The Case Against the New “Secular Stagnation Hypothesis”
Abstract: The new “secular stagnation hypothesis” developed by Lawrence H. Summers attempts to justify why the demand stimulus applied in the aftermath of the global financial crisis failed to revive growth in a satisfactory manner. Building on previous ideas of Keynes, Hansen, and Bernanke, Summers claims that excess savings together with feeble investment drove the natural rate of interest down to zero and advanced economies into stagnation. As the US monetary policy rate is not allowed to fall below the zero bound, Summers calls for “quantitative easing” and more expansionary fiscal policy to spur investment demand. This paper refutes Summers’s hypothesis by revealing its internal inconsistencies and presenting both theoretical arguments and empirical evidence on the long-term evolution of savings, investment, productivity, and capital stock. It also estimates the natural rate of interest following the approach of Salerno (2020), which is further refined based on Rothbard’s “pure interest rate” theory. The calculation shows that the natural interest rate did not drop to zero after the global financial crisis, but has actually remained consistently and significantly above the federal funds rate and the bank loan prime rate. This not only invalidates Summers’s central claim, but confirms once more the explanatory power of the Austrian business cycle theory in relation to the main trigger of the global financial crisis and its subsequent unfinished recovery.
JEL Classification: E43, E51, E52, E31, E32, E12, E14
Mihai Macovei ([email protected]) holds a PhD in international economics from the Academy of Economic Studies in Bucharest. He is an associated researcher at Ludwig von Mises Institute Romania and works for an international organization in Brussels, Belgium. The author is grateful for useful comments from Nikolay Gertchev and Amanda Howard.
Puzzled by the anemic growth performance in advanced economies five years after the global financial crisis (GFC) of 2007–08 and the inability of mainstream macroeconomic theories to explain it, former US Treasury secretary and Harvard professor Lawrence H. Summers (2013) expounded a new “secular stagnation hypothesis,” reviving an old Keynesian theory developed by Alvin Hansen during the Great Depression. At the core of the theory, which tries to justify government interventionist policies, lies the assumption that major structural societal changes have reduced investment demand in modern economies, whereas savings have continued increasing. This has created a “savings glut,” which has driven the equilibrium or natural real interest rate all the way down to near zero and made monetary policy largely ineffective.1 In order to combat the secular stagnation engulfing advanced economies, monetary policy would allegedly need to be recalibrated toward “quantitative easing,” and fiscal policy, in particular public investment, should be used more aggressively.
It may not be a coincidence that both Hansen and Summers released their theories precisely at times when the Keynesian theoretical framework was incapable of explaining why interventionist policies stimulating demand could not lift the economy out of recession. But instead of pouring old wine in new bottles, Summers could have usefully consulted the Austrian business cycle theory (ABCT) in order to understand the disappointing output growth following the global financial crisis. The ABCT was primarily elaborated by Austrian school economists Ludwig von Mises and Friedrich A. von Hayek and explains how excessive growth in bank credit due to artificially low interest rates set by a central bank or fractional reserve banks triggers an unsustainable boom and “malinvestments,” i.e., intertemporal misallocation of factors of production. A recession is bound to follow, because there are not enough real savings to support all the projects started in the boom. The recession liquidates the boom’s “malinvestments” and adjusts the structure of production to the economy’s new saving-investment preferences and natural interest rate. According to the ABCT, further monetary expansion via “quantitative easing” and larger fiscal stimuli, as advocated by Summers, can only prolong the gap between the loan and natural interest rates, perpetuate entrepreneurial miscalculations, and cause economic stagnation. The Keynesian supposed cure for low growth is actually its main cause.
The key point in assessing the validity of Summers’s hypothesis is the claim that chronically weak investment demand together with a “savings glut” have significantly decreased the natural interest rate to close to zero and below the market loan rate. This allegedly depresses growth and justifies “quantitative easing” and negative interest rates. After brief presentations of the new “secular stagnation hypothesis” and of Knut Wicksell’s “natural interest rate” theory in the following sections, this article explains why the main arguments underpinning Summers’s theory are flawed. Using both theoretical proof and statistical evidence on the evolution of real savings, investment, productivity, capital stock, and inflation, this article disputes Summers’s central claim that the natural rate of interest fell significantly toward zero in recent years. Going a step further, it then estimates the natural interest rate for the US economy starting from an approach devised by Joseph T. Salerno (2020), which is further refined based on Murray N. Rothbard’s “pure interest rate” theory. The latter describes how the pure rate of interest is determined in the time market and permeates the entire structure of production. The final section concludes that the refutation of the new “secular stagnation hypothesis” calls for ending the decade-long policies of stimulating demand, which have proven detrimental to reviving sound economic growth.
THE NEW “SECULAR STAGNATION HYPOTHESIS“
In the presidential address delivered at the American Economic Association in 1938, Hansen presented a new interpretation of the protracted weak recovery from the Great Depression. According to him, the US economy was suffering from “secular stagnation,” i.e., it had reached a maturity stage where savings were increasing, but investment was falling due to a decline in population growth and subdued technological progress. If the main challenge of capitalist economies in the nineteenth century had been weathering business fluctuations, the twentieth-century problem became unemployment as depressions became longer and deeper (Hansen 1939).
