Sunday, 20 November 2016

Explaining our current stagnation

Ever since the financial crisis of 2007-2009 and its subsequent (slow and modest) recovery many have claimed the world has entered into a state of prolonged stagnation. In addition to economic growth being relatively low (and therefore not enough to close the potential GDP gap caused by the crisis), real wages are also stagnating, unemployment is still high (although in relative decline), inflation is close to zero, while productivity growth is sending troublesome signals for some time now. This is particularly true of Europe, as it bears the strongest resemblance to Japan, and is on a good course to repeat Japan's (still ongoing) two decades of stagnation (more on emulating Japan in my next text). 

We all know the story. I, for one, have told it many times on the blog (see herehere, here, here, here, here or here). After the financial crisis, which usually tends to cause prolonged and slow recoveries, many governments adopted stimulus and bailout programs in 2009 that all but destroyed their public finances at the time. In retrospect this was a textbook Keynesian solution in times of crisis - in order to restore confidence and replace the lack of private sector investment the government should step in and provide as much liquidity and stimulus as possible. And most of them did. The US, the UK, almost all European countries, even some Asian countries (like China) were forced to adopt stimulus packages as an immediate response to boost confidence. In addition central banks did their part and lowered interest rates to historical lows to provide the much needed liquidity to the banking sector (whose reaction was mainly to hoard this cash, not let it flow in the system). But this doesn't work, the conventional wisdom teaches us, since you can only lower rates so much, forcing you to fall into a liquidity trap. And the only thing that can get you out of a liquidity trap is more government spending.

This solution was applied throughout. And its main consequence, in only a single year, was that debt levels have risen sharply (to be fair bank bailouts contributed to rising debt levels even more). They almost doubled in the US and in the UK, as in many European countries, while in countries like Ireland and Iceland they quadrupled. Budget deficits also went haywire. The UK in 2010 had the third biggest deficit in the world: -10% of GDP (behind only the revolution-undergoing Egypt and the shambolic Greece). Even for rich and usually fiscally responsible countries like the US or the UK, this was too much. The textbook Keynesian solution might have prevented a deeper slump as some economists claim (this we will never know as we cannot prove it), but it also dramatically increased budget deficits and public debt levels (this we can prove - see my discussion here). Austerity was imposed only after the stimulus and bailout packages (starting in 2010/11), it was not the initial reaction. Many argue that austerity was applied too quickly, before the economies actually recovered, but that too is a discussion for another time. 

The slow recovery is only part of a longer trend of stagnation? 

In order to understand the big picture of why the recovery was so slow, we must look at the trends that have occurred before the crisis. Many claim the stagnation (particularly in productivity and real wages) started long before. The first graph looks at the decline in the growth rate of total factor productivity (TFP) in the US, relative to its 1947-1973 trend. Natural logs are used to emphasize the relative stagnation of TFP. (Btw, the FT Alphaville blog has assembled in one place all the different hypotheses and ideas on why TFP growth started to decline since the 70s).

The quarterly TFP rates for the US from 1947 till 2010.
Graph taken from David Beckworth's blog
The second figure depicts a very modest, almost nonexistent, growth of real wages compared to productivity which has, as shown in the previous graph, experienced its own relative slowdown (the reason the graphs are not comparable is that the upper one uses natural logs, whereas in the lower one the second part of the picture only shows the rate of change from 1979 to 2009). Knowing that productivity rise fell short of its trend-based expectations, it is all the more striking to see the relative stagnation of real wages in the past 30-40 years
Source
In addition, the wage growth was distributed unequally, where the trend for the bottom 90% of income earners was even worse throughout the observed period, not only for the US but for some other developed countries as well (shown here are Australia, Canada, France, Sweden and the UK): 
Source
So what are the structural factors responsible for this 30-year long era of relative stagnation in productivity and real wages? Are these structural factors the same ones disabling our economies from fully recovering from the recent crisis?  

Economists came up with several competing hypotheses, each very interesting in its own way. I will present five of them briefly. 

