What is Secular Stagnation?

Secular stagnation in economics refers to a situation when a market-based economy has little to no economic growth. The term ‘secular’ means long term. Alvin Hansen proposed the idea for the first time in 1938.

Alvin Hansen, the president of the American Economic Association, gave a troubling speech to the organization in 1938 as the Great Depression ended. 

He argued that there may not be any natural tendency toward full employment and that the Great Depression may be the beginning of a new period of ongoing unemployment and economic stagnation. 

In the United States, Lawrence Summers highlighted the possibility that the 2008 financial crisis, like Alvin Hansen in 1938, may have signaled the start of secular stagnation.

Keynesian economist Larry Summers served as the World Bank's Chief Economist. In addition, he held the positions of Director of the National Economic Council under President Barack Obama and Treasury Secretary under President Bill Clinton.

Understanding Secular Stagnation

A country's economic development is influenced by the pace of demographic and technological change. In other words, investment rates change in response to changes in consumer demand. However, as technological advancement and the birth rate slow, so do investment prospects.

Investors become panicked and start focusing more on saving than investing. As a result, employment growth slows, inflation falls, income disparity rises, and, over time, interest rates decline. 

Secular stagnation is the term used to describe the sustained decline in an economy's capital stock brought on by a lack of investment demand.

Savings and investments must balance out for an economy to be stable. The idea suggests that the amount of money flowing in from the outside and from within should be equal. It might be challenging to compare savings with investments in a weak economy.

An interest rate below zero may be necessary to balance savings and investment in an economy experiencing secular stagnation. 

The cycle is as follows:

1. High consumer debts, aging demographics, income inequality, lack of innovations, and cheaper capital goods
2. Fewer consumer demands
3. Less investment spending and more saving 

A paper by The Center for Economic Policy Research provides us with two critical aspects of the phenomenon:

1. Negative real interest rates are required to equate savings and investment with full employment.
2. It becomes much harder to achieve full employment with low inflation and a zero lower bound (ZLB) on policy interest rates.

Summers’ Theory of Secular Stagnation

The term describes a market economy with a persistent (long-term or secular) lack of demand. In the past, inflation in wages and prices of goods was a sign of an expanding economy with low unemployment and rapid gross domestic product (GDP) growth. 

Even when the economy is growing, an economy experiencing secular stagnation behaves like it is underperforming; inflation does not emerge.

For instance, in the years preceding the Great Recession, the United States experienced low unemployment but little inflation.

Low interest rates encourage consumption and investment. This balances savings and investments in a healthy economy when household savings surpass business investments. 

Price increases in financial assets or real estate may be caused by the surplus of savings over investments. 

Meanwhile, when significant growth is attained—as it was in the United States between 2003 and 2007—it results from dangerous levels of borrowing that convert excessive savings into unsustainable levels of investment (which, in this case, emerged as a housing bubble). 

In a 2016 article titled "The Age of Secular Stagnation," Summers outlined his argument: "The economies of the industrial world, in this view, suffer from an imbalance resulting from an increasing propensity to save and a decreasing propensity to invest. 

The result is that excessive saving acts as a drag on demand, reducing growth and inflation, and the imbalance between savings and investment pulls down real interest rates.”

In his paper, Summers asserts that it is logical to assume that interest rates adjust to balance savings and investments, just as wheat prices change to balance supply and demand. 

Excess savings drive the interest rates down, and investment demand increases.

According to Summers, secular stagnation occurs when neutral, real interest rates (actual interest rates that balance out savings and investments) are so low that they cannot be achieved through conventional central-bank policies.

Real Interest Rates and Secular Stagnation

The interest rate an investor, saver, or lender receives (or anticipates receiving) is the real interest rate. The Fisher equation asserts that the real interest rate is roughly the nominal interest rate minus the inflation rate.

Equation is:

(1 + i) = (1 + r)(1 + π)

Where, 

• i = nominal interest rate
• r = real interest rate
• π =expected inflation rate

According to Paul Krugman, an American Economist, the average real interest rate in the US from peak to peak business cycles fell from 5% in the 1980s to 2% in the 1990s to just 1% in the 2000s. 

