On the Secular Stagnation Debate; Why Exercise?

From: aditya rana
Date: Sat, Apr 11, 2015 at 2:05 PM
Subject: On the Secular Stagnation Debate; Why Exercise?


As a follow-up to last week’s newsletter on why interest rates are so low, this newsletter will focus on the important (and related) topic of secular stagnation. Ben Bernanke wrote a second post in his new blog on the subject which questioned Larry Summers’ view that the U.S. was possibly in a state of secular stagnation. The post drew interesting responses from Summers as well as Paul Krugman, and I will summarise below the key points made by (perhaps) three of the most influential economists opining on public policy in the world today. The summary is a bit wonkish but well worth the time taken to read and digest as this issue is central to forming a view on world economic growth and the performance of asset classes in the years ahead.

Ben Bernanke:

-Larry Summers’ secular stagnation hypothesis holds that trying to achieve all three of the main goals of economic policy: 1)full employment, 2) low and stable inflation, and 3) financial stability may prove to be difficult.

-The term secular stagnation was first coined by an economist called Alvin Hansen during the Great Depression – arguing that due to the slowdowns in population growth and the pace of technological advance, companies were likely to invest less in capital goods, which when combined with tepid consumer demand, would lead to lower long-term growth.

-Hansen was proved to be wrong as the post-war population boom, and rapid technological advance, led to an era of high economic growth. Summers thinks that Hansen’s thesis is valid today due to declining population growth rate and the reduced capital intensity of industry (i.e. Facebook versus steel-making). With the low return on capital, real interest rates need to remain low (and even negative) to achieve full employment (see graph below) which has been the case in recent years. Summers also argues that low capital spending and low consumption demand, as well as the loss of workers’ skills due to unemployment, will eventually reduce the U.S.’s productive capacity.

-Given that the Fed cannot reduce nominal interest rates below zero, the minimum real rate (assuming 2% inflation) is -2.0%, and secular stagnation implies that the equilibrium real interest rate (to achieve full employment) will remain below -2.0% indefinitely. This means that the Fed can only achieve full employment by either increasing its inflation target (thereby driving real rates below -2.0%) or my allowing financial bubbles to form which would result in higher consumer and business spending.

-Summers’ solution to this problem is to increase fiscal spending – particularly on infrastructure, to achieve full employment. However, this is not a valid long-term solution assuming secular stagnation, as government debt is already very high by historical standards and even public investment will be subject to declining returns.

-He is sceptical that the U.S. is in secular stagnation based on three reasons:

1)A permanently negative or zero level of real interest rates would create ample profitable investment opportunities – in fact, almost any investment would be profitable.

2)A recent critique of Summers secular stagnation hypothesis questions the claim that full employment in recent decades has only been possible due to financial bubbles. The study notes that tech bubble came late in the 1990s boom, and positive effects of the housing bubble in the 2000’s, was largely offset by special factors like the sharp increase in oil prices and the large trade deficit of 6% which led to a demand outflow. The study concludes that the current slowdown is due to temporary “headwinds” which are in the process of dissipating.

3) His greatest concern with the hypothesis is that it ignores the international economy, as the existence of profitable opportunities in others part of the world will offset domestic secular stagnation. For example, if U.S. firms invest abroad it would lead to an outflow of capital lowering the value of the dollar which would boost exports. This, in turn, would raise production and employment in the U.S.. Therefore, in an open global economy, secular stagnation implies permanently low returns on capital everywhere which is unrealistic.

Larry Summers:

-The secular stagnation hypothesis rests on the phenomena of chronic excess savings over investment. As nominal rate cannot fall below zero, interest rates cannot converge towards the real equilibrium rate required to equate savings and investment. While Bernanke’s point about achieving a -2.0% real rate via 2% inflationary expectations is true, it is questionable that central banks have been to achieve their target inflation rate as inflationary expectations have fallen short of 2% across much of the developed world for over a decade.

-Real (risk free) rates may persist below zero due for protracted periods of time due to factors including improper functioning of credit markets which lead to much higher borrowing rates than the risk free rate. Real rates have been negative in the U.S. for 30% of the time over the twentieth century.

-The view that positive effects of the housing bubble during the previous expansion were offset by the increase in the trade deficit, and the tech bubble in the late 1990s were only modestly relevant needs to be studied further, but it would be hard to deny the role of the housing bubble in the growth rate prior to the financial crisis as well as the wealth effects of the stock market in the late 1990s.

-Fiscal policy, in particular public investment, is a natural instrument to promote growth in a zero real rate environment (despite a large debt burden), as the spending can pay for itself via higher GDP growth and actually reduce debt-to-GDP ratios (as pointed out by the IMF in their 2014 report). In addition, fiscal policy in countries with low and declining inflationary expectations (like Germany and Japan) can actually lower real rates by increasing inflationary expectations.

-The global aspect is critical as the spectre of secular stagnation extends to much of the developed world. To address the chronic global saving-investment imbalance, one must encourage countries with excess savings to reduce their savings or increase investment and not resort to currency devaluation to stimulate demand which are a zero-sum game.

Paul Krugman:

-Bernanke is correct in critiquing Summers’ lack of attention to global flows, but is incorrect in arguing that international flows would mitigate concerns about secular stagnation.

