate has been stable over the long run while rising and falling in response to the business cycle. The risk-free interest rate was negative for much of the last five years, for example, but it has been inching higher during our slow recovery. The market, in short, is not telling us that strong growth is in the rear-view mirror.
#page#The zero bound on nominal interest rates, meanwhile, is less of a problem than Summers and others imagine. We have strong evidence that monetary policy can stabilize an economy in recession even if interest rates are low. FDR’s devaluation of the dollar is one example; examples from the last few years include the devaluation of the Swiss franc, Abenomics in Japan, and quantitative easing in the United States. “Unconventional” monetary policies other than interest-rate manipulation have helped to close the gap between actual and potential output.
Monetary policy could, however, be made more effective still, and without raising the targeted level of inflation. The Fed could set a different kind of target, seeking to keep the total amount of spending in our economy growing at 4 percent a year. If you assume that the average rate of real economic growth is around 2 percent, that goal implies an average inflation rate of 2 percent. Under this policy, the Fed would also commit to making up for any deviations from the target: If spending growth were only 3 percent one year, it would aim for 5 percent the next.
This policy would stabilize the economy in response to all the different kinds of shocks that might occur to it. Take the case of a financial panic that makes people more inclined to hold money balances and less inclined to spend them. That kind of “demand shock” could cause spending, economic growth, inflation, and interest rates all to go negative. If markets expected the Fed to make up for one year’s temporary decline in spending the next year, however, the floor under all of those variables would be higher than if markets did not expect any catch-up. Better still, the expectation that the Fed would keep total spending on its targeted path would reduce the likelihood and severity of demand shocks in the first place.
The reason for targeting spending rather than inflation is that it minimizes the effects of other types of shocks. A rigid inflation target would require the Fed to tighten money when, for example, an interruption in oil supplies brings productivity down. That Fed response would compound the damage to the real economy from that interruption. And the Fed would also have to respond inappropriately to a productivity surge: Increased productivity would tend to lower prices, so the Fed would have to loosen money amid the boom to stick to its target.
So a spending target makes sense whether we expect future growth to be high or low. In the case of high growth it would have a further advantage. Productivity breakthroughs can cause enormous economic disruption, but a spending target would soften the blow because high-growth years would also see a falling price level. Thus even people who do not receive raises would share in the general prosperity.
And for all the talk of stagnation, rapid productivity gains have been a problem for monetary policy in the recent past. The Fed did not allow the productivity surge of 2001–04 to result in commensurately falling inflation, as it should have, but instead kept monetary policy very loose — helping to inflate the housing bubble.
In 2007–08, the Fed started making the opposite mistake: tightening money in response to a supply shock (rising oil prices). It thus made the collapse of the bubble worse. It then failed to respond adequately to the resulting panic: Spending has not come anywhere near to catching up to its pre-crisis trend. The Fed has never suggested it favors catching up, let alone acted to bring it about. That’s one of the main reasons the recovery has been so disappointing.
And that, in turn, is why arguments that we are set for a secular stagnation sound so very plausible now. Fed mistakes are distorting our intellectual life, not just our economy — just as they did in the 1930s.
– Mr. Beckworth is an assistant professor of economics at Western Kentucky University and a former international economist at the Department of the Treasury. Mr. Ponnuru is a senior editor of National Review.
Chart Sources: The risk premium comes from “Treasury Term Premia: 1960-Present” (Adrian, Crump, and Moench, 2013). Other estimates, such as that in “An Arbitrage-Free Three-Factor Term Structure Model and the Recent Behavior of Long-Term Yields and Distant Horizon Forward Rates” (Kim and Wright, 2005), also show a trend decline in the risk premium since the early 1980s.