The stagnant state of economics

The fervent debate on whether America is suffering from “secular stagnation” reveals little about the economy but much about the bankrupt state of economics. There is little original in the discussion of the malady and even less of anything profound.

Larry Summers, a former US Treasury secretary among many other things, kicked off the debate at a recent International Monetary Fund (IMF) conference. After congratulating the authorities for their “remarkable job” in containing the 2007-8 financial crisis he went on to highlight the shallowness of the recovery. Since 2009 the proportion of people in employment has not unchanged and GDP has fallen even further behind its potential.

To explain the parlous state of the economy he suggested reviving the idea of secular stagnation from the 1930s. This notion was most closely associated with Alvin Hansen, an influential economist from that era sometimes known as the “American Keynes”.

The next stage of his argument was to point to an apparent paradox. Before the crisis there were many signs of rapid credit expansion yet this did not boost aggregate demand or stoke up inflation. Nor has there been much of a bounce back since 2009 despite the stimulus.

For Summers this raises the possibility that real interest rates have been negative since the middle of the last decade. In other words there is a strong incentive to hoard cash since returns to investment are worse than zero.

The implicit conclusion drawn by Summers was that, rather than tapering, the Federal Reserve should engage in even more extensive monetary policy. There should also be a more active fiscal policy rather than retrenchment. In his view borrowing, lending and asset prices all need to increase for a true recovery to materialise.

Summers argument was endorsed by many heavyweight economic commentators including Paul Krugman in the New York Times, Martin Wolf in the Financial Times and Gavyn Davies on his FT blog.

There is not enough space in a short blog post to do a proper critique of Summers’ argument but he is certainly right to point to the serious challenges facing the American economy. I, along with many others, have often pointed to the low levels of investment in America. Andrew Smithers, an economic consultant, has recently published a report showing that economic growth and investment have both been on long-term downward trend.

The fundamental problem with Summers’ argument is its one-sidedness. He posits a negative real interest rate but there is no proper explanation of how it came about or how it can be changed. In his telling it has simply become embedded in the economy as an almost insurmountable limit. His overwhelming focus on the demand side blinds him to the structural weaknesses of the real economy and the possibility of tackling them. He is obsessed with such things as monetary policy and asset prices rather than the real world of production.

Essentially Summers has articulated a one-sided response to the current malaise of the American economy. He follows many other varieties of pessimism including the idea that the low-hanging fruit of technological innovation have all been picked , the notion of the new normal and Krugman’s talk of a liquidity trap and “depression economics”.

Perhaps Summers should be reminded why the secular stagnation theory was discredited last time around. Alvin Hansen, in his 1938 presidential address to the American Economic Association, had argued that America was facing a high level of permanent unemployment because three factors that had previously driven growth had come to an end: the frontier, rapid population increase and capital-intensive technological change.

A few years later, shortly after the second world war had ended, America entered two decades of the most rapid period of economic growth it has ever enjoyed. That is not to claim that such a dramatic recovery is inevitable today but it is a poignant warning of the dangers of excessive pessimism.

This comment was first published today on Fundweb.