Solving Secular Stagnation

There is now a sense of gloom that pervades the corridors of power in the developed world, six years on from the Lehman Brothers' default and the ensuing “great recession” we are still in the economic dead-zone.  In particular Europe is marred by low growth, high unemployment, falling prices and the worry is that this is the “new normal”.  Most economist are satisfied that the problem is poor aggregate demand, caused by falling investment in both the private and public sectors combined with diminishing disposable income - wages have been flat for years.  This malaise has been characterised as “Secular Stagnation” (SS), a term made famous by Larry Summers a former Head of the US Treasury department.

Larry Summers - feeling the torpor of Secular Stagnation

SS is a pervasive “liquidity trap”, which in turn has been described in Keynesian economics, as where injections of cash into the private banking system by a central bank fail to decrease interest rates and hence make monetary policy ineffective.  SS can only happen when interest rates are “at the zero-bound” and are unable to fall further, resulting in a trap where interest rates are never low enough to stimulate demand.  Also the monetary conditions that SS creates ; negative real interest rates and huge injections of new money into the system - Quantitative Easing  (QE) creates a risk of bubbles in financial assets and huge amounts of money chase short term returns rather than long term investment opportunities - see chart 1.

Chart 1

There is little in the way of consensus on how we might resolve secular stagnation and break the liquidity trap; the worry is that Japan has been experiencing this condition for over 25 years – that’s a whole generation lost to low growth and falling incomes.  It’s worth studying Japan in more detail as we don’t want to mirror their attempts at breaking the liquidity trap.  In Japan in 1990 asset prices were stratospheric - NTT (the telecoms giant) was valued on the Nikkei at more than the entire London stock exchange, a joining fee to a smart golf club in Tokyo could costs around $1m.  Their world had gone mad.  Unsurprisingly there was a bust in 1990 and Japan has been on a downward spiral ever since.  Over the next 25 year Japan has tried variations on one theme to resolve the issues of low growth  - ultra loose monetary conditions.  Interest rates have been suppressed, QE has been used to inject further liquidity but to no avail.   More recently Abenomics has introduced massive public spending and sale tax rises into this cocktail, but there are still no signs of recovery!

The problems in Japan are complex with an aging population and low employment levels for Females but may also be failure to de-leverage (public debts are still very high) and this results in a  switch from long term investment to the pursuit of short term yields; a direct result of ultra-loose monetary conditions.  Japan has  negative real interest rates, very high levels of personal saving combined with very low levels of investment in the productive economy combined with relatively high asset prices – this split in the economy between the real productive economy  (low growth and fall demand) and the market for financial assets (rising asset prices) - see the chart 1.

The trap that Japanese policy makers have fallen into is that that over the last 25 years they have focused only on trying to increase aggregate demand in the real economy (Line R) and have ignored the needs to deal with over-priced assets (line A).  This has had the effect of supressing aggregate demand further as high asset prices combined with wholesale indebtedness reduce confidence in long term investment in capital projects.  Business will always prefer to hang on to their money than risk long term investment when there is the possibility of a bust or even a default – so investment will go overseas or wash around chasing short term gain in financial assets - demand will weaken further as in chart 2.

Chart 2

Learning from the Japanese experiments with QE and their ultra-loose monetary conditions over 25 years, should we modify our plan of attack on secular stagnation?  Maybe the first step must be to deal with asset prices (line A) and de-leverage (reduce debts) by raising interest rates.  This will result in short term pain including: loss of savings, rising unemployment, defaults and lower growth.  Once the de-leverage is complete in both private sector and public sector confidence will slowly return (if supported by sensible public expenditure) and private investment in the productive economy will deliver the growth and prosperity we have become accustomed to.  But if we don’t  deal with the issues of de-leverage and unsustainable asset prices investment and growth will never return.  It is interesting to note that the only policy option open to Japan that they haven’t tried is to increase interest rates and tighten monetary policy – a lesson for us in the West?