-Bernanke makes the argument that the lackluster recovery during 2001-2007, despite the mother of all housing bubbles was due to the offsetting surplus accumulated by China and other emerging markets, therefore resulting from a global savings glut rather than secular stagnation. While this has merit, his point that this can be addressed by making capital mobile and pressuring foreign governments to open up their capital accounts and reducing their savings is not quite right.

-Bernanke argues that capital outflows from countries in secular stagnation (from lack of demand) raises their natural interest rate to the offshore level does not work if the fall in demand is perceived to be temporary. This is because the initial currency fall will also be seen as temporary, and the market would expect the currency to rise subsequently thereby limiting the rise in its natural rate of interest.

-But since secular stagnation is about excess savings that last a very long time and are quasi-permanent should the ability to move capital freely make secular stagnation impossible in a single country?

-While this makes theoretical sense, Japan provides a real world counterexample. Japan has been in at the zero bound since the 1990s, with the rest of the developed world reaching that state only after 2008. So why didn’t capital flow out of Japan, driving the yen lower and getting it out of its zero bound trap.

-The answer is that real rates in Japan were not very low, and were actually about the same as those abroad – and did not happen due to the theoretical normalization of natural rates as Bernanke describes. Instead, Japan experienced deflation which kept the real rate well above the natural rate as the graph below illustrates.

-The conclusion is that if other countries are able to achieve a moderate rate of inflation, and a country slips into deflation or “lowflation”, that country can be stuck in a secular stagnation state despite other countries offering positive return opportunities.

-Regarding Bernanke’s point (in his third blog piece) that the global savings glut is temporary as Germany is the new China and its current account surplus reflects the cyclical weakness in the periphery which should correct itself. However, the market is not buying into this with German interest rates being negative out to 7 years implying expectations that the euro economy will be depressed for years.

-Furthermore, fundamentals support this expectation with the working-age population in decline (like in Japan), the euro system with a shared currency but no fiscal integration thereby limiting fiscal policy, and core inflation down to 0.6%.

-The above situation implies a persistently weak Euro and chronically large European current account surpluses as Europe tries to export its secular stagnation to the U.S. and elsewhere – with deflation/low inflation keeping real rates relatively high which prevent economic recovery. The global savings glut is here to stay for a while.

-The problem cannot be addressed by cracking down on currency manipulation and pressuring other countries to reduce their current account surpluses, as the European problem is fundamentally a weakness in domestic demand which can only be addressed by policies which boost demand – as suggested by Summers.

Fascinating and sensible arguments made by all three economists, and I find Krugman’s analysis of the global situation to be the most persuasive. Krugman has been looking at the issue of liquidity traps and capital flows since his seminal work in 1998, and has been remarkably accurate in analyzing the global economic situation in the aftermath of the financial crisis (using relatively easy to understand tools) and making the case for persistently low interest rates, low inflation and low growth. So it does seem we are in for a period of low growth, low interest rates and ongoing QE for the foreseeable future! Stay long risk assets!.

Why Exercise?:

A recent study on the benefits of exercise and its key role in reducing mortality risk as summarised by David Katz.

David Katz, M.D.

Director, Yale Prevention Research Centre


-There is an enormous benefit from even a little bit of exercise, more benefit from more, and then a threshold past which returns diminish, but don’t decline. The take-away message is that there is enormous potential for even a little bit of action to make our health, and lives, better.

-We have long known this, frankly. It is the reason why prevailing recommendations for physical activity rally around 30 minutes or so, roughly five days out of every seven. That’s not really very much for a species that spent millennia as roaming bands of hunter-gatherers. It is, however, enough to generate decisive health benefits in an age when the clan is a distant memory, and the couch a constant temptation.

-A new study reaffirms this. Just published on-line in JAMA Internal Medicine, the paper explores the relationship between weekly, average exercise and mortality in more than 650,000 men and women. The findings confirm our convictions, and validate our fervent hopes, about motion.

-The risk of dying prematurely was reduced 20 percent in those who did "any" routine physical activity, as compared to those who did none. Those how met that recommended minimum of 150 minutes per week of moderate activity had more than a 30 percent reduction in mortality risk. Those who exceeded the minimum by a factor of two to three had a nearly 40 percent mortality reduction. Benefits went up as exercise increased, but they diminished; the mortality benefit was front-loaded.

-While the new study looked at benefit in terms of mortality, the real rewards of routine exercise may be even better captured in considerations of morbidity, or its converse- vitality. Lack of habitual motion has long been atop the short list of factors contributing to both premature death, and chronic disease. Conversely, routine activity is a key factor on the short list associated with a lifetime reduction in the risk of all chronic diseases of roughly 80 percent.

-Those of us who are active routinely probably all agree that motion is its own reward. We have vital, animal bodies made to move. Taking them off the leash and out of the cage of modern, sedentary living just feels good. For those who doubt it, a major reduction in the lifelong risk of any major chronic disease is a pretty good, alternative motivation.

-Move, because your body was made to move. Move, because you will be less likely to die prematurely. Move, because you will be less likely to succumb to any major chronic disease, and more likely to recover from, or thrive despite, any you already have. Move, because it is vital to health. And strive for health not because I say so- but because healthy people have more fun.

Here’s to keep moving and to “adding years to your life and life to your years”!




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