To remedy declining investment demand, which had theoretically fallen below the level necessary to absorb savings, and the ensuing unemployment problem, Hansen advocated more rapid technological progress and the development of new industries to replace the maturing ones by increasing investment opportunities. He also saw a role for public spending in preventing the fall in national income below a critical level. But he surprisingly cautioned, with quite strong words, against the use of public investment as a panacea for filling the saving-investment gap: “[P]ublic spending is the easiest of all recovery methods, and therein lies its danger” (Hansen 1939, 14). Carried too far, the latter would lead to higher costs and prices, prolong economic maladjustments, and displace the otherwise available flow of private investment via both taxation and borrowing. Hansen also doubted the role that the interest rate could play in spurring investment, claiming that plentiful lending at low interest would not revive stagnating real investment. Despite the fallacy of his theory, Hansen’s original view of both fiscal and monetary stimulus as a potentially dangerous and partial cure to economic stagnation seems much more reasonable than that of Summers and other modern Keynesians.2
The secular stagnation theory fell into oblivion once the post–World War II baby boom solved at least one of Hansen’s fears, i.e., the decline in population growth. In addition, the war ended the Great Depression and new inventions like jet airplanes and computers supported the subsequent boom in productivity and output. As reality basically invalidated Hansen’s claims, his theory was laid to rest until Summers (2013) resurrected it in a speech at the International Monetary Fund (IMF). Faced with a similar challenge, i.e., a very weak recovery from the global financial crisis, despite unprecedented fiscal and monetary stimulus, Summers borrowed Hansen’s theory and refocused it on the zero lower bound, which prevents negative nominal interest rates and waters down the Keynesian monetary cure.3
Noting that growth in the United States and other advanced economies had been feeble despite buoyant financial conditions during the previous fifteen years, Summers (2014a; and 2014b) hastily concludes that mature industrial economies can hardly achieve adequate growth under conditions of full employment and ﬁnancial stability. He believes that this is caused by a substantial decline in the equilibrium or natural rate of interest to close to zero, reflecting a signiﬁcant shift between savings and investment. The economy has supposedly undergone an “increase in private savings, and a decrease in the level of investments” which could only be balanced at full employment at “an unattainably negative level of the nominal interest rate” (Summers 2015a). According to him, the fact that nominal short-term interest rates cannot fall below zero (or some bound close to zero)4 prevents the adjustment needed to equate saving and investment at full employment (Summers 2015b).
The question is how such a chronic excess of savings over investment can exist in flexible markets, and Summers borrows Hansen’s main contributors to secular stagnation, i.e., low population growth and weak technological progress, to answer it. In addition, he points to other complementary factors. Savings have supposedly been boosted by an increase in income inequality to the benefit of people with a higher saving propensity and, most important, by a surge in global savings. Summers emphasizes the “open economy” factor and his agreement with Ben Bernanke’s “savings glut” argument.5 Emerging economies, but also advanced ones such as Japan and Germany, have supposedly accumulated excess savings for precautionary purposes and distributed them to the industrialized world, in particular the United States, by investing them in safe assets, such as US Treasurys (Summers 2015c). In turn, the United States has not been able to channel the excess savings originating abroad into domestic investment. Summers considers that the decline in the demand for debt-financed investment, reﬂecting the legacy of the period of excessive leverage before the Great Recession, also played a role.6 In addition, a drop in the relative price of capital goods—he gives the example of computers—has rendered investment less costly and therefore profitable companies, such as Apple and Google, will allegedly “ﬁnd themselves swimming in cash and facing the challenge of what to do with a very large cash hoard” (Summers 2014a).
In order to overcome the “secular stagnation” challenge, Summers (2013 and 2015b) calls for more intrusive macroeconomic policy measures. He advocates monetary policy expansion via quantitative easing and a sizable reduction of real interest rates down to negative levels in order to match the fall in the natural rate of interest. Investment demand should also be increased, with a substantial role to be played by public investment and measures to reduce barriers to private investment. He argues in the Keynesian tradition that a substantial increase in public investment would not increase the public debt-to-GDP ratio because the investment multipliers are quite large until full employment is reached and the zero interest rate policy would suppress the debt service costs (Summers 2014a). He even calls for global action to solve the excess of savings over investment, arguing that “secular stagnation is a contagious malady” (Summers 2015c).7
It is most striking that although Summers presents some circumstantial empirical evidence in support of his hypothesis, this does not include any substantial data on the alleged global increase in real savings and collapse of investment, which are central to his argument. Moreover, in order to prove the decline in the natural rate of interest to zero, he only relies on some estimates in Laubach and Williams (2003) complemented by data on the decline in international real interest rates. Early on, a large inconsistency is evident in his treatment of interest rates. On the one hand, Summers (2015a and 2015b) claims that savings are chronically in excess of investment because nominal interest rates are constrained by the zero lower bound. On the other hand, he argues that real interest rates need to follow the decline in the natural rate of interest in order to address the saving-investment imbalance (Summers 2014a, 2015a, and 2015b). First, even if nominal interest rates are stuck at the zero bound, real interest rates can still be significantly negative with positive inflation.8 Second, Summers (2015c) enters into a circular argument when he uses the decline in real interest rates as a proof of the sharp decline in the natural rate while at the same time blaming “secular stagnation” on the fact that real rates have not mirrored the decline in the natural rate (Summers 2014a, 2015a, and 2015b). Third, the charts with which he illustrates the decline in the natural rate of interest and in real interest rates—for the US Treasury Inflation-Protected Securities (TIPS) and for the world average—do not support his claim, but show a similar downward trend from about 3 percent per annum in 2000 toward zero in 2012–13, only that the former fell faster during the financial crisis (Summers 2014a and 2015c).
