With a few short-lived and unsustainable exceptions, the story of the last 30 years appears to be one of constantly falling interest rates and disappointing growth. Central banks try to keep stimulating the economy, but investment demand never really seems to gather pace in response to their efforts. Instead, investment seems stagnant and unresponsive to policy during normal periods, but shoots up during events like the dotcom and real estate bubbles, which then burst and leave everyone worse off.
People have been puzzling over this pattern for decades, but it took a speech by Larry Summers to the IMF in 2013 to really crystallise the whole picture, and bring it into the public eye. Ever since, it’s been known by the term he gave the phenomenon: ‘secular stagnation’. But he didn’t invent it. It was first coined by Alvin Hansen in the post-Depression 30s, when technological progress seemed to have ground to a halt.
The revival of the term could be misleading on a number of levels. First, Hansen wasn’t necessarily right about the 30s and even if he had been, the same factors wouldn’t necessarily be at work today. Second, in its more recent application, ‘secular stagnation’ implies a condition unrelated to the business cycle and suggests it is with us for ever. It also seems to relate to a broader loss of vigour.
So it’s worth clearing our minds of the conceptual baggage around the term, and applying it on a limited, more domestic scale. What might secular stagnation look like in a very small, family-sized economy? What if it happened in a single household?
Before we compare a national economy to a household budget we need to flag up that this has been one of the most fertile sources of error in economics since the subject was invented. The trouble is that if you’re going to compare an economy to a household, it has to be a very odd kind of household indeed. Specifically, one where everybody works for the family firm; where that firm sells nearly all of its output to family members; and where nearly all investment is financed by the bank of mum and dad.
There almost certainly isn’t a household in existence with the kind of set-up that would make it a valid analogy for a whole economy. But fiction might offer a more easy to use version of this state. Take the Smurfs, the friendly little blue and white creatures from the comic and TV franchise, who all seem to work for each other, buy each other’s produce and fund each other’s business ventures. So, by stretching a point, and with apologies to any Smurfologists out there, we can think about how secular stagnation might come to Smurf village.
The economy of Smurf village had been smurfing along pretty well for a long while. Papa Smurf, the patriarch of the family, made most of the decisions on investment. He bought most of the machinery from the workshop operated by Brainy Smurf (and occasionally provided working capital for the entrepreneurial businesses of Jokey Smurf). Hefty Smurf was employed as a labourer, chiefly in spreading manure on the smurfberry bushes, the procurement of which was the job of his sister, Grouchy Smurf. Every year, everyone received their wages, or payment for the tools and fertiliser they supplied, and spent it on smurfberries, cakes, stocking caps and other smurf goods.
The youngest daughter, Smurfette, handled all banking business for the family and because of this role, had the important job of ensuring the economy of Smurf village was kept ticking over. Although nobody could tell Papa Smurf what to do in terms of investing in new assets or employing labour, Smurfette was able to subtly manipulate him by altering the rate of interest he got on his savings . (This is just a toy economic model, so we’re not going to worry about how she did that.) If she wanted him to invest more, she would move it down until he declared “Oh, might as well, I’m getting nothing in the bank.”. If she thought spending was running ahead of output capacity, she would move the interest rate up until all Brainy and Jokey’s ideas were met with, “Well I’m sorry, boys, but this savings bond is too good an opportunity to miss!” People tended to be rather suspicious of Smurfette and to grumble behind her back, but in general she was trusted as she seemed to be doing a good job.
After a while, though, the family became discontented. It was noticed that Hefty and Grouchy were spending a lot of their time idle, Brainy and Jokey didn’t have as much to spend as they used to, and the output of smurfberries was not growing as much as it had done in the past. Smurfette kept on moving the rate of interest Papa got on his savings further and further down, but nothing really seemed to happen as a result. There was one episode – Papa got excited about a scheme to extract biodiesel from turnips – when it looked like everything was getting better, but this turned out to be an embarrassing failure which left everyone considerably worse off than they had been before. So a big conference of all the Smurfs was held, to answer the question:
“Why is it seemingly impossible for Smurf village to have full employment at any level of interest rates, except when there is an unsustainable bubble going on?”
