An Access Advertising EconBrief:
The Secular Stagnation of Macroeconomic Thought
The topic du jour in economic-policy circles is “secular stagnation,” thanks to two recent speeches on that topic by high-powered macroeconomist Lawrence Summers. The term originated just after World War II when Keynesian economists, particularly Alvin Hansen, used it to justify their forecast of the high unemployment and low growth that ostensibly awaited the U.S. after the war.
Now, nearly 70 years later, it is back. In a recent Wall Street Journal op-ed, monetary economist John Taylor likened its re-emergence to a vampire arising from his crypt. There is indeed something ghoulish about the propensity of Keynesian economists to ransack outdated textbooks in search of conceptual support for their latest brainstorm.
The backstory behind secular stagnation is only half the story, though. The other half is the insight it offers into the mindset of its patrons.
The Birth of the Secular Stagnation Hypothesis
As World War II drew to a close, economists gradually turned their attention to a problem that had intermittently occupied them since the late 1930s. The Great Depression had soured the profession on the workings of free markets. The publication of John Maynard Keynes’ General Theory of Employment Interest and Money had suggested a new framework for economic analysis that placed emphasis on unemployment and its elimination. While war mobilization had made this issue moot, the return of servicemen and readjustment to a peacetime economy brought it back to prominence.
Many Keynesians foresaw a return to mass unemployment and Depression. The leading American exponent, Alvin Hansen, developed a specific hypothesis along those lines. Keynes had posited a simple theory of aggregate consumption: consumption was a stable, linear function of income. These properties implied that, over time, it might become progressively more difficult to maintain full employment.
A numerical example using the simple Keynesian macroeconomic model will clarify this point. Y = real income or output, which is the sum of C (Consumption), I (Investment) and G (net Government spending). Further, C is a linear function of Y; that is, C = a + bY, where the “a” term reflects the influence on Consumption of factors other than real income and “b” (the slope of the Consumption function depicted diagrammatically) is the marginal propensity to consume from additional income acquired. Assume, purely for expository purposes, that a = 50, b = .75, I = 100 and G = 100. If Y = 1000, then C = 50 + .75 (1000) = 800. The influence of technology, which improves from year to year, will cause productivity to increase and output to increase over time, all other things equal. Assume, again purely for illustrative purposes, that this increase is 5%. In that case, the full employment level of income will increase from 1000 to 1050. But C does not increase by 5% to 840; it increases only to 837.50. In order to preserve full employment (according to Keynesian logic), the sum of I and G will have to increase by 212.50, an increase of 6.25% over its previous value of 200 – which is more than 5%. Over time, this putative annual shortfall in Consumption would get larger and larger, requiring successively larger doses of I and G to keep us at full employment.
Already we can see the germ of logic behind Hansen’s secular stagnation hypothesis, which is that Consumption over time will fall farther and farther behind the level necessary to preserve full employment. (The word “secular” does not reflect its customary meaning of “non-religious or worldly” but rather its technical economic meaning of “a long time series of indefinite duration.”) Underconsumption is a theme dear to the hearts of Keynesian economists. In this case, it depends as a first approximation on the algebraic structure of the simple Keynesian model, in which Consumption is a simple linear function of income (Y).
There was much more to the analysis than this. In principle, Consumption might increase for reasons unrelated to income. But Hansen predicted just the opposite. He believed the primary source of autonomous increases in Consumption was population growth, and he foresaw a sharp in U.S. population growth after the war. He was equally pessimistic about increases in autonomous Investment because he thought the highest-returning investments had already been tapped. Thus, by default, government deficit spending was the only possible remedy for progressively worsening unemployment and stagnating economic growth – hence the term “secular stagnation.”
The Gruesome Death of the Secular Stagnation Hypothesis
Alvin Hansen was known as the “American Keynes.” Presumably this was because of the apostolic fervor with which he preached Keynesian gospel. In this case, he shared something else with Keynes: the thoroughness with which history repudiated his ideas.
Hansen predicted population decline. Instead, the U.S. experienced the biggest baby boom in history. Among other effects, this produced an explosion of household investment in consumer durables such as homes, automobiles and appliances. The shortages and government-imposed rationing of World War II had generated a pent-up demand that burst its boundaries in the postwar climate.
Rather than unemployment and depression, the U.S. enjoyed one of its biggest expansions ever in 1946. This eventually created problems when, during the Korean War, the Truman administration preferred to fund the war via money creation rather than employing the borrowing that had financed most defense expenditures during World War II. The result was inflation, which the Administration countered with wage and price controls.
