Whenever the U.S. economy experiences a nasty shock or extended period of sluggish growth, economists—particularly those on the left—start speculating that maybe the good times really are over for good. Irrational exuberance quickly shifts to unreasonable pessimism about the ability of a market economy like America’s to continue broadly raising living standards as it has in the past. This habit of mind is so ingrained that even an economist of so towering an intellect and such supreme self-confidence as former Treasury secretary and Harvard president Lawrence Summers could not resist its gravitational pull.
Back in November 2011, at a debate in Toronto, Summers had little patience with the idea that America risked becoming Japan, a nation whose economy was beginning its third consecutive lost decade, a period of stagnation and deflation. He conceded that the U.S. economy was recovering only glacially from the Great Recession and Financial Crisis. But better times were just around the corner: “We remain the place where everyone in the world wants to come and the place where everyone in the world wants to put their money.” He continued: “We are a uniquely resilient society and we have seen this before. John Kennedy died believing that Russia would surpass the United States by the early 1980s. Every issue of the Harvard Business Review in 1991 proclaimed that the Cold War was over and that Japan and Germany had won, and that was before the best decade in U.S. economic history.”
But almost two years later to the day, Summers spun an almost completely opposite tale for the attendees of an International Monetary Conference in Washington, D.C. Japan’s long malaise, he remarked, “may not be without relevance to America’s experience.” Summers now worried that the United States and Europe really were in great danger of sliding into a Japanese-style permanent slump, or the dreaded “secular stagnation.”
In this condition, inflation would stay moribund while employment and wage growth would stay weak. Summers speculated that the “natural interest rate” in advanced economies—or the short-term real interest rate consistent with full employment—had fallen “to negative 2 percent or negative 3 percent sometime in the middle of the last decade.”
And there’s the rub. Conventional monetary policy can’t push rates that low, at least not if central banks insist on keeping inflation around 2 percent. (Summers apparently operates under the assumption that higher inflation, which could push real rates deep into negative territory, is not, either politically or economically, doable or both.) An economy with a natural interest rate in negative territory is trapped in a pit where the interest rates set by banks are chronically too high to help achieve a full-employment economy that is hitting on all cylinders. Central banks can try to boost demand by keeping rates extraordinarily low for an extended period and creating bubbles during economic expansions, as in the 1990s (technology stocks) and 2000s (housing), but that strategy risks creating massive economic instability. Thus, Summers concluded, “We may well need, in the years ahead, to think about how we manage an economy in which the zero nominal interest rate is a chronic and systemic inhibitor of economic activity, holding our economies back, below their potential.”
To put it more plainly, Summers is worried that real interest rates simply cannot fall far enough into negative territory to generate adequate business and consumer spending. As a result, in business cycle after business cycle, the U.S. economy will keep falling further and further behind its growth potential. And as business fails to invest and workforce skills diminish, the economy’s growth potential erodes, too—or, as Citigroup’s chief economist, Willem Buiter, has written: “Today’s high actual unemployment rate becomes tomorrow’s high natural unemployment rate.”
So what happened to optimistic Larry Summers? Perhaps at some point between November 2011 and November 2013, Summers had an epiphany when he saw that his mental model of how the world worked was out of step with reality. Recall that Alan Greenspan told a House panel investigating Wall Street’s meltdown that when it came to bank regulation, he had “found a flaw” in his laissez-faire ideology and was “distressed by that.” Maybe Summers became comparably distressed when he saw that the aftermath of the Great Recession was not playing out exactly the way he had expected.
Back in 2009, Summers was the economic-policy czar of President Barack Obama’s new administration, serving as the director of the White House’s National Economic Council. He and the rest of the new Obama economic team were audaciously hopeful about the economy’s ability to rebound strongly from the worst downturn since the Great Depression. After all, not only were deep downturns typically followed by robust recoveries, but that $800 billion stimulus they pushed through Congress would provide an added fillip. What’s more, Summers himself thought the massive jobs cuts in late 2008 and early 2009—employers shed an incredible 4.5 million jobs in just six months, more than half of the total jobs lost during the 18-month recession—were in part a psychological overreaction by a Corporate America that feared total global economic collapse. Once employers saw the world was not coming to an end, he believed, hiring would bounce back even faster than economic growth. By the middle of 2013, the Obama administration predicted, unemployment would be back down to 5 percent and the economy would be experiencing its third straight year of 4 percent economic growth or higher—with another one on the way in 2014.
