March 20, 2016

What Explains the Great Global Slowdown?

IDFC Institute's Vivek Dehejia wrote in Mint about "arcane economics concept from the 1930s" that "occupy centre stage in economic policy debates today".

 

Excerpts below:

 

"... along with “financial instability”, “secular stagnation” is now well on its way to becoming a household term. It befits an era of economic volatility in a global economy which is yet to recover fully from the great financial crisis of 2007-10...

Most recently, writing in the influential journal, Foreign Affairs, Summers argued that secular stagnation holds the key to understanding the current global macroeconomic situation...

Put most simply, secular stagnation refers to a situation of insufficient aggregate demand, or, equivalently, a situation of excess aggregate supply....

Yet another equivalent, demand-side, definition is to say that secular stagnation reflects an excess of savings over investment...

While small negative nominal interest rates are theoretically and practically possible, contrary to what is sometimes believed, the nominal interest rate required to equilibrate aggregate demand and aggregate supply in a situation of secular stagnation is so large and negative that it would be impossible to achieve using conventional monetary policy.

The key reason is that depositors may tolerate a small negative interest rate as a convenience charge, but, facing a large enough negative interest rate, it would be cheaper to hold money in cash, even if one has to pay for storage and security. In theory, the government could directly tax currency holding at whatever rate it wishes, which would push even lower a sustainable negative nominal interest rate, but this seems impractical and politically difficult.

Summers argues that the current global macroeconomic picture is entirely consistent with a situation of secular stagnation...

Stemming from his diagnosis of the global economy’s current woes, Summers’ policy prescription is a return to the centrality of fiscal policy, which has been neglected as of late. For a decade and a half before the financial crisis, the consensus view in the economics profession was that monetary policy, as delivered through inflation targeting, would suffice to fine-tune the economy and keep it close to its long-run potential level of output and employment, while at the same time overcoming, or at least mitigating, the ebb and flow of the business cycle...

In a sense, Summers’ policy prescription returns to the original Keynesian orthodoxy—not the more recent “new Keynesian” consensus view—which saw fiscal policy and monetary policy as two wheels of the macroeconomic policy bicycle, with each needing to push in the same direction if one wanted to move forward. And if, indeed, the current problem is secular stagnation, only fiscal policy, not monetary policy, could work to raise the neutral real interest rate, through government spending, closing the gap in deficient demand.

Further monetary loosening, if that were possible, would even have the perverse effect of reducing interest rates (both nominal and real) and thereby further fuel asset price bubbles and excess savings without reducing insufficient demand. That would also tend to rule out tax cuts as a viable solution, since the extra income in the hands of households would likely be saved rather than spent.

It should not be surprising that, in a hotly contested arena such as macroeconomics, Summers’ diagnosis, and the prescription which flows from it, is not universally shared... the main point of contention between Rogoff and Summers is not the existence of a private sector debt overhang and the subsequent painful deleveraging, which is not in doubt, but rather whether it is the cause or the effect of deficient demand and of unconventional monetary policies which were put in place to cure it. Rogoff sees it as a cause, Summers as an effect.

Meanwhile, Gordon’s theory might be considered a supply-side alternative to Summers’s demand-side explanation. Gordon’s principal contention is that labour productivity has declined sharply in the US from the golden century 1870-1970 during which it rose steadily, and that this accounts for the current protracted economic stagnation in the US and other advanced economies.

But, as Summers rightly points out, Gordon’s hypothesis is one of insufficient supply—not of excess supply—and, if true, should result in inflationary pressures, of the type the global economy witnessed during the so-called stagflation of the 1970s following successive oil shocks. Instead, however, advanced economies are currently experiencing low inflation, with deflation—rather than high inflation—the present worry...

Rounding out the major explanations for current global economic woes is the classical Keynesian liquidity trap hypothesized by Krugman. In a way, this hypothesis is observationally equivalent to Summers’s explanation. For the essence of a liquidity trap as theorized by Keynes and his followers is that the creation of additional liquidity by a central bank is absorbed by the private economy as additional savings, which remain unspent or are not invested.

Typically, this is thought to occur at or close to a zero nominal policy interest rate—the so-called zero lower bound, at which point conventional monetary policy ceases to be effective. Japan went through such a liquidity trap for a decade, and, in a sense, the unconventional monetary policies employed to combat the global financial crisis in the US and elsewhere have led to what one could argue is a liquidity trap like situation.

The Krugman and Summers explanations converge on the reality of low inflation, or even deflation, being the norm for the near to medium term, as a counterpart to the continuing stagnation of output and employment. They also converge on the ineffectiveness of conventional monetary policy as a cure, but for different reasons, and the policy advice also, therefore, differs..."

Topic : Transitions / In : OP-EDS
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