This is a simplified version of the secular stagnation question that Larry Summers raised. We have an economy that has entered a period of low growth, and monetary policy doesn’t seem to be able to help. Every now and then, growth and investment are stimulated by bubbles, but these can’t be the object of policy and they cause problems of their own. So what’s gone wrong in the Smurf economy?
Papa Smurf spoke first, as usual. “Frankly,” he said, “I blame Brainy and Jokey. In the good old days, they were always coming up with great ideas for the farm – new tractors, magic wells, bakeries and such like. I was happy to invest in them. But nowadays, they just seem to have run out of ideas. There’s nothing really great to invest in any more.”
Papa has come up with the ‘technological progress’ explanation. Investment spending, to the extent that it does more than just replace depreciated kit, has to be driven by an expected return on capital greater than the cost of capital. This return is driven by numerous factors, one being technological progress. New technologies can either allow totally new consumer demands to be met (in which case investing firms can be confident of selling their output at a premium price); or they can allow existing demand to be met more efficiently (making them sufficiently cost effective to justify buying new capital even if the existing capital base is not worn out). If technological progress and innovation slows down, you would expect the relationship between the interest rate and investment demand to change, too.
Brainy responded indignantly. “Now come on, Papa Smurf, you know that’s not fair. I’m coming up with all sorts of great ideas. Indoor toilets, community radio, smurf fever vaccination: everyone agrees these are all really great projects. The trouble is, all of these ideas are quite difficult to make a profit from, so I can’t pay a return on your investment. What we need is for everyone to chip in a little bit to the family kitty and reward me for all my hard work.”
Papa Smurf’s theory of technological stagnation has one big flaw when applied to developed economies between 1990 and 2015: it doesn’t take into account the internet, mobile communications, green energy and a host of other technologies. But there’s a subtler version of the theory that might fit the newer scenario better. Take the fact that lots of internet and telecoms companies have gone bust. One reason for this might have been that although technological progress was continuing, the things being invented provided far more benefits to consumers than could realistically be charged for. Modern communications technology derives its advantages from the network effects, but people can only be billed for their own usage. This consumer surplus is great news for users but, in terms of providing investment incentives, it might as well not exist.
“Well I blame Smurfette,” Jokey piped up, to general approval. “She’s meant to be advising Papa Smurf on his investments and doing the paperwork on all our projects. Instead, she’s spending half her time mooning over Vanity Smurf and taking jaunts up to Gargamel’s Castle in her Porsche. The financial system in this village is in a mess.”
If we are looking for theories which correspond fully with the facts, the ‘broken finance’ explanation is also a promising candidate. Financial firms are big and complicated, and subject to a bewildering variety of incentive problems. Some of these are the subject of government regulations, which themselves often result in perverse or unintended consequences. Given all this, it was stunningly optimistic of economists to suppose that the supply and direction of credit in a modern economy could be modelled as a straightforward supply and demand function, with the interest rate doing the work of bringing the two into equilibrium.
We certainly do know that a lot of financing was diverted into property over this period, while small business funding was much more restrained, and stock markets experienced wide oscillations. The financial sector is chaotic and it’s certainly possible that, for a long time now, it’s found an equilibrium in which the relationship between interest rates and investment spending doesn’t work in the same way as it has in the past.
Smurfette was quick to defend herself, fuming with anger. “You’re all just too thick to understand what’s wrong! It was an easy job, dealing with Papa’s finances when inflation was 10 per cent a year; I could push the rates down to 2 per cent and he’d have to go out spending on more or less anything. Now that prices have been stable for ages, he still doesn’t feel like he’s being rewarded for the risks he takes on your businesses, even when I push the rates down to zero. And I can’t move them any lower than zero or he just smurfs it under the mattress!”
