In the Long Run: Secular Stagnation in Open Economies

Some readers have probably wondered why inflationary pressures in the United States are missing in action despite the fact that labor markets have strengthened. A tighter labor market has traditionally been associated with inflation as companies start to offer higher wages in the competition for relatively more scarce workers.

If the U.S. economy has been growing at 2% since 2009 and labor markets have tightened, why is the U.S. Federal Reserve (Fed) not raising interest rates? Well wonder no more.

In a short blog post on The Centre for Economic Policy Research’s Vox website, Brown University Economics Professor Gauti Eggertsson and former U.S. Treasury Secretary Lawrence Summers summarize two of their recent groundbreaking papers that address the key issue of the day: Secular Stagnation in a Globalized World.

As summarized in their post, the Secular Stagnation hypothesis suggests that low interest rates may be the new normal in the years to come. Eggertsson and Summers argue this shift should not only lead to a major rethinking of monetary policy from the perspective of individual economies, but also a major rethinking about monetary and fiscal policy in the international context, the role of international capital flows, and the role of policy coordination across borders.

This fits in extraordinarily well with a key point that I have been making for quite some time: In a deleveraging world – a world where saving impulse is high and investment impulse is low – looking at cyclical conditions in the United States to divine the direction of U.S. interest rates is the wrong approach and a belief in that methodology is highly misplaced.

In a set of two papers, Eggertsson and Summers, along with authors Neil Mehrotra and Sanjay Singh, show a formal model to make the point (hereand here).

Secular Stagnation, as defined in 1939 by one of the most eminent U.S. economists in history, Alvin H. Hansen, is an increased propensity to save and a declining propensity to invest in an economy. As a result, the equilibrium real interest rates remain low for a very long time. To be sure, this issue remains very controversial in the academic world of economic theory, with a majority of economists remaining deeply skeptical. I, for one, remain a firm believer in this concept as it fits the growth and inflation data in the post-financial crisis world very well.

Secular Stagnation as Contagion

The key to Eggertsson’s and Summers’ approach is, however, relatively straightforward: In a globalized world, secular stagnation is a contagion and, like a virus, it spreads from an afflicted to a non-afflicted economy through global flows of goods AND funds. The first channel for the contagion is quite well accepted: As demand softens in a country afflicted by secular stagnation, exports to that country fall, which weakens demand in an otherwise non-afflicted country.

The true innovation from Eggertsson and Summers is in identifying a second channel of contagion: International capital flows. In a globalized world, savings from an economy afflicted by secular stagnation will travel to other countries through current account surpluses. The ensuing flow of funds from those surpluses seeks higher returns abroad. This, in turn, reduces real rates in another economy that otherwise was quite healthy.

Further, if the central bank in this other country wants to tighten policy and raise rates on the basis of an advancing business cycle, its currency would appreciate, circumstances that will lead to even more capital flowing into the economy from abroad, amplifying any negative economic consequences of high capital inflows. This cycle makes it very difficult for any economy to decouple from a global trend towards secular stagnation.

Radical Policy Implications

The policy implications, if you believe Eggertsson’s and Summers’ Secular Stagnation thesis, are quite radical.

First, monetary policy becomes ineffective after a while, as has been the case in the developed world for quite some time. Further, fiscal policy is truly the panacea and the cost of those fiscal initiatives is quite modest. Unfortunately, in today’s developed world, there is no political will for such an initiative. For interest rates to rise meaningfully in developed markets, coordinated fiscal initiative is needed. Otherwise, I believe we will have zero or negative rates globally for a long time.

Second, emerging markets can provide a natural barrier to this global contagion. After all, emerging markets can take those global savings, invest them productively and, in my opinion, cure the world of the contagion. But for that to happen, the current overhang of unproductive investment has to be dealt with expeditiously. Unfortunately, that too seems quite unlikely in the near term.

The world in the throes of Secular Stagnation will have low real rates for a long time. As investors, we have no choice but to accept that reality.

DISCLOSURE:

These views represent the opinions of OppenheimerFunds, Inc. and are not intended as investment advice or to predict or depict the performance of any investment. These views are as of the publication date, and are subject to change based on subsequent developments.