Things haven’t worked out that way. GDP growth over the course of the recovery has been only about half of what Obama White House economists predicted. Instead of four years of 4 percent growth or higher, we’ve had just two quarters of growth that substantial. If the U.S. economy had recovered in the wake of the Great Recession as it had after the previous six downturns, the nation’s gross domestic product would be more than $2 trillion larger today (adjusted for inflation). Likewise, if the U.S. labor market were experiencing a typical recovery, there would be 15 million more Americans with jobs. Obama defenders point out that real-time economic data in 2009 had understated just how bad the recession was; if White House economists had fully comprehended the severity of the downturn, they would have tempered their forecasts. But similarly Pollyannaish projections followed those in 2010, 2011, and 2012. Nor do Obamanomics apologists usually note that the slow recovery happened despite both massive fiscal stimulus and massive monetary stimulus from the Federal Reserve, which they did not expect.
Yet, despite all the stimulus, as Summers said in his IMF speech, the economy continues to sputter along at a pace that traditionally would put it at a heightened risk of tumbling into recession. And while Summers would have, in retrospect, preferred a bigger stimulus and surely thinks the budget-sequester and debt-ceiling crises have been bad for growth, he clearly thinks there are long-term forces weighing down U.S. economic growth that go beyond the difficulties of this economic cycle. Even before the recession and financial collapse in 2008, Summers explains, the economy wasn’t quite right:
If you go back and study the economy prior to the crisis, there is something a little bit odd. Many people believe that monetary policy was too easy. Everybody agrees that there was a vast amount of imprudent lending going on. Almost everybody agrees that wealth, as it was experienced by households, was in excess of its reality. Too easy money, too much borrowing, too much wealth. Was there a great boom? Capacity utilization wasn’t under any great pressure; unemployment wasn’t under any remarkably low level; inflation was entirely quiescent, so somehow even a great bubble wasn’t enough to produce any excess in aggregate demand.
So what was and is wrong with the U.S. economy that it takes bubbles to achieve anything close to full employment?
Summers used the phrase “secular stagnation,” just as the economist Alvin Hansen (whom some called the American Keynes) did in the late 1930s. Hansen worried that America would never really recover from the Great Depression and return to prosperity due to declining population growth and slowing technology innovation. He called this “secular stagnation.”
There is some reason to see both these factors as problems for the modern American economy. The U.S. Census Bureau says America’s population grew just 0.72 percent between July 2012 and July 2013, the slowest rate of growth since the Great Depression and well below the nation’s post–World War II average of 1.2 percent. And according to the latest findings from the Centers for Disease Control and Prevention, the number of U.S. births per 1,000 women between the ages of 15 and 44 is now at the lowest level on record. Indeed, the Obama White House economists stated in the administration’s budget proposal last year that economic growth in the future “is likely to be permanently slower…because of a slowdown in labor force growth initially due to the retirement of the post–World War II baby boom generation, and later due to a decline in the growth of the working age population.”
Many economists are also worried today, as Hansen was in the 1930s, that technology innovation is slowing. They note a productivity slowdown starting in the late 1970s, only briefly interrupted by the information-technology-driven boom between 1995 and 2005. J.P. Morgan economists Michael Feroli and Robert Mellman point out that certain high-tech equipment prices are falling more slowly than they were a decade ago—a possible warning sign that innovation is decelerating. Northwestern University’s Robert Gordon has received considerable attention for his paper “Is U.S. Economic Growth Over?” in which he argues that today’s IT innovations will have far less impact on productivity than past innovations such as electricity, the internal-combustion engine, and public sanitation. “The rapid progress made over the past 250 years could well turn out to be a unique episode in human history,” he concludes. If the techno-pessimists are correct, there are simply too few high-return investment projects available in which business can invest the cash hoard they have been compiling.
Summers also wonders if the increase in high-end income inequality isn’t playing a role in America’s flaccid economic performance. The rich are different from you and me—they save a lot more. So perhaps one reason that the level of spending at today’s interest rates is likely to have declined is due to “reduced consumption demand, due to a sharp increase in the share of income held by the very wealthy and the rising share of income accruing to capital.”