1) The secular stagnation hypothesis

The first in line is the so-called secular stagnation theory. Its main proponent is Larry Summers. According to this theory, "economies suffer when higher propensity to save is coupled with a decreasing propensity to invest". Excessive savings will therefore lower aggregate demand which puts a downward pressure on inflation and on real interest rates (hence the low inflation and low interest rates we are experiencing) and lower economic growth. Furthermore even when high growth is achieved within this several-decade-long stagnation, it was usually a result of excessive borrowing that translates savings into unsustainable investments and causes bubbles.

I'm having difficulty in buying this argument given that the data shows a clear trend of declining savings rate in the US for the past 30-40 years before the crisis (see graph below). Besides, a bubble could not have lasted that long. It is true that higher savings was a response to the crisis (as you can also see in the graph), and it's also true that the immediate post-crisis consequence was massive deleveraging of a population overburdened with debt, but it certainly isn't a long term trend.

Source
Perhaps Summers is referring to total gross savings, which has indeed been steadily increasing in the past 40 years, but in this case looking at the absolute value is wrong. Even gross savings as percentage of national income have been in a steady decline since the 1980s. To be fair, Summers is perhaps more preoccupied with the last couple of years (given that only in the last 7 years have we had historically low real interest rates):
"Secular stagnation occurs when neutral real interest rates are sufficiently low that they cannot be achieved through conventional central-bank policies. At that point, desired levels of saving exceed desired levels of investment, leading to shortfalls in demand and stunted growth. This picture fits with much of what we have seen in recent years. Real interest rates are very low, demand has been sluggish, and inflation is low, just as one would expect in the presence of excess saving. Absent many good new investment opportunities, savings have tended to flow into existing assets, causing asset price inflation."
However, hasn't China had a massive imbalance between savings and investments for the past 30 years? In times when its economic growth rates were in double digits for decades? It was this circumstance in particular that turned China into the greatest creditor nation in the world (S>I, meaning that EX>IM), while the US became the greatest debtor nation in the world. The US had a much higher propensity to invest than to save, and this imbalance led to a huge current account deficit (just the opposite of above; I>S, mean that IM>EX). The story of trade, unlike what the politicians make you believe, revolves around the relationship between savings and investments; here I fully agree with Summers.

2) The debt accumulation hypothesis  


The next one comes from Reinhart and Rogoff. They tend to blame massive debt accumulation. In other words, a period of sustained and bold optimism in which asset prices kept on rising, meaning that both the public and the private sector may borrow indefinitely. This happened not only in the US, but across the spectrum, as many countries ran large current account deficits prior to the crisis. This was particularly problematic in Europe as the desire to eliminate risk through the introduction of the common currency encouraged borrowing from abroad where high CA deficits were channeled into consumption rather than investment. What explains the slow recovery is deleveraging - a typical reaction to financial crises caused by an excessive accumulation of debt. In fact, in their excellent book "This Time Is Different" the authors point out that banking crises that arose due to an excessive accumulation of debt always imply a very slow and prolonged recovery, not only for the financial centers but also for the periphery.  

However this is still a theory focused only on the explanation of the post-crisis stagnation; it doesn't stretch long enough to explain the puzzling decline in productivity and real wages for the past 30 years. So we move on to the next one.

3) The global savings glut hypothesis

This famous hypothesis was proposed by Ben Bernanke, the former Fed chairmen, back in 2005. According to Bernanke reducing a financial surplus (households pushing savings) or running large deficits (governments or households financing consumption) will result in a (potentially decade-long) boom on the asset market. Bringing this up on an international level, financial surpluses from Asian households and governments were translated into investments and consumption in the West. The analogous story can be told in Europe: the 'interaction' between the savings in the "core" and the deficits in the "periphery".

