The search for a model to explain Secular Stagnation is happening behind the scenes at the moment. Larry Summers is presenting Secular Stagnation as an Inverse of Say’s Law… “Lack of demand over time creates lack of supply”. But getting the mathematical mechanisms of how lack of demand suppresses supply (output) seems to be missing.
I now refer to two models, first a new paper by Gauti Eggertsson and Neil Mehrotra, A Model of Secular Stagnation. Second my model that I presented here on Angry Bear on December 16, 2013, Fed Policy is Heading into Trouble.
First the EM paper is an effort to provide a model for Secular Stagnation. As the authors say in their introduction…
“Despite the prominence of Summers’ discussion of the secular stagnation hypothesis and a flurry of commentary that followed it (see e.g. Krugman (2013), Taylor (2014), Delong (2014) for a few examples), there has not, to the best of our knowledge, been any attempt to formally model this idea, i.e., to write down an explicit model in which unemployment is high for an indefinite amount of time due to a permanent drop in the natural rate of interest. The goal of this paper is to fill this gap.“
The paper reaches 3 stabilizing solutions to Secular Stagnation…
- higher inflation target
- more government spending
- redistribution of income
As such, Paul Krugman today mentioned the need for a higher inflation target and maybe permanent fiscal stimulus… Why doesn’t he include redistribution? Eventually he will…
- “while an inflation target, if believed, can bootstrap you out of secular stagnation, it has to be a sufficiently bold target. Announce your commitment to 2 percent inflation when the economy needs 4, and nothing happens.”
- “I need to work a lot more on the mechanics of this paper; I’m wondering in particular whether there is a possibility of sustaining the economy with permanent fiscal expansion.”
Apart from the solutions, the EM paper highlights the causes of Secular Stagnation. The implication is that if the causes are removed, Secular Stagnation will fade away.
“Perhaps a main takeaway from the analysis is not just that a permanent recession is possible, but instead that a liquidity trap can be of arbitrary duration and last as long as the particular dynamics that give rise to it (such as a deleveraging shock and/or rise in inequality and/or population growth slowdown).”
As you might notice, I highlighted a rise in inequality as a dynamic causing Secular Stagnation. Inequality will affect the ability to deleverage. So it is a fundamental cause of the Secular Stagnation that we see.
Back in December, 2013, I presented a video that gave a model to explain Secular Stagnation. My model focuses on inequality through the variable of labor share. I put the video again here.
In the video, I show how the Effective Demand limit pushes the natural level of real GDP lower as labor share shifts lower (in terms of the composite utilization level of capital and labor, Total Factor Utilization Rate, the x-axis in the video.) I see that the Fed and other economists are slow to recognize the significance of this shift. The result is that they are still thinking that the economy will return to the previous composite level. Thus, in order to return to the previous higher natural level of real GDP, a negative real interest rate would be necessary, but it is not a desirable path. The Fed’s forward guidance is taking us down a dangerous path.
In the video, I refer to Larry Summers and his idea of Secular Stagnation where the natural real interest rate will have to be negative for many years to bring us back to full employment (17:30 point). You will see a solid brown line sloping down from left to right. This line marks the natural real interest rate needed to maintain any given level of composite utilization of capital and labor in regards to the effective level of labor share. So, if the natural level of real GDP is actually lower than expected, and economists try to calculate the natural real interest rate at full employment real GDP, there is a good chance they will calculate a negative real interest rate.
As the EM paper above stated, inequality is a cause and redistribution is a cure for Secular Stagnation. I support that view with my model saying that labor share has to rise.
I agree with Mr. Krugman about the benefits of fiscal expansion. I agree with him on a higher inflation target. But there is a little detail which I would hope to contribute. Even if government spending and the inflation target were to increase, their effectiveness would be muted unless labor share also increased. Thus, the bottom line in any solution to Secular Stagnation involves an increase in labor share.
One final note, as Michael Pettis has laid out, the rise in labor share has to be coordinated globally among advanced nations. If one country raised its labor share, most likely the benefit would be experienced not by its own country’s labor force, but another’s. And we can ultimately conclude that the problem of a falling labor share is not particular to one or two countries… Low labor share is a problem throughout the advanced countries, including Japan by the way. Thus, Secular Stagnation is deepened by being a global phenomenon… and so raising the inflation target just in the US, or increasing government spending just in the US is most likely not going to solve the problem.