Since the collapse of Lehman Brothers, they have averaged about -1%. Low interest rates play a vital role in secular stagnation for two main reasons:

1. Adverse macroeconomic shocks are more likely to necessitate negative real rates to restore total employment/investment savings balances if real rates are low in standard times.
2. Financial stability is threatened by low nominal and real interest rates.

Causes of Secular Stagnation

Many situations lead to secular stagnation. Some of them are listed below:

The imbalance between savings and investments: Following a recession, the employment rates are directly impacted when economic growth slows. The public saves more and spends less due to factors such as job uncertainty, shaky market circumstances, social inequalities, etc.

Additionally, the national and global economies are impacted by constrained investments due to decreased capital goods pricing and a lack of new job creation. Lack of confidence in economies leads to widespread divestment. 

The following circumstances produce an imbalance between saving and investing:

1. Distribution of population amongst different age groups

In many developed nations in recent years, populations have, on average, continued to age, with the effect slowly becoming more prominent.

As a result, dependency ratios have risen, necessitating higher tax rates to cover healthcare costs and pensions. Decreased population growth also results in lower potential productivity growth, slowing economic recovery.

The age structure and labor supply across various industries are determined by fertility, lifespan, and retirement age in a simple life-cycle framework.

2. Technological development

Secular stagnation has also been linked to the rise of the digital economy. As technology continues to advance, less capital is absorbed, creating comparatively fewer new investment opportunities.

Increased manufacturing efficiency has made the cost of capital goods cheaper.

This advancement could eventually prevent the economy from establishing a long-run balanced growth path, with constant factor shares, completely removing human labor as a critical production element. 

Technological integration leads to fewer job opportunities and an increase in the number of people unemployed.

As Summers puts it, consider how Airbnb has affected hotels, the effects of Uber on transportation, Amazon's impact on shopping centers, information technology on the need for copiers, printers, and office space, and the list goes on.

3. Economic growth

The ability of banks to lend money and make investments has decreased due to the 2008 Financial Crisis. It had such a significant effect that interest rates and the US and EU economies experienced a record decline.  

Even though the market made an effort to rebound, the slow rate of economic expansion was insufficient to keep the investment-savings balance intact. 

Large economies worldwide are still being affected by this decline, resulting in secular stagnation.

Impact of Secular Stagnation

Secular stagnation dramatically impacts the economy in the following ways:

1. Increases contagion from economic weakness: Normal economic conditions allow the US or any other afflicted economy to compensate for lost demand and competitiveness. Additional easing is, however, impossible (or at least significantly more complex) when interest rates are already at their lowest point. This dramatically increases each country's impact on the global economy's health.

2. Increases danger of competitive monetary easing: Near-zero capital costs mean money is easy to get, increasing competition, leading to a rise in demand. Currency exchange markets switch demand from one country to another rather than increasing it globally.

3. Significant global impacts: In comparison to previous years, emerging market capital outflow will be greater than inflow. As a result of these capital outflows and the resulting rises in net exports, secular stagnation in the developed world will be exacerbated by further declines in demand and neutral real interest rates. Therefore, measures to boost developing market confidence will boost the global economy.

The Solution to Secular Stagnation

Summers suggests two strategies to address this issue, with both designed to boost the economy's demand.

His first suggestion is for the government to adopt a fiscal policy that prioritizes spending heavily, especially on areas like infrastructure and the creation of alternative energy sources. 

“An expansionary fiscal policy can reduce national savings, raise neutral real interest rates, and stimulate growth.” $535 million was invested by Obama in Solyndra, a solar energy firm that ultimately failed. 

This example makes it particularly clear that Summers’ theory does not show concern over government debt. 

Martin Wolf, a British journalist, challenges the global economy's reliance on central banks for their low-interest rates. 

Additionally, he suggests implementing a fiscal strategy that permits using government deficits as a disguise for private investment.

He previously espoused that decreased business regulations can help sustain economic growth. Summers, however, also maintains the paradoxical view that the Dodd-Frank Act, which enhanced governmental regulation of financial firms, should have been voted into law years earlier.

Researched and authored by Ishpreet Kaur | LinkedIn

Reviewed and edited by James Fazeli-Sinaki | LinkedIn

Free Resources

To continue learning and advancing your career, check out these additional helpful WSO resources:

• Balance of Trade (BOT)
• Growth Accounting Equation
• Capital Flows
• Externality of Production
• Fiscal Multiplier