The U.S. had borrowed to the max in its conquest over the Axis powers, with debt climbing to its highest level as a percentage of national output. In his recent book, David Stockman pointed out the important role played by the Eisenhower Administration in paying down this debt and returning a semblance of sanity to federal-government spending.
This combination of private-sector buoyancy and government fiscal retrenchment left no need or room for the Keynesian remedy proposed by Hansen. As the 1950s unfolded, economic theoreticians on all sides of the spectrum delivered the coup de grace to the secular stagnation hypothesis.
In 1957, Milton Friedman presented his “permanent income” hypothesis of consumption spending, which fleshed out the individual utility-maximizing theory of consumer behavior with the picture of a consumer whose spending is governed by an estimation of lifetime or “permanent” income. He or she will tend to dissave by borrowing when young and by drawing down accumulated assets when old, meanwhile accumulating assets via saving in prime earning years. It is not actual or realized income so much as this individualized conception of expected normal income that influences consumption spending.
Keynesian Franco Modigliani developed his own theory of “life cycle” consumption, rather broadly similar to Friedman’s, within the same time frame. Left-wing economist James Duesenberry developed a “relative income” hypothesis stating that consumption was influenced by the consumer’s income relative to that of others. While there were important theoretical and practical differences between the three theories, they all rejected the simple Keynesian linear dependence of consumption on income. And this drove a stake through the heart of the secularly widening gap between consumption and income. The slats had been kicked out from under the secular-stagnation platform.
The secular stagnation hypothesis had already been proved to be a resounding flop in practice. Now it was shown to be wrong in theory as well. Before Keynesian economics had even been adopted on a wholesale basis, it had suffered its first crushing defeat.
The Rise of the Undead: Secular Stagnation Rises from the Crypt
Broadway impresarios sometimes revive past productions, but they invariably choose to revive hit plays rather than flops. Based on its first run, secular stagnation would not seem to be a prime candidate for revival. Nevertheless, Lawrence Summers mounted a new version of the concept and took it out of town for a tryout in two recent speeches, supplemented by comments on subsequent blog posts.
In his first speech, made to the International Monetary Fund Research Council, Summers grappled with the theoretical issues involved in resurrecting Hansen’s ancient bogeyman. Paraphrasing Clemenceau on war and generals, Summers mused that “finance is too important to be left to financiers.” The U.S. quickly recovered from the financial panic of 2008-09, but the ensuing four years brought astonishingly little progress when measured in standard macroeconomic metrics like employment and output growth. Although the term “secular stagnation” has long been neglected by his profession, Summers now finds it “not…without relevance” in understanding our current situation.
If the U.S. suffered a mass power blackout, output would fall precipitously. It would be idiotic for economists to object that electricity constitutes “only 4%” of total output – obviously, its importance is not indicated by its fraction of total output. Similarly, finance should be viewed in the same light – as the intermediating, lubricating force that enables the bulk of our goods and services. If a power blackout did occur, we would naturally expect restoration of service to be followed by a catch-up period of increased output, rather than the sort of prolonged stagnation we have actually experienced after the financial crisis. So why hasn’t it happened?
Summers’ explanation to the IMF audience was technical – that the “natural rate of interest” is negative; e.g., below zero. “We may need to think about 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.” Summers means that the practical inability to charge negative rates of interest – e.g., subsidize loans rather than charge money for them – is what is chaining the U.S. economy down.
In his second speech and follow-up blog comments, Summers elaborated on the policy implications of his musings. “Our economy is constrained by lack of demand rather than lack of supply. Increasing our capacity to produce will not translate into increased output unless there is more demand for goods and services.” Of course, this is the old-time Keynesian religion of underconsumption, set to the background music of Cole Porter’s “Everything Old is New Again.” Secular stagnation has been brought down from the attic, fumigated with a dusting of demographics (the declining U.S. birth rate) to remove the stench of disgrace left by Hansen.
We need to “end the disastrous trends toward less and less government spending and employment each year.” In other words, the problem is not that we overspent and created too much sovereign debt in 2008-09; the problem is that we spent too little – and then cut spending after that. We should replace coal-first power plants – that will necessitate a huge program of capital spending to keep the power on. Following Keynes, Summers stresses the importance of supporting domestic demand by improving the trade balance.
