|Larry Summers - feeling the torpor of Secular Stagnation|
SS is a pervasive “liquidity trap”, which in turn has been described in Keynesian economics, as where injections of cash into the private banking system by a central bank fail to decrease interest rates and hence make monetary policy ineffective. SS can only happen when interest rates are “at the zero-bound” and are unable to fall further, resulting in a trap where interest rates are never low enough to stimulate demand. Also the monetary conditions that SS creates ; negative real interest rates and huge injections of new money into the system - Quantitative Easing (QE) creates a risk of bubbles in financial assets and huge amounts of money chase short term returns rather than long term investment opportunities - see chart 1.
The problems in Japan are complex with an aging population and low employment levels for Females but may also be failure to de-leverage (public debts are still very high) and this results in a switch from long term investment to the pursuit of short term yields; a direct result of ultra-loose monetary conditions. Japan has negative real interest rates, very high levels of personal saving combined with very low levels of investment in the productive economy combined with relatively high asset prices – this split in the economy between the real productive economy (low growth and fall demand) and the market for financial assets (rising asset prices) - see the chart 1.
The trap that Japanese policy makers have fallen into is that that over the last 25 years they have focused only on trying to increase aggregate demand in the real economy (Line R) and have ignored the needs to deal with over-priced assets (line A). This has had the effect of supressing aggregate demand further as high asset prices combined with wholesale indebtedness reduce confidence in long term investment in capital projects. Business will always prefer to hang on to their money than risk long term investment when there is the possibility of a bust or even a default – so investment will go overseas or wash around chasing short term gain in financial assets - demand will weaken further as in chart 2.
Learning from the Japanese experiments with QE and their ultra-loose monetary conditions over 25 years, should we modify our plan of attack on secular stagnation? Maybe the first step must be to deal with asset prices (line A) and de-leverage (reduce debts) by raising interest rates. This will result in short term pain including: loss of savings, rising unemployment, defaults and lower growth. Once the de-leverage is complete in both private sector and public sector confidence will slowly return (if supported by sensible public expenditure) and private investment in the productive economy will deliver the growth and prosperity we have become accustomed to. But if we don’t deal with the issues of de-leverage and unsustainable asset prices investment and growth will never return. It is interesting to note that the only policy option open to Japan that they haven’t tried is to increase interest rates and tighten monetary policy – a lesson for us in the West?