The fact that real interest rates followed the natural rate toward zero and even turned negative from 2012 to 2013, makes one wonder why the economy did not exit “secular stagnation” afterward. And yet, as economic growth performance gradually improved in the United States and the validity of his theory was questioned, Summers (2018) defended it forcefully, claiming that the economic recovery was due to “extraordinary policy and financial conditions.” But in doing so, he contradicted his own policy recipe:
There is also a question over whether the current policy mix and financial conditions can be maintained indefinitely. This is doubtful for fiscal policy especially in the US. Monetary policies involving low or negative real interest rates may be sustainable over the long term but they are likely to encourage financial risk, unsound lending and asset bubbles with potentially serious implications for medium-term stability. (Summers 2018)
And he even went further, saying that “[c]urrent palliatives are appropriate but unlikely to be long-term solutions” (Summers 2018), implicitly admitting that his policy recommendations are only short-run placebos. Such easily identifiable inconsistencies show that Summers’s main arguments are seriously flawed. Moreover, his entire theory is refuted by available statistics on savings, investment, productivity, and the estimated level of the natural interest rate, which will be presented in the next sections. But first, the theoretical foundation of the analysis, Wicksell’s “natural rate of interest” theory which was later incorporated into the ABCT, will be introduced.
THE WICKSELLIAN THEORY OF THE NATURAL INTEREST RATE
Showing a keen interest in price fluctuations, Wicksell ( 1962) was among the few economists who endorsed the quantity theory of money (when this idea was largely discredited) and tried to improve it further. He noted that interest rate fluctuations played an important role in price changes and concluded that a connection must exist between the “natural” rate of interest which arises in the capital structure of the economy and the rate of interest that emerges on the credit market. Wicksell thought that these two rates of interest are supposed to converge under normal circumstances, in which case the rate of interest on loans is neutral with respect to prices. On the other hand, any persistent deviation of the market loan rate from the natural interest rate would generate a cumulative change in the price level. Keeping the money rate below the natural rate of interest would lead to an increase in prices and vice versa.
Building on the work of Eugen von Böhm-Bawerk, Wicksell argued that the natural interest rate is determined by the supply and demand for real capital goods, as if the latter were lent in kind in an imaginary economy without money. As a result, the natural rate is ultimately determined by the relative excess or scarcity of real capital goods and should be “roughly the same thing as the real interest of actual business” (Wicksell,  1962, xxv), i.e., the businesses’ return on capital investment.
Although the supply of real capital is limited physically by economic output, the money supply can be expanded without limit in theory. Wicksell stated very clearly that fractional reserve banks are able, especially in concertation, to lend “any desired amount of money for any desired period of time at any desired rate of interest, no matter how low, without affecting their solvency, even though their deposits may be falling due all the time” ( 1962, 111). He even acknowledged the possibility that “the money rate of interest could fall almost to zero without any increase in the amount of real capital!” ( 1962, 111; his italics). This is the extreme case that Summers and the modern proponents of negative interest rates are asking for, supposedly in order to match the fall in the natural rate of interest, which is prevented by the zero lower bound of monetary policy. Although an exact coincidence of the money and natural rates of interest is unlikely, Wicksell argued that any permanent negative difference, even small, between the money and natural rates would raise the general level of prices continuously and to an unlimited level. Therefore, if Summers’s assumption is wrong, reducing the money rate of interest all the way down to zero (or even below) when the natural rate hasn’t changed accordingly is bound to increase prices considerably and negatively impact the economy, as Mises later posited.
Wicksell described in detail the negative impact of the divergence between the money and natural interest rates on changes in the price level, but it was Mises who extrapolated the effects of interest rate manipulation to the capital structure of the economy. This was to become the backbone of his Austrian business cycle theory. According to Mises ( 1998, 521–34), the interest rate is determined by the prevailing “time preference” in the society, i.e., the degree to which people prefer present to future satisfaction. A lower time preference rate will be reflected in a greater share of investment to consumption, a lengthening of the structure of production, and a building up of capital. Mises called “originary” interest the interest rate that is price neutral. This rate is similar to Wicksell’s “natural rate of interest,” and is determined by the discount of future goods versus present goods ( 1998, 539–48
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