In essence this hypothesis also begins with the period of low interest rates that reflected higher world savings. I wrote about it in my 2011 paper "The Political Economy of the US Financial Crisis": "There was strong demand for safe assets from Asian and oil exporting countries that contributed to depress the yield on long term government securities issued by advanced economies, the US in particular. A low US savings rate also contributed in steering assets from current account surplus countries into financing US investments and consumption. However, capital inflows were used to finance current consumption rather than investment into productive assets. The US current account deficit started to grow uncontrollably by the end of 1998 and reached its highest level around 2006, while at the same time oil exporting countries and emerging Asian countries experienced high surpluses in their current accounts. This period is matched by the likewise high growth in the US housing market. There is no proof that the current account deficit itself caused the housing boom, but there is evidence that the inflow of foreign capital was mainly used at the time being for the purchase of real-estate, adding to the housing bubble. Excess savings in Asia were being invested into safe assets such as US government securities, which contributed to a high level of capital inflows into the US. High inflows into the US brought about excessive risk taking and exposed domestic financial institutions, companies and households to exchange rate risk. Pushing excess savings towards assets increases the demand for these assets which resulted in an appreciation of asset prices. This put additional pressure on demand as well as on total output. An inflow of foreign savings, combined with low interest rates and expectations of constantly increasing asset prices resulted in the creation of an asset bubble in both houses and securities. An increasing demand for assets motivated the financial market in developing new instruments and securities (derivatives) whose main purpose was to diversify risks." 

4) The long-run decline in growth hypothesis 

The most recent hypothesis, attributed to economist Robert Gordon, does go back long enough to explain the fundamental decline in the total factor productivity growth. In fact, that's what the theory is all about. In his bestselling new book "The Rise and Fall of American Growth", Gordon paints a very pessimistic picture of an exhausted american growth model. He claims that all the life-altering innovations of the past (in particular from 1870 to 1970) will not be repeated in the future, meaning that our TFP as well as our economic growth rates may go down even more (he makes a prediction of long-run economic growth to fall down to only 0.2% - see graph below). Some of reasons of why this could be so (the so called 'headwinds' the economy is facing) are the rising inequality, an ageing population, poor education, and rising debt levels. In brief, Gordon's view is that the technological revolution will not increase our living standards. I personally disagree with this assessment, as I find it unnecessarily pessimistic. I will challenge it thoroughly in my next blog post.

Robert Gordon's projection of average growth until 2100.
What about the origin of the current stagnation? According to Gordon it was a mere exhaustion of innovation. None of the stuff produced in the late 20th and at the beginning of the 21st century (like the Internet, or iPhones, or Google and Facebook) can match themselves to the benefits given to our societies during the late 19th and 20th century - things like electricity, cars, penicillin, running water in homes, the telephone, etc. Many of the 'headwinds' such as the rise of inequality, the ageing of the baby boomers, or rising debt levels are attributed to this very problematic feature and are, according to Gordon, responsible for the relative decline as well as for the even worse future rates of growth. So the current stagnation is a mere beginning of a long trend of close to zero economic growth given that we will fail to emulate the technological breakthroughs of the 20th century. A truly depressing outlook. 

5) The 'low-hanging fruit' hypothesis

Finally, Tyler Cowen in his great book "The Great Stagnation" argues that the US simply ran out of low-hanging fruits which fueled american growth from the late 19th century onward. He makes an interesting claim that these low-hanging fruits brought the country to its current technological plateau and now it's stuck here for a while before a next major revolution happens. 

So what are these low-hanging fruits the US had and has by now exhausted? Cowen cites the three most important ones: free land and abundant resources (particularly in the late 19th and early 20th century as it attracted many talented Europeans to enjoy the relative abundance); technological breakthroughs from the 1880s to the 1970s (the same ones Gordon mentions: electricity, motors, cars, planes, telephone, plumbing, pharmaceuticals, mass production, radio,TV, etc.), and last but not least smart, uneducated kids (a vast amount of people that educated themselves and massively contributed to economic growth).

All of this is gone now. Moving a student from high school to college today will only reap marginal returns at high costs. Moving a child from a farm to high school back then significantly increased its skill-set and thus opened up room for innovation. This innovation came in the form of massive technological improvements which all greatly increased our living standards; not only in terms of faster transportation or handy appliances - it also significantly improved our health and increased life expectancy. No modern-day innovation can improve our living standards that significantly nor can it expand our life expectancy to a 100 years. The Internet, social networks, search engines and smartphones are all cool and useful stuff, but their impact on our living standards is not even comparable to that of electricity, engines, conveyor belt production, or pharmaceuticals. 

Yet! We have no idea how the Internet will change our life in the future and what opportunities the current technological plateau will open up for us. Remember, we are in the midst of the Third Industrial Revolution - the IT Revolution. It's benefits won't be obvious to us quite yet. My hypothesis is that the IT Revolution is at the heart of the current stagnation. I will defend this argument in more depth in the next post. 

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