But is there a problem to be explained here? One thing nearly all people agree on is that investment spending ought to depend on real (inflation-adjusted) rates, rather than nominal ones. And another thing most people agree on (with a few awkward exceptions) is that the relevant interest rate to consider is the ‘risk-free’ interest rate (that earned on money in the bank, or on AAA government bonds), plus a premium. But there is very little agreement about what that premium should be. If it was a big number, a situation could arise where the level of real ‘risk-free’ rates needed to stimulate investment demand was not an achievable one; because if inflation is low or zero, then a very low real interest rate might imply a negative nominal interest rate (not achievable because it can always be beaten by the zero interest rate payable on cash-under-the-mattress).
There was an awkward silence, and then Hefty Smurf spoke up. “Actually ...”, he said, rather diffidently, “I don’t see why all the money seems to end up with Papa Smurf. In the olden days, we all had a little bit and we all spent it. But as time has gone on, it seems like a bigger and bigger share of the smurf fortune has ended up in Papa Smurf’s bank account. He’s got richer much faster than the rest of us. Papa doesn’t spend the money at the same rate we do, so if he doesn’t invest it in new projects, it just sits there and doesn’t circulate.”
Hefty Smurf has raised the ‘inequality explanation’ here (perhaps he’s been reading Thomas Piketty’s book, Capital in the Twenty-First Century, or Inequality and Instability by James Galbraith, which makes the point more explicitly). The interest rate is one thing every businessman looks at when deciding whether to invest, but it’s not the only – or even the most important – thing.
The most important factor in the investment decision is the fundamental question every business asks every day: are there enough potential customers to buy the product? Poorer people spend a higher proportion of their income than richer people. This is true all along the income distribution scale, right up to the very richest, who spend proportionally the least of all. Thinking in terms of consumer goods, it’s easy to see why a concentration of wealth and income in the top one per cent might break the investment-demand relationship: if the customers of Samsonite luggage get a payrise, Samsonite can expand production and increase its sales. Louis Vuitton, on the other hand, has limited supplies of skilled labour and high-quality leather – all it can do is raise its prices, or watch the queues form for its latest handbag.
There was a clamour of opposing voices as everyone argued over Hefty’s suggestion. During a brief lull in the noise, Grouchy Smurf finally spoke up. “I sometimes wonder if it’s anybody’s fault at all,” he said. “The thing is, this is only a small village based on smurfberry farming, and there’s only so much investment that can be ploughed into it in any given year. And we’ve had access to some really cheap things over the last few years. We got that Belgian supplier who sold us manure for half price. And Brainy got the address of that Chinese company who could make combine harvesters really cheaply. The trouble is that when Papa bought all the capital that the farm needed, there was still a lot of cash left over. And because we sold everything at low prices, me, Brainy and Jokey were left broke.”
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Grouchy has reached the most technical explanation of all: the ‘investment goods deflation’ explanation. If there is a limit to the amount of physical capital investment possible, then a fall in the price of capital goods can mean investment gets ‘maxed out’ and the market mechanism doesn’t work any more. Whatever the interest rate policy, nobody produces any more investment goods because the market can’t handle the existing supply as it is. That’s difficult to understand in the abstract, but easier to grasp in the light of the other big economic phenomenon of the 1990-2015 period: the rise of China and of outsourcing/offshoring, combined with a sharp reduction in the price of microprocessors. Investment just became much cheaper, at every level of interest rates; but this meant that every rate-cut had a diminishing effect. The same investment projects were made viable every time the US Federal Reserve reduced rates; but pursuing those projects didn’t involve anything like the same amount of investment demand, and therefore stimulus to the economy.
With all these ways for the relationship between monetary policy and investment demand to go wrong, it’s perhaps surprising that the Smurfs did so well for as long as they did. And maybe that’s the answer to the whole question: it’s simply an act of faith to believe investment is going to respond to interest rate policy in a predictable, supply-and-demand pattern.
The real lesson of the Smurf village model is that secular stagnation isn’t really about growth slowing down. It’s about growth slowing down, and none of the normal policy levers being able to speed it up again. What all six of the Smurfs’ explanations have in common is that investment capital, instead of circulating round the economy, gets stuck and starts to pile up somewhere, despite price signals telling it that it ought to be chasing new investments. So any policy response to secular stagnation needs to come up with new ways of persuading investors to invest, ways which aren’t (at least, not in the conventional sense,) price signals.