To back up the argument, secular stagnationists point to a recent paper out of the St. Louis Fed that finds “the demand drag caused by inequality is now constraining the U.S. economy” and questions “whether the U.S. economy can generate the demand growth necessary to maintain stable full employment.” The St. Louis Fed economists suggest that “redistributive tax policy could help to meet this goal,” although, they say, “direct redistribution is politically contentious.” So: Take from the top 1 or 2 percent and funnel that money to the 99 or 98 percent somehow, whether through tax cuts or some government transfer program.
Another option is that if the private sector won’t invest, then the public sector should take the lead. The approach that “holds most promise” in countering secular stagnation “is a commitment to raising the level of demand at any given level of interest rates, through policies that restore a situation where reasonable growth and reasonable interest rates can coincide,” Summers wrote in the Washington Post. “This means ending the disastrous trend towards ever less government spending and employment each year—and taking advantage of the current period of economic slack to renew and build out our infrastructure.”
Talk of higher taxes on the rich and more public investment to boost consumer spending as the solution to America’s economic woes is sweet music to the progressive wing of the Democratic Party associated with the Harvard Law professor-turned-senator Elizabeth Warren. Up until now, however, this so-called middle-out economics has been a political strategy masquerading as a macroeconomic one. But now Summers and fellow secular stagnationist Paul Krugman have added some scholarly respectability to the middle-out agenda items by tying them all together with grand theory.
But is the theory true?
One high-profile critic of the Summers secular stagnation thesis is Goldman Sachs. In a recent analysis, the Wall Street bank’s economic team concludes that the economy’s current weakness is cyclical rather than secular, and it takes issue with Summers’s reading of the economic history of the 2000s. Goldman acknowledges the expansion that took place from 2001 through 2007 after the 2001 recession was weaker than recoveries seen in the 1980s and 1990s—despite a housing bubble and a big rise in household debt. But, the bank goes on to say, “we see other, simpler explanations for this than a negative equilibrium real interest rate.” While the recovery from the 2001 recession wasn’t particularly vigorous, the downturn itself hadn’t been particularly severe with only two, non-consecutive quarters of negative growth. Mild recessions make for mild recoveries. When the recovery began, as the Goldman Sachs study notes, the unemployment rate was just 5.5 percent and the share of the non-incarcerated, non-military adult American population with a job was near an all-time high. Second, while the housing and credit bubbles added a lot of demand to the economy, a lot of demand was sucked from the economy by a big rise in the price of oil and other commodity imports and a negative wealth effect from the collapse of the Internet stock bubble.
Goldman also takes a more sanguine view of the post–Great Recession performance of the U.S. economy, which, “while poor in absolute terms, is actually not too bad by the standards of prior severe financial crises.” This is reference to the work of economists Carmen Reinhart and Kenneth Rogoff, who have examined the performance of advanced economists after financial crises. They say the current U.S. recovery actually places it in the upper range of economic rebounds.
Rutgers University economist Michael Bordo has found completely the opposite result in looking at U.S. economic performance using a different set of financial shocks. By his reckoning, the current recovery is slower than every preceding recession featuring a financial crisis. That would seem to support the Summers thesis. But Bordo actually attributes the slow recovery to the fact that the financial crisis was accompanied by a housing collapse. As Bordo writes, “The recent recovery is much slower than historical averages after deep recessions, largely attributable to the unprecedented housing bust that accompanied the financial crisis.” He says that “the shortfall attributed to problems in the financial sector was not able to account for the recovery’s slow pace.” With residential investment finally on the mend, Bordo expects a rebounding housing sector to accelerate GDP growth in the coming quarters so the economy will again grow at its pre-recession pace.
A look back at how Alvin Hansen’s prediction panned out should also give us pause before we leap to the conclusion that secular stagnation has us in its grip. The productivity research of Alexander Field finds that the years 1929 through 1941 were actually exceptionally innovative ones, “with the consequence that a significant fraction of the productivity foundations of the postwar epoch were already in place before 1941.” At the exact time Hansen and many other first-generation Keynesian economists were fretting about a permanent innovation slowdown, the U.S. economy actually was experiencing a particularly fertile period for new ideas, approaches, and technology. Rather than being mired in secular stagnation from a dearth of good investment opportunities, the U.S. economy in the 1930s was suffering from overly tight monetary policy and FDR’s ham-handed attempts at central planning.
