Lawrence Summers is a professor and past president at Harvard. He was Treasury secretary from 1999 to 2001 and economic adviser to President Obama from 2009 through 2010.
Last month I argued that the U.S. and global economies may be in a period of secular stagnation in which sluggish growth and output, and employment levels well below potential, might coincide for some time to come with problematically low real interest rates. Since the start of this century, annual growth in U.S. gross domestic product has averaged less than 1.8 percent. The economy is now operating nearly 10 percent, or more than $1.6 trillion, below what the Congressional Budget Office judged to be its potential path as recently as 2007. And all this is in the face of negative real interest rates for more than five years and extraordinarily easy monetary policies.
Even some forecasters who have had the wisdom to remain pessimistic about growth prospects the past few years are coming around to more optimistic views of 2014, at least in the United States. This is encouraging but should be qualified with the recognition that even on optimistic forecasts, output and employment stand to remain well below previous trends for many years. More troubling, even with the high degree of slack in the economy and with wage and price inflation slowing, there are signs of eroding credit standards and inflated asset values. If the United States were to enjoy several years of healthy growth under anything like current credit conditions, there is every reason to expect a return to the kind of problems of bubbles and excess lending seen in 2005 to 2007 long before output and employment returned to normal trend growth or inflation picked up again.
The challenge of secular stagnation, then, is not just to achieve reasonable growth but to do so in a financially sustainable way. There are, essentially, three approaches. The first would emphasize what is seen as the economy’s deep supply-side fundamentals: the skills of the workforce, companies’ capacity for innovation, structural tax reform and ensuring the sustainability of entitlement programs. This is appealing, if politically difficult, and would make a great contribution to the country’s long-term economic health. But this approach is unlikely to do much in the next five to 10 years. Apart from obvious lags like those in education, our economy is held back by lack of demand rather than lack of supply. Increasing capacity to produce will not translate into increased output unless there is more demand for goods and services. Training programs or reform of social insurance may, for instance, affect which workers get jobs, but such efforts would not affect how many get jobs. Indeed, measures that raise supply could have the perverse effect of magnifying deflationary pressures.
The second strategy, which has dominated U.S. policy in recent years, is lowering relevant interest rates and capital costs as much as possible and relying on regulatory policies to ensure financial stability. No doubt the economy is far healthier now than it would have been in the absence of these measures. But a growth strategy that relies on interest rates significantly below growth rates for long periods virtually ensures the emergence of substantial financial bubbles and dangerous buildups in leverage. The idea that regulation can allow the growth benefits of easy credit to come without cost is a chimera. The increases in asset values and increased ability to borrow that stimulate the economy are the proper concern of prudent regulation.
The third approach — and the one that holds the most promise — is a commitment to raising the level of demand at any given level of interest rates through policies that restore a situation where reasonable growth and reasonable interest rates can coincide. To start, this means ending the disastrous trends toward ever less government spending and employment each year and taking advantage of the current period of economic slack to renew and build out our infrastructure. If the federal government had invested more over the past five years, the U.S. debt burden relative to income would be lower: allowing slackening in the economy has hurt its long-run potential.
Raising demand also means spurring private spending. Much could be done in the energy sector to unleash private investment toward fossil fuels and renewables. Regulation that requires more rapid replacement of coal-fired power plants would increase investment and push growth as well as help the environment. And it is essential in a troubled global economy to make sure that a widening trade deficit does not excessively divert demand from the U.S. economy.
Secular stagnation is not inevitable. With the right policy choices, the United States can have both reasonable growth and financial stability. But without a clear diagnosis of our problem and a commitment to structural increases in demand, we will be condemned to oscillating between inadequate growth and unsustainable finance. We can do better.