August 25, 2015 Thieß Petersen

5 Reasons Industrialized Economies Might Be Looking at Secular Stagnation

The term “secular stagnation” describes an economic situation in which a country’s economic growth is very low or non-existent over a longer period of time. At least in highly developed national economies especially Germany and Japan, there are a number of signs that these countries are facing such a phase.

The concept of secular stagnation can be traced back to an article by Alvin Hansen written in 1939. The term refers to long-term stagnation, or stagnation lasting for years. This concept faded into obscurity in the course of the global economic boom after World War II. Hansen’s idea experienced a renaissance in November 2013 through a presentation given by former US Treasury Secretary Lawrence Summers at the International Monetary Fund’s Annual Research Conference. There are a whole series of reasons for a long-lasting phase of economic weakness.

1. Shrinking population weakens economic growth

When a country’s population stops growing or even declines, it has an impact on both supply and demand for goods. A shrinking population means fewer consumers so that demand for material goods and services goes down. If a company responds to this trend by limiting production, the country’s GDP declines. At the same time, a shrinking population also implies a reduction in people of employment age. This reduces society’s production possibilities, which weakens economic growth.

2. Rising income inequality hampers demand for goods

Rising income inequality results in an increasing percentage of society’s aggregate income flowing into high-income households. These are generally characterized by an above-average saving rate. As such, society’s savings grow, which means that demand for goods declines. If this decline in demand is not compensated for with appropriately high investment expenditures, society’s aggregate demand shrinks as a whole. If companies adapt by reducing production, the GDP goes down. Therefore, income inequality puts the brakes on growth.

3. Saturation points lead to declining demand

In highly developed national economies, people enjoy a high material standard of living. Sooner or later, it reaches a saturation point. This initially impacts food products and later consumer goods as well. As incomes grow, the percentage of total economic saving in the GDP increases, which is accompanied by a decline in the consumption rate. Investments are no longer worthwhile because the products a business could produce with them would not find any buyers. Therefore, saturation points induce a demand-side stagnation trend.

4. High capitalization weakens investment activities

High saving levels do not necessarily put a halt to growth automatically, because the lack of demand can be compensated for with corresponding investments. However, in developed economies the capital holdings are already very high so that investment needs tend to be low. But when consumer demand also declines, there are no incentives for further investment. As a result, a shortfall in consumer demand is not compensated through new investment.

5. Lack of government investment reduces progress in productivity

High-quality government infrastructure offerings (e.g., transportation network, electricity and energy supply, research and development institutions) and state education offerings (early childhood education, elementary and secondary education, university-level education as well as vocational training and continuing education) are a necessary prerequisite for high aggregate productivity. If the government neglects the appropriate investments, it weakens economic progress in the nation’s productivity – and therefore economic growth as well.

The theoretical interdependencies outlined here can be summarized as follows: A decline in investment occurs in highly-developed industrialized nations on the demand side. There can be different reasons for this, but a country’s investment activities drop as a result. Declining investment means that the growth of aggregate capital stock is lower. If net investment ceases completely, capital stock remains constant, as do production capacities. This leads to supply-side stagnation.

Indicators of secular stagnation

The direct indicator for secular stagnation is an ongoing low growth rate for the real GDP. In addition, there are further indicators that point to a stagnation trend:

If declining investments are met by high and growing saving levels, the aggregate saving is greater than aggregate investment. If an economy builds up saving over a longer period of time that exceeds the country’s net investment, this indicates a trend toward secular stagnation. Ben Bernanke, Chairman of the US Federal Reserve from 2006 to 2014, was already talking about a savings glut back in 2005.
The savings of a nation represent the availability of capital, while investments mean a demand for capital. Secular stagnation causes the availability of capital to be greater than the demand for it. This excess of supply in the capital market causes the price of capital to decline – in other words, a reduction of the interest rate. Therefore, ongoing stagnation is characterized by a nominal interest rate close to zero
When a national economy exhibits a general lack of demand, it means there is an excess supply on the goods market. This is why prices decrease. In the case of secular stagnation, the lack of demand adversely affects the aggregate demand for goods so that prices for essentially all goods drop. This results in a declining price level or negative inflation rate, meaning deflation.