Just as this program begins to sound suspiciously like a hair of the dog that bit us – or maybe the entire hair coat – Summers removes all doubt. It is “a chimera to rely on regulation” to pop asset bubbles in the face of the monetary excess necessary to underpin his program.
At the close of his first speech, Summers provided the only saving grace with the caveat: “This may all be madness and I may not have this right at all.”
Krugman’s Endorsement of Summers: For This We Need Economists?
Summers’ revival of the secular stagnation hypothesis was the talk of policymaking circles. Half of the talk was probably devoted to wondering what Summers was saying; the other half to wondering why he was saying it. Perhaps trying to be helpful, Summers’ partner in Keynesian crime Paul Krugman weighed in with his own interpretation of Summers’ remarks.
Inevitably, Krugman’s own views crept in to his discussion. The result was a blog post that could scarcely be believed even when read. (Readers with broad minds and strong stomachs are referred to “Secular Stagnation, Coalmines, Bubbles, and Larry Summers,” 11/16/2013, on the Krugman archive.)
Krugman begins with an uncharacteristic (and unrepeated) touch of humility. Noting the similarity between his own previous published diagnosis of our economic ills and Summers’ current one, he admits that Summers’ is “much clearer…more forceful, and altogether better.”
According to Krugman, he and Summers both view the U.S. economy as stuck in a “liquidity trap.” This is another Keynesian illustration of market pathology. As Keynes originally described the concept, a liquidity trap existed during an economic depression so intense that monetary policy was rendered impotent. Governments use banks as their tool for creating money; securities sold to the public are snapped up by banks, which in turn use them as the basis for making loans to businesses. But banks cannot force businesses to take out loans. If businesses decide that conditions are so bad that investing is too risky no matter how low the borrowing rate of interest, then monetary policymakers are helpless. In contrast, fiscal policy labors under no such constraint, since the government can always spend money for stimulative purposes. In a liquidity trap, though, monetary policy is likened to “pushing on a string” – a fruitless effort.
Krugman carries this notion further by identifying it with Summers’ evocation of a negative equilibrium interest rate. Investment demand is so weak and the desire to save so strong that the two are equilibrated only when “the” interest rate is below zero. In this climate, Krugman maintains, “the normal rules of economic policy don’t apply…virtue becomes vice and prudence becomes folly. Saving hurts the economy – it even hurts investment thanks to the paradox of thrift.” Krugman hereby drags in Keynesian anachronism #3. The so-called “paradox of thrift” states that the attempt to save more results in less saving because ex ante increases in saving will reduce income and employment, thus preventing the saving that consumers are trying to do, while reducing consumption as well. The only problem with this is that we have actually realized increases in saving and income at the same time, which is diametrically opposite to the effects predicted by the concept.
But these are trifles compared to the powerhouse contentions Krugman has coming up. Summers outlined a general program of public spending to increase demand and frankly admitted the futility of suppressing bubbles caused by the money creation necessary to finance the spending. Is Krugman troubled by this? Not merely “no,” but “Hell, no.”
“While productive spending is best, unproductive spending is still better than nothing…this isn’t just true of public spending. Private spending that is wholly or partially wasteful is also a good thing, unless it somehow stores up trouble for the future.” And how could that possibly happen? (See “Europe, Sovereign Debt of; Europe, Financial Crises of; Europe, Bailouts Multiply Across; Europe, Political Protests Blanket.”)
Krugman continues with an example of wasteful spending by U.S. corporations that produced virtually no payoff after three years. “Nevertheless, the resulting investment boom would have given us several years of much higher employment, with no real waste, since the resources employed would have otherwise been idle.[emphasis added]“ F.A. Hayek characterized Keynesian economics as the negation of the market, a description well befitting this rationalization. In Krugman’s world, the labor market and relative prices might as well not exist, for all the effect they have. Microeconomics either does not exist or operates on a different plane of existence than the macroeconomic plane on which the statistical construct of aggregate demand wields its decisive influence. For this we need economists?
Krugman now arrives at “the radical part of Larry’s presentation” – as if the foregoing weren’t radical enough! He straightforwardly, even proudly admits what Summers guardedly suggests – that asset bubbles are a good thing. In fact, according to Krugman, U.S. prosperity has been built on bubbles for quite a while. “We now know that the economy of 2003-2007 was built on a bubble.” Krugman is being coy here since he made a celebrated statement in 2002 calling for the Federal Reserve to create a bubble in the housing market. Oddly enough, this attracted almost no attention at the time and has brought him no adverse reaction since then. “You can say the same about the latter part of the 90s expansion; and… about the later years…of the Reagan expansion, which was driven …by runaway thrift institutions and a large bubble in commercial real estate.”
