EIU
May 13th 2015
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Is the world heading for secular stagnation?
The recovery of many economies from the global recession of 2009 has been weak, and forecasts have been revised down more than up in the years since. Consequently, there are now valid questions being asked about whether low economic growth is the result of temporary headwinds or of a more fundamental shift. This latter view was encapsulated by eminent US economist Larry Summers when, in late 2013, he revived the concept of secular stagnation to refer to a permanent situation where it is not possible to have interest rates at a low enough level to balance savings and investment while also achieving full employment. The Economist Intelligence Unit believes that secular stagnation can easily be avoided with the right policy choices, but there is a significant level of political risk for some economies about whether these will be feasible.
Secular stagnation refers to more than just slow growth. Slow growth may be the result of any number of temporary phenomena, such as political unrest, poor policy choices or the bursting of a financial bubble. Under secular stagnation more permanent factors lead to growth being low for an extended period of time. According to the theory, economies suffering from secular stagnation will exhibit some combination of increased savings and reduced demand for investment. In normal times the interest rate—which is in effect the price that brings saving and investment into balance—will decline until the induced fall in savings and rise in investment returns them to equilibrium.
The downside of China's rise
However, this mechanism breaks down when the required real interest rate (that is, the interest rate adjusted for inflation) falls below zero and there is low inflation. Balancing saving and investment in this situation can require nominal interest rates to remain well below zero for an extended period, but this is difficult to achieve in practice. In such a circumstance, nobody will want to hold deposits in that currency, and there is a higher risk of asset bubbles forming. The current global economic situation has many of the hallmarks of secular stagnation: slow growth, low inflation, low interest rates and high unemployment. Even in China, one of the world's fastest-growing economies, low inflation (as measured by the GDP deflator) has led the central bank repeatedly to cut nominal interest rates in order to stop real interest rates becoming so high as to throttle the economy. This effect has led to monetary policy being tighter in struggling economies such as Italy than in booming economies like the Philippines.
China has also been one of the drivers of excess savings in the global economy. Despite its rapid growth, China has one of the world's highest savings rates, estimated at 48% of GDP in 2015, because of a cultural aversion to debt and the inadequate provision of welfare by the public sector. China's domestic savings are equivalent to 106.9% of its investment, meaning that these excess savings act to push down interest rates elsewhere. This ratio is similarly high in many other large emerging economies, particularly in east and south-east Asia and, critically, also in Japan and Germany. Of the world's four largest economies only the US invests more than it saves. Meanwhile, those countries that invest more than they save, many of which are in Africa, have much smaller economies and so cannot effectively absorb others' savings.
Conditions for secular stagnation
Poor policy in many economies has also led to an increase in the risk of secular stagnation. The debt crises that have plagued various markets and economies since 2008 have led to significant private-sector deleveraging, as households and companies have increased savings and paid down their debt. At the same time, inappropriately timed fiscal austerity, most notably in the euro zone, has reduced demand and investment from the public sector at a time when there was considerable slack in the economy and record-low investment costs. With many government bond yields close to zero, a public investment project can generate almost no return and still reduce the debt to GDP ratio, even if it is financed entirely through borrowing. Countries where the private sector is deleveraging amid fiscal austerity, like Finland, the Netherlands and Greece, are particularly at risk of prolonged slow growth.
For the secular stagnation hypothesis to hold, it is necessary to believe that excess savings and deficient demand for investment will persist, thereby requiring negative real interest rates. In addition to fiscal austerity, demand for investment might be permanently low because of a lack of technological progress, limited progress on structural reforms (particularly in big emerging markets with lots of growth potential), financial regulation making risky assets more expensive or investment in modern sectors such as communications that is inherently less capital intensive. The supply of savings may also rise permanently because of ageing populations, increasing inequality, or if emerging economies like India and China do not expand public healthcare so that households can reduce precautionary saving.
Easy and difficult solutions
It is not inevitable that the conditions for secular stagnation will persist. Investment opportunities can be expanded through structural reform, public-sector spending, and by those countries with more growth potential and investment needs being open to capital flows. The savings rate could be reduced by cutting unrealistic entitlements and early retirement in places like Europe and Japan, ending the need for current workers to save to fund the entitlements of existing retirees while simultaneously saving for their own retirement (which presumably will not be funded by the state). For emerging markets the policy prescription is different: an increase in public-service provision in countries like India and China would reduce saving. Inflation targets could also be raised so that it is possible to achieve lower real interest rates without nominal rates needing to go below zero. Through some mix of these policies, the current period of low growth could easily be made temporary.
There are three risks that could undermine this: demographic change, a lack of integration from emerging markets, and the politics of policymaking. Overcoming the impact of ageing populations on the savings-investment balance will be more difficult, and has to go beyond entitlement reform. Immigration could play a temporary role in some economies, but broader changes will be needed to adapt to more part-time work, the integration of older workers, and to fund public-services sustainably. Investment needs in countries like India, Nigeria and Indonesia are an obvious destination for excess savings, but this could be prevented by restrictions on capital flows and deficiencies in the business environment. Finally, and most alarmingly, politics may prevent the type of policymaking that is required to see off secular stagnation. The contrast between the political acceptance of austerity in Europe and the economic evidence showing that it has clearly been deployed incorrectly is a worrying precedent in this regard.
The choice embodied in secular stagnation—between high unemployment and a series of asset bubbles—can be avoided. Our expectation is that the current period of slow growth will come to an end as policymakers come to understand better the underlying drivers of secular stagnation, but this depends on good policymaking and, by extension, politics.