The question, of course, is why growth has been so sluggish. Larry Summers, for one, thinks that it's part of a longer-term trend towards what he calls "secular stagnation." The idea is that, absent a bubble, the economy can't generate enough spending anymore to get to full employment. That's supposedly because the slowdowns in productivity and labor force growth have permanently lowered the "natural interest rate" into negative territory. But since interest rates can't go below zero and the Fed is only targeting 2 percent inflation, real rates can't go low enough to keep the economy out of a protracted slump.
Is secular stagnation just an illusion?
But is this right? On the one hand, secular stagnation makes sense in theory, and even seems to in practice. Technological innovation—and with it, productivity—really have slowed down the past few decades, as Tyler Cowen, Robert Gordon, and John Fernald all point out. So has labor force growth now that the Boomers are starting to enter their golden years. And most telling, according to Summers, is the way that real interest rates have steadily fallen since the 1980s. But, on the other hand, there are real problems with the way we calculate real rates—problems that make it look like real rates have fallen more than they really have. And furthermore, today's techno and demographic pessimism both look overdone.
In other words, there might not be any reason to think the economy is slumping into secular stagnation.
Let's talk about everybody's favorite subject: measuring real interest rates. Now, when people say that inflation-adjusted rates have been falling the past few decades, most of them are just subtracting expected inflation from the nominal interest rate. Seems simple enough. But the problem is the resulting real interest rate is not the same as the natural interest rate at the heart of the secular stagnation story. That's because it still includes a risk premium. And that's particularly problematic, because the risk premium was highly elevated in the early 1980s—just when the secular stagnation story is supposed to have begun, as you can see below.
The real story is about uncertainty. See, back in the early 1980s, inflation was at its most volatile and Fed Chair Paul Volcker engineered two sharp recessions to finally whip it. But at that point, it wasn't clear what the Fed was going to start using as a nominal anchor—what it was going to target. This pushed up risk premiums, because lenders demanded to be compensated for the higher levels of uncertainty and expected inflation. Now, over time these risk premiums declined as policy improved and the economy stabilized. So failing to account for this creates an artificial downward trend in the natural interest rate.
Don't forget about risk!
You can see this in the next few charts of the benchmark 10-year Treasury rate. The first shows the 10-year Treasury yield along with two of its key components: expected inflation and the term premium. The former measures how much annual average inflation is expected the next decade, and the latter how much the risk premium increases as a bond's duration does. (I constructed the expected inflation series using the data from the Survey of Professional Forecasters and the Livingston Survey. The term premium numbers come from the average of the Kim-Wright and Adrian, Crump, and Moench figures).
As you can see, both expected inflation and the term premium started a long decline in the early 1980s. And if we subtract both from the nominal interest rate, we can see the real risk-free interest rate below.
The economy is bad today, not forever
Suddenly there doesn't seem to be so much secular stagnation. That's because the real risk-free rate is the same as the natural rate—and there's no evidence it's been falling. In other words, there's no evidence of secular stagnation. Instead, there's just a long-term trend around 2 percent. And, interestingly enough, the deviations around this trend seem to be explained, in part, by the business cycle. You can see this in the chart below, which plots the real risk-free rate against the CBO's estimate of the output gap.
But just how does the state of the economy explain the state of the risk-free rate? Well, I scatter plotted the two against each other, going back to 1961 and 1983. In the first case, the business cycle explains about 41 percent of the risk-free rate's variation, and in the second, over 55 percent.
This strong relationship is what standard finance theory tells us should be true. The 10-year real risk-free rate should be equal to the average of the expected path of short-term real risk-free rates over the same time horizon. The first five or so years of this driven by the business cycle, which explains the risk-free rate's correlation with the output gap. And the remaining years are driven by expected productivity and labor force growth.
So what does all this mean? The simplest explanation is that the low rates of the last five years are just the result of a prolonged business cycle, not secular stagnation. Now, if that seems like a long time for a business cycle, remember that the Great Depression took twice as long, yet the economy eventually returned to its pre-crisis trend. And, just like today, people had become pessimistic, and worried that, yes, secular stagnation meant the slump would just go on and on.
Robots and millennials are about to save the economy
There are a few more reasons to be skeptical about secular stagnation. For one, productivity growth might not be as bad as we think. That's because the way we measure it is having a harder and harder time capturing the real gains in the economy. Just think, for example, about the way smart phones are replacing books, newspapers, cameras, scanners, bank ATMs, voice recorders, radios, encyclopedias, GPS systems, maps, and dictionaries, among other things. All of these items used to be sold separately and each counted as a part of GDP. Now, many of them are available as free apps, and aren't counted as a part of GDP. This under-measuring of economic activity translates into slower observed productivity growth. And this problem is only going to get worse as more of the economy becomes digitized.
Actually, a tech slowdown could be the least of our problems. As Erik Brynjolfsson and Andrew McAfee argue in The Second Machine Age: Work, Progress, and Prosperity in a Time of Brilliant Technologies, it looks like smarter and smarter machines are going to radically transform the economy. This digitization of everything could mean a big growth is just around the corner. The near future will be an economy where machines like IBM's Watson will be coordinating driverless cars, diagnosing illnesses, and organizing robot work in homes. So productivity growth and returns on capital will both be high. The real challenge, according to Brynjfolsson and McAfee, won't be too little economic growth, but dealing with the disruptive nature of so much of it.
And finally, if demographics really are destiny, then our destiny isn't secular stagnation. As Bill McBride has pointed out recently, the Census Bureau now reports that Baby Boomers aren't the largest cohort anymore, and that the prime working-age force is expected to start growing again in a few years. In other words, the demographic outlook actually points to stronger economic growth. (Thanks, millennials). And this isn't just an American development: the United Nations projects that working-age populations will increase in many parts of the world through 2050. That should create plenty of demand for new investment.
In short, it doesn't seem like secular stagnation is the right story for the U.S. economy. A better story is that the economy got hit by a once-in-three-generations crisis that's taken awhile—too long, really—to overcome. But in the long run, the slump will be dead. And it might just be "Morning in America" again.