Stagnation trends in Japan and Germany

When viewed in the context of these outlined theoretical considerations, Germany and Japan are two predestined candidates for secular stagnation. These are two countries where:

the population is shrinking and aging at the same time.
Both economies are in highly developed countries with a high standard of living, which indicates tendencies toward saturation points.
Income inequality has grown in both countries since the mid-1980s.
And finally, both economies have a high level of capital holdings, which leads to little need for investment.

Although the growth rates in both countries are not yet down to zero, the other indicators mentioned previously point toward stagnation trends. In Germany, the tendency toward shrinking demand and the resulting reduction in net investment has led to an excess of saving on the whole. (This applies to Germany since around 2002 and to the former West German states since the mid/late 1980s (see Fig. 1).)

Japan has also seen a surplus of aggregate saving over investment since the mid-1980s. Furthermore, long-lasting weak demand has been expressed in a deflationary trend. Japan – like Germany – is countering the demand-side stagnation trend this has caused with an export surplus. However, even these export surpluses are not enough to compensate for the aggregate lack of demand. Japan is handling the dearth of private demand for goods by consumers and companies by offering long-term loans for economic stimulus packages. This has resulted in massive growth of the national debt, which is currently nearly 250 percent of Japan’s GDP.

Therefore, the concept of secular stagnation is not simply a theory: It is an eminently realistic possibility for growth, at least for highly developed industrialized nations.

Risks of secular stagnation

A stagnating GDP is not a serious problem in and of itself. For example, if the GDP remains constant and the population shrinks at the same time, the GDP per capita could still increase permanently despite the stagnation and thereby improve individual material wealth. However, a stagnating GDP can have a series of negative consequences. This includes three primary dangers:

Without economic growth, there is no employment growth, which means that existing unemployment cannot be reduced. It can even lead to rising unemployment: Even at a very low level of technical progress, a steady GDP results in the same amount of goods being produced with less labor – and unemployment (as measured by the necessary work hours per year) declines.
A country’s permanent surplus of saving over its investment yields an excess of supply on the capital market, which causes interest rates to go down. Low interest rates make it easier for every participant in the economy to take on debt. This increases the risk of a credit bubble. At the same time, a low interest rate increases the incentive to invest savings in the markets for assets and hope that rates go up (stock markets, currency markets, raw materials markets, precious metals markets, etc.). This increases the danger of creating a speculation bubble, which could cause dramatic problems for the real economy if it bursts.
Economic growth is a key prerequisite for reducing national debt. If production and employment grow, government revenues grow as well. At the same time, expenditures needed for combating unemployment go down. Government revenues cannot increase without economic growth. This makes reducing debt more difficult.

Economic policy consequences: Old instruments don’t work anymor… and new ones haven’t been developed yet

Increasing the money supply is a standard answer to an economic weak phase to increase the investment activities of private enterprise through decreasing interest rates and thereby stimulate economic growth. However, this form of monetary policy fails in cases of secular stagnation. Interest rates in countries with stagnation trends are usually nearly at zero already so that reducing interest rates further is impossible. Moreover, businesses barely increase their production capacities due to pessimistic market expectations even with interest rates almost at zero, because they fear that any additional products they could produce would not sell.

Attempts to compensate for the absence of domestic demand through increasing exports also reach their limits because countries with an import surplus suffer from increasing economic problems (rising unemployment, growing foreign debt). Moreover, it can be expected that a growing number of industrialized nations will reach a phase of secular stagnation as a result of further economic development. Thus the question arises of who should take on the increasing export surpluses.

Unconventional approaches are needed to replace the old ones or, as Lawrence Summers expressed it recently: ”New conditions require new policies”. One solution could be a monetary policy that heavily increases the inflation rate anticipated in the future, making the buildup of saving unattractive. A redistribution policy that reduces income inequality is also conceivable and greater government investment in the areas of infrastructure and education. The former would need to be financed through taxes to prevent national debt from increasing further.

However, how these measures should be specifically designed is still largely unclear. Phases of long-term stagnation were not a real problem for economic theory and policy up to now, so theory and policy are not prepared for secular stagnation.

Recommended reading

If you are interested in this topic, the anthology Secular Stagnation: Facts, Causes, and Cures (http://www.voxeu.org/sites/default/files/Vox_secular_stagnation.pdf) contains many articles written by prominent economists.