Michael Spence: How to fight secular stagnation

Much of the world, especially the advanced economies, has been mired in a pattern of slow and declining GDP growth in recent years, causing many to wonder whether this is becoming a semi-permanent condition – so-called “secular stagnation.” The answer is probably yes, but the question lacks precision, and thus has limited utility. There are, after all, different types of forces that could be suppressing growth, not all of which are beyond our control.

To be sure, there is a strong case to be made that many of the growth-destroying headwinds that we currently face would be difficult, if not impossible, to counter in the near term without endangering future growth and stability. The result of these persistent conditions can be called “secular stagnation one” (SS1).

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The first indication that we are experiencing SS1 relates to technology. If we are, as the economist Robert Gordon argues, experiencing a slowdown in productivity-enhancing technological innovation, long-term potential growth would be constrained. But even if innovation has not dropped off too much, or picks up again soon, the structural adaptation and behavioral changes needed to take advantage of the concomitant productivity gains will take time.

A second condition supporting SS1 is rooted in the impact of heightened uncertainty – about growth, job security, policies and regulations, and the many developments that could affect any of those factors – on investment and consumption. People simply don’t know whether their governments are going to start making progress in combating deflationary pressure, countering rising inequality, addressing social and political fragmentation, and restoring economic growth and employment.

With future demand far from guaranteed, private investment has been declining in many countries, including, most recently, China. The same goes for household consumption, particularly in the advanced economies, where a larger share of consumption is optional (for example, replacing consumer durables, traveling, and eating out at restaurants). Given how long it took the US economy, for example, to recover fully from the Great Depression – until World War II, when the government took over much of the demand side of the economy – it seems that a reversal in these trends will not arrive anytime soon.

The third indication that we are stuck in SS1 is debt. Households, corporations, financial institutions, and governments are all facing balance-sheet constraints, which it seems plausible to assume, are holding back expenditure and investment, elevating savings, and contributing to a broadly deflationary environment.

Actions aimed at supporting deleveraging and balance-sheet repair – such as recognizing losses, writing down assets, and recapitalizing banks – carry longer-term benefits but short-term costs. Indeed, balance-sheet repair takes time, especially in the household sector, and produces an unavoidable drag on growth.

The picture is somewhat bleak. But there is more to the story, revealed by another, more precise, question: is there a set of policy responses that could, over time, increase the level and quality of growth? Here, the answer also seems to be yes, suggesting that we are also facing another type of secular stagnation – call it “secular stagnation two” (SS2) – that is dictated by our unwillingness or inability to implement the right policy mix.

A key element of that policy mix would focus on tackling rising inequality. While the forces fueling this trend – in particular, globalization and progress in digital technology – will be difficult to counter fully, their adverse effects can be mitigated through redistribution via the tax and social-security systems. As economies undergo prolonged structural transformations, individuals and families need the resources to invest in new skills.

Moreover, monetary policy, which has been shouldering much of the burden of recovery since the 2008 economic crisis, must be rethought. The fact is that years of ultra-low interest rates and massive quantitative easing have not increased aggregate demand sufficiently, much less reduced deflationary forces adequately.

But raising interest rates unilaterally carries serious risks, because in a demand-constrained environment, higher interest rates attract capital inflows, thereby driving up the exchange rate and undermining growth in the tradable part of the economy. Given this, advanced-country policymakers should consider imposing some controls on their capital accounts (much as successful emerging economies do) – a move that would facilitate more independent and tailored approaches to exiting financial repression.

A third priority should be to strengthen fiscal responses, especially with respect to public-sector investment. Europe, in particular, is paying a heavy price for underusing its fiscal capacity – a decision that has been driven by the political unpopularity of debt and fiscal transfers. Under the right conditions, the balance sheets of pension and sovereign-wealth funds could also be tapped to fund investment.

There are many more areas where countries may need to consider reforms. These include tax policy, the inefficient or improper use of public funds, impediments to structural change in product and factor markets, and mismatches between the reach of global financial institutions and the capacity of sovereign balance sheets to intervene in case of financial distress.

SS1 will make addressing SS2 much more difficult. In fact, it seems that not even robust domestic and international policy responses would be sufficient to eliminate the risk that demand and growth will remain subdued for an extended period. But that is no reason to delay action in the areas where policy can make a difference. Just as our past policy choices helped to generate the SS1 we face today, failure to implement policies aimed at tackling SS2 could create a much more intractable and potentially unstable situation tomorrow.