Why the future looks sluggish
Former US treasury secretary Lawrence Summers suggested that there could be no easy return to pre-crisis normality
Former US treasury secretary Larry Summers suggested that there could be no easy return to pre-crisis normality in high-income economies. Instead, he sketched out a disturbing future of chronically weak demand and slow economic growth.
Lawrence Summers has poured gallons of icy water on any remaining optimists. Speaking on a panel at the International Monetary Fund’s annual research conference, the former US treasury secretary suggested that there could be no easy return to pre-crisis normality in high-income economies. Instead, he sketched out a disturbing future of chronically weak demand and slow economic growth.
Mr Summers is not the first to identify the possibility of so-called “secular stagnation”: the fear of emulating Japan’s lost decade has been in the minds of thoughtful analysts since the crisis. But his was a bravura performance.
Why might one believe him? It is possible to point to three relevant features of the western economies.
First, the recovery from the financial crisis of 2007-08 has been decidedly weak. In the third quarter, the US economy was just 5.5 per cent bigger than at its pre-crisis peak, more than five years earlier. US real gross domestic product has continued to decline, relative to the pre-crisis trend. Moreover, such weakness has endured, despite ultra-expansionary monetary policies.
Second, today’s crisis-hit economies experienced rapid rises in leverage, particularly in the financial and household sectors, together with strong jumps in house prices, before the crisis. This was a “bubble economy”. Many governments, notably in the US and UK, also adopted expansionary fiscal policies. Nevertheless, none of the obvious symptoms of excess – particularly above-trend economic growth or inflation – appeared in either Britain or America, before the crisis hit.
Third, long-term real interest rates remained remarkably low in the years before the crisis, despite strong global economic growth. The yield on UK long-term index-linked gilts fell from close to four per cent to around two per cent after the Asian financial crisis and then to negative levels after the financial crisis. US Treasury inflation-protected securities (TIPS) followed a similar course, albeit later.
Merely restoring a degree of health to the financial system or reducing the overhang of excessive pre-crisis debt is, then, unlikely to deliver a full recovery. The reason is that the crisis followed financial excesses, which themselves masked or, as I have argued, were even a response to pre-existing structural weaknesses.
One of those weaknesses is the “global savings glut”, which can also be labelled an “investment dearth”. Low real interest rates are evidence of such a glut: there were more savings searching for productive investments than there were productive investments to employ it.
Another indication of the savings glut was the “global imbalances” – the huge current account surpluses (net capital exports) of east Asian emerging economies (particularly China), oil exporters, and several high-income economies (notably Germany). These economies became net suppliers of savings to the rest of the world. This was true before the crisis and it remains true today.
Before the financial crisis, the US absorbed much of the global excess savings, but not in productive investments. Despite easy access to cheap credit, fixed investment declined as a share of GDP, after 2000. One reason for this fall was that the relative prices of investment goods declined: the share of real investment remained stable, while that of nominal investment shrank. Except in the pre-2000 stock market bubble, business also financed its investment out of its own savings: it did not need finance from elsewhere.
Thus, the counterpart of savings imported into the US was household and government borrowing. A rise in inequality of incomes made relying on household net borrowing yet more difficult. Other things equal, this should raise household savings: the richest, who tend to earn more than they spend, will tend to save even more as they become richer.
A (temporary) solution to this problem was to entice poorer people to borrow more than they could afford so they could keep spending. But this blew up in the crisis of 2007-08.
In brief, the world economy has been generating more savings than businesses wish to use, even at very low interest rates. This is true not just in the US, but also in most significant high-income economies.
The glut of savings, then, has become a constraint on current demand. But since it is connected to weak investment, it also implies slow growth of prospective supply. This difficulty predates the crisis. But the crisis has made it even worse.
So what is to be done? One response to an excess of desired savings over investment would be even more negative real rates of interest. That is why some economists have argued for higher inflation. But that would be hard to achieve, even if it were politically acceptable. Another possibility, stressed by Andrew Smithers in The Road to Recovery, is to tackle obstacles to corporate investment head on. His biggest villain is the “bonus culture”, which encourages management to manipulate stock prices, via buybacks, rather than raise productive investment.
Yet another possibility, discussed by Mr Summers and supported by many economists (including myself), is to use today’s glut of savings to finance a surge in public investment. That might be partly linked to a shift to lower-carbon growth. Another possibility is to facilitate capital flows to emerging and developing countries, where the best investment opportunities must lie. It makes no sense for so much of the world’s savings to seek investment opportunities where they do not apparently exist and shy away from places where, one hopes, they do.
The underlying argument that more has happened to high-income economies than just a financial crisis is persuasive. It is also hard to believe that a surge in business investment in these countries would manage to absorb the excess desired savings of the world. Why, after all, should one expect any such thing to happen in countries with ageing populations, high wages and sluggish economies? But these countries do then confront a challenge far bigger than the damage done by the crisis alone, big though that is. They may face a far longer-term future of weak demand and enfeebled supply.
The best response then is measures aimed at raising productive private and public investment. Yes, mistakes will be made. But it will be better to risk mistakes than accept the costs of an impoverished future.
Copyright: The Financial Times Limited 2013