From New Normal to Secular Stagnation?

From New Normal to Secular Stagnation?

The FINANCIAL -- After six years of sluggish growth, are another six years about to follow? Michael Heise and Mohamed A. El-Erian comment on a worst case scenario, what has gone wrong in generating economic growth and what could be done instead. Japan has been suffering from a crisis which started in the 1990s and lasted almost until today. There are signs that the US and Europe are struggling with similar problems today. Will we struggle as long as Japan did?

Michael Heise: Actually, no. Of course, the Japan scenario has a lot of similarities to what is happening in Europe and the US at the moment. Nonetheless, there are two big differences. Firstly, the asset bubble in Japan at the end of the 1980s was a lot bigger than the one in the US or Europe pre 2008. Therefore, the so-called balance sheet recession lasted much longer. Secondly, we acted more quickly in the US and in Europe by recapitalizing and streamlining the banking sector. Basically the banking reform in Japan came ten years after the bubble had burst. Many economists give “Secular Stagnation” as an answer for why we have been living in a low interest environment for quite some time. According to Lawrence Summer, the essence of Secular Stagnation is a chronic excess of saving over investment. What are your different points of view on this phenomenon? 

Mohamed A. El-Erian: For the person in the street, secular stagnation is felt in different ways: in a feeling not being as productive as they could be, in persistent unemployment, in jobs that are below skillsets, and in sluggish wages. As such, skills erode and society faces the risk of a lost generation. 

Michael Heise: I agree, while the negative development was initially caused by the bursting of a financial bubble and a downturn in demand, it can become entrenched and structural over time. With 18 million people unemployed in the EU, we must prevent such a secular stagnation. 

Mohamed A. El-Erian: There is an active economic debate going on as to whether we have a cyclical or a structural problem, involving more recently Ben Bernanke and Lawrence Summers. Regardless of where they feel the balance is today, most would agree that the longer growth disappoints, the greater the risk that the problem becomes embedded in the structure of the economy and thus is harder to solve. Where does this issue come from? 

Mohamed A. El-Erian: There are three sets of drivers here: First, we see a whole range of structural components including the impact of machines, demographics, education and the lack of infrastructure. 

The second category has to do with inadequate aggregate demand. Not only with the usual level of demand but also with a mismatch between the willingness to spend and the ability to do so. For example, the rich who have been capturing the bulk of the recent income increases have the wallet to spend but not the will; whereas the poor have the will to spend but not the wallet.

The third element has to do with balance sheets. If you have an overhang of excessive indebtedness, new capital is understandably hesitant to engage as it does not wish to get contaminated by the mistakes of the past. Is the word Secular Stagnation just another way of describing the concept of new normal as of 2009?

Mohamed A. El-Erian: SecStag is a new label that has been attached to the similar concept of the new normal. If you recall, the new normal was signaling that, coming out of the global financial crisis there was not going to be a cyclical recovery. This has been the case now for six years so the question arises: can open economies stay in the new normal for an even longer period? So, what else do we have to expect in the next six years?

Michael Heise: Both concepts (New Normal and Secular Stagnation) describe developments with fairly low growth rates and low rates of return on your assets. But we need to differentiate between them. In my view, Secular Stagnation is purely a demand-driven issue, whereas the New Normal also has a supply side or trend component to it. I don’t think that SecStag is the right description for the current situation in the US or the EU. What are the solutions we can think of today? 

Michael Heise: What I think we need to do is to focus on improving the conditions for investment and innovation. You can do this via taxation and regulation. We also need to improve labor productivity, which means people need better education, skills and qualifications. On the supply side these measures would create higher potential growth for the economy. Not enough has been done on that side. On the other hand, just pushing down interest rates even more deeply by using the most unconventional instruments of monetary policy will not do the job. Ultra-low interest rates have not visibly helped to stimulate investment or consumption demand. This is not really surprising. Rather than being a solution, low interest rates are starting to become a part of the problem as they are creating big holes in the whole pension system and people are getting worried about their retirement funds. In occupational pensions, a larger share of profits has to be used to fill these huge pension gaps, and some companies even sold assets for this purpose. That is not conducive to corporate investment. Spendings in infrastructure and education are often proposed as solutions. Is this a recommendation you would follow considering the debts that weigh on states? 

Mohamed A. El-Erian: We need to address this challenge of inadequate growth with a comprehensive policy response. This includes structural reforms, demand policies and balance sheet rehabilitation. When we talk about the issues facing different countries, you can think of a kind of menu where the weight of each varies. Some problems, like inadequate infrastructure, are common to many countries. Actually Allianz has shown that private capital can help in doing some of the heavy lifting here, particularly in the context of public-private partnerships. So there is a way of improving infrastructure without putting excessive pressure on government finances. With education, there are many issues that go beyond spending. We need to improve the way the money is spent. And we should not fall into the trap of allowing budget constraints to limit our imagination. Will the Fed (the Central Bank of the United States) decision this summer or fall show on whether the US and Europe are concerned in the same way?

Michael Heise: This fall will show that neither the US nor Europe is in the Secular Stagnation trap. In the Eurozone we will probably return to 1 1/2 percent real and 3 percent nominal growth. We can see that the banks are being less restrictive to lending money again. Employment and wages are growing on both sides of the Atlantic. My bet is that in September the Fed will take the first step towards higher interest rates. This will not do harm to the US economy. In Europe, we will have a tapering discussion as soon as we have an inflation rate of 1.5 percent, which I expect for the years end. Therefore, I do not think that the European Central Bank (ECB) will really carrying on with its program of bond purchases to the bitter end.

Mohamed A. El-Erian: At the end of the year, the US will be back on a growth path of 2.5 – 3 percent. I agree that the Fed is likely to hike interest rates in September. In the case of Europe, I am a little more worried. I do not believe that the pick up we are seeing in Europe will gather sufficient steam and last until more comprehensive policies are put in place. It would not surprise me if the ECB were to keep its foot fully on the accelerator. Overall, it is a multi-speed world with divergent central bank responses.