Krugman’s recall of history is curiously defective, especially considering that he was employed in the Reagan Administration at the time, albeit in a minor position. The 1986 tax reform law was, and still is, pinpointed for tax-law changes that helped pop a real-estate bubble largely built on tax-deductibility. The political Left is fond of criticizing Reagan for claiming to have lowered taxes in the early 80s while actually raising them later on. The Left is even fonder of excoriating Reagan and Paul Volcker for ending inflation on the backs of the poor by killing off inflation by stopping monetary expansion too abruptly. Now Krugman is criticizing Reagan for doing just the opposite!
Krugman’s piece de resistance is his riposte to future critics who will object to the runaway inflation that the Summers/Krugman project will promote. Krugman unblinkingly admits that inflation “expropriates the gains of savers,” but replies that “in a liquidity trap, saving may be a personal virtue but it’s a social vice.” And in an economy facing secular stagnation, the liquidity trap is “the norm. Assuring people they can get a positive rate of interest on safe assets means promising them something the market doesn’t want to deliver.”
Krugman implicitly and explicitly assumes that markets are as dysfunctional as life-support patients with no respirator. But when he needs a justification for deep-sixing the life savings of hundreds of millions of people, he suddenly pulls out “the market” and gives its ostensible verdict a personal blessing of moral authority. Yet in this very same blog post, he cavalierly dismisses his critics as “a lot of people [opponents of Krugman] want economics to be a morality play and they don’t care how many people suffer in the process” [!!] For the benefit of readers unfamiliar with the long-running debate between Krugman and his critics, those critics are free-market economists who want bubbles to end with unsustainable businesses being liquidated rather than bailed out, and the business cycle to be cut short rather than prolonged indefinitely with each iteration worse than the previous one.
Intellectual Stagnation, Not Economic
At this point, it is all too clear that secular stagnation has taken place. But the stagnation is intellectual, not economic. Keynesian economists are framing policy arguments using terms like “secular stagnation,” “liquidity trap” and “paradox of thrift.” These recondite terms went out of fashion over thirty years ago, along with the paleo-Keynesian economic theory that spawned them. They survive in the 20th-century textbooks and graduate-school memories of economists now approaching retirement.
The shocking character of the Summers/Krugman hypothesis doesn’t derive from its vintage, though. Its anti-economic character – relative prices are irrelevant, waste is a good thing, markets are worthless except when economic managers need a pretext for arbitrary action – is professionally repellent. Even more frightening is the hubris on display. Summers is a disgusting sight, standing up in front of an audience at the International Monetary Fund, pontificating with grandiose gravity about “managing an economy” – as if he were the CEO of a U.S. economy of some 315 million people and tens of thousands of businesses.
There are quite a few people who consider a large public corporation too unwieldy to manage effectively. The difficulty of one economist managing an entire economy must increase not merely linearly but exponentially, considering the interaction and feedback effects involved. At least Summers had the minimal presence of mind to recognize that he might be mistaken. Krugman, in contrast, displays the same mindset as his intellectual antecedent, John Maynard Keynes. Several biographers and friends – including F.A. Hayek, with whom his relations were cordial despite their opposing views – remarked that Keynes was obsessed with his own preeminence as a public intellectual rather than with mastery of economic theory as such. Hayek remarked that Keynes may have been the most brilliant man he ever encountered but was a bad economist. Summers and Krugman show no signs of possessing the intellectual diversity and flexibility of Keynes – only his arrogance and deep-seated need for personal attention.
There is another shocking aspect to this latest policy flap. Summers/Krugman are in the anomalous position of criticizing the results of their own policies. That is, even they cannot credibly maintain that we have lived under a regime of laissez-faire or tight fiscal or monetary discipline for the last five years. They can only insist that not enough was done. Of course, this is the standard big-government lament; when big-government fails, try bigger government. But in this case, they are telling us that the results they formerly called bad were really good and we should expect no more from them in the future. The friendliest left-winger would have to acknowledge that Summers/Krugman are confessing failure and telling us that this is the best we can do. Notice, for example, that neither man stressed the very short-term nature of their policy prescription or promised that once their strategy of fiscal inebriation reached its apogee, we could let the market take over. No, theirs was a counsel of despair reminiscent of late 1970s malaise.
You can’t get any more stagnant than that.