America may well be going through a similar period today. Summers fails to adequately consider the role of the Federal Reserve in turning a moderate downturn caused by a real-estate slump and an oil-price spike into the Great Recession and subsequent Financial Crisis. In my view, the Federal Reserve Board under the direction of Ben Bernanke made two huge mistakes at the outset of the troubles. First, it failed to slash interest rates between April 2008 and October 2008 as the economy rapidly deteriorated. Second, hawkish inflation statements by Fed policymakers effectively tightened monetary policy that summer by pushing up the expected path of the federal-funds rate. As Richmond Fed economist Robert Hetzel has written: “Restrictive monetary policy rather than the deleveraging in financial markets that had begun in August 2007 offers a more direct explanation of the intensification of the recession that began in the summer of 2008.” Had the Fed responded more aggressively in early 2008 with deep rate cuts, quantitative easing, and, perhaps mostly important, a strong statement that the central bank would do whatever it took to support spending in the economy, there might have been no grand collapse—and there would be little interest today in gloomy secular-stagnation theories.
And just as Hansen missed an innovation boom in the 1930s, today’s techno-pessimists may be understating the impact of the information-technology revolution. In their new book, The Second Machine Age, MIT’s Erik Brynjolfsson and Andrew McAfee argue that today’s digital technologies are only now beginning to transform the American economy in fundamental ways. “We’re living in a time of astonishing progress with digital technologies—those that have computer hardware, software, and networks at their core,” they write. “These technologies are not brand-new; businesses have been buying computers for more than half a century, and Time magazine declared the personal computer its ‘Machine of the Year’ in 1982. But just as it took generations to improve the steam engine to the point that it could power the Industrial Revolution, it’s also taken time to refine our digital engines.”
Learning how to use cutting-edge innovations to boost productivity takes time. Stephen Oliner of the American Enterprise Institute, a former Fed economist, writes in a recent paper, with David M. Byrne, on the Federal Reserve Board, and Daniel Sichel, an economics professor at Wellesley College, that slower productivity growth is largely explained by reduced contributions from information technology following the tech boom from the mid-1990s to mid-2000s. Now business is perhaps finally learning to take full advantage of digital technologies. Oliner also points out that chip innovation is continuing at a rapid pace, “raising the possibility of a second wave in the IT revolution” where the pace of labor productivity growth returns to its long-run average.
Still, whatever the flaws or weak spots on the 21st-century version of secular stagnation theory, it wouldn’t be the worst idea to assume that generating fast economic growth will be harder in the future than in the past. Indeed, a little paranoia about impending national decline could be an effective motivational tool for Washington. Perhaps it’s better to pay more attention right now to Summers 2013 than Summers 2011. If there are worthwhile infrastructure projects, the federal government or the states should take them on.
And we should assume there really aren’t enough high-investment projects out there for the private sector and start instituting policies that might help create more of them. For instance, a recent study by Boston University economist Laurence Kotlikoff finds that eliminating the U.S. corporate income tax would produce “rapid and dramatic increases in American investment, output, and real wages.” The innovation guru Clayton Christensen recommends phasing out capital-gains taxes as a way of encouraging more transformation innovation that creates new goods, services, and jobs. And does anyone believe the U.S. education system is maximizing our human capital? A 2013 study by Raj Chetty, John Friedman, and Jonah Rockoff finds that replacing a teacher in the bottom 5 percent of quality with an average teacher would increase the present value of a student’s lifetime income by approximately $250,000 per classroom. The consulting firm McKinsey thinks better public policy in areas such as energy, trade, infrastructure, and education could create nearly an additional million jobs a year by 2020 and $2 trillion in additional GDP growth. From these few examples, it should be clear the U.S. economic policy is hardly anywhere near optimal for maximizing growth. But there is no reason it can’t be and no reason that a decade from now we cannot look back at the Summers Secular Stagnation Scenario as a call to action.