The U.S. economy has fallen, and it can't get up.
At least that's the way it seems. That's because our slump hasn't really ended, even though the Great Recession officially did more than five years ago. Growth has been low, unemployment is still high, and it'd be even more so if the labor force hadn't shrunk so much. And all this, remember, has happened despite interest rates being zero the whole time. It's the opposite of what we would have expected: big crashes are usually followed by big comebacks. So why has this time been different?
Well, it hasn't — not if you compare it to other recoveries from financial crises. These, as economists Carmen Reinhart and Ken Rogoff have shown, tend to be nasty, brutish, and long: it takes, on average, eight years