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The stagnation era

The stagnation era
November 25, 2021
The stagnation era

President Biden recently signed into law a bill authorising $1 trillion of extra infrastructure spending, just eight months after a $1.9 trillion fiscal stimulus package. Which poses a question that should trouble all investors: why does the US need so much extra spending?

The thing is that economic policy was already super loose. Not only are real interest rates sharply negative, and expected to remain so for years, but also government borrowing was big even before the latest fiscal boost: the OECD estimates that the cyclically-adjusted primary deficit (a measure of the fiscal stance) will be 13 per cent of GDP this year.

And yet despite this policy support, the economy is still weak. One measure of this is the proportion of the population in employment. At 58.8 per cent, this is well below its 2019 level, which in turn was below the 2000 peak. Another measure is that economic growth has been slowing for years. In the 15 years to 2019 real GDP per person rose by only 1.1 per cent a year despite ultra-low interest rates. That compares to 2 per cent a year in the 15 years before the financial crisis and 3.2 per cent a year during the long boom of 1958-73.

This trend decline in growth explains both the long-term fall in interest rates and the recourse to looser fiscal policy. The US economy has been losing momentum for decades, so policy-makers must press harder on the accelerator if they are to maintain its speed.

We tend to think of policies as being exogenous interventions. But this is only part of the story. They are also symptoms of underlying malaises. And the malaise behind low interest rates and fiscal stimuli is a long-term slow down in growth.

The most popular account of this process has been Larry Summers’ theory of secular stagnation. “A decreasing propensity to invest,” he has written, has led to both slower trend growth and lower interest rates.

Such stagnation is of course not confined to the US. We’ve seen a similar thing in Japan, the eurozone and the UK.

Exactly why this has happened is controversial – and there need not of course be a single explanation.

One possibility, suggested by Robert Gordon at Northwestern University, is that we have run out of massive transformative innovations: yes, there’s still technical progress but it is much less capital-intensive than, say, electrification was in the early 20th century.

Another possibility is companies have learned from the tech crash that innovation and investment often don’t pay, so they are doing less of it. The Nobel laureate William Nordhaus has pointed out that companies capture “only a minuscule fraction” of the returns to innovation. And Salman Arif and Charles Lee have showed that higher capital spending has in the past led to more earnings disappointments and slower growth. Yes, animal spirits have weakened in recent years – but this might be because they have become more realistic.

A third possible explanation is a fear of future technical progress. Nobody will spend £1m on robots or AI if they expect their rivals to get better robots and AI in a few years’ time for £500,000 and so undercut them. Talk of new technologies can therefore co-exist with weak investment – and in fact be a cause of it.

But there’s something else, which was foreseen two centuries ago by classical economists such as David Ricardo – diminishing returns. A larger capital stock tends to earn a lower return, and such lower returns reduce companies incentives to invest and grow. Figures from the US Federal Reserve show that non-financial companies’ returns on non-financial assets (at historic cost) were in trend decline from the 1950s to 2019: yes, they have bounced back since, but this might be a temporary effect of a sharp post-lockdown bounce back in activity rather than the start of a new trend.

In fact, this trend decline might be a lot older than merely 70 years. “Global real rates have shown a persistent downward trend over the past five centuries,” writes the Bank of England’s Paul Schmelzing. Which suggests that the trend is not the result of any particular economic policies or policy regimes, but of deeper structural forces.

Because of this, he says, ultra-low interest rates will become “a permanent and protracted monetary policy problem”. Financial markets agree with him. UK gilt markets are pricing in 10-year real yields of minus 2.2 per cent in 10 years’ time. Which, of course, is not just a monetary policy problem but one for all of us. It means we should budget for negative real returns on safe assets for many more years. And insofar as such losses are a symptom of ongoing low growth we should not assume that equity returns will be high to compensate for this.

More plausibly, we should assume that total returns on financial assets generally will be low in coming years. This means young people should expect to have to save more or work longer to pay for their retirement while we oldsters should either learn to live frugally or run down our wealth in retirement.

There’s another issue here. Summers has said that “secular stagnation does not reveal a profound or inherent flaw in capitalism” because “raising demand is actually not that difficult”. But this is questionable. Japan has been trying intermittently to raise demand for 30 years and has not escaped the trap of zero interest rates. Schmelzing’s work shows that real interest rates trend down even as public spending trends upwards. And to the extent that weak private sector growth is the product of a declining profit rate, there most assuredly is a flaw in capitalism.

Which is not to say we are on the brink of revolution. What it does mean is that we are in a very different era to the one of our youth, to the one that formed our world views. Of course, US monetary and fiscal policies might be misjudged. But unless they are very wrong indeed the fact is that they are a symptom of a profound problem which policy-makers and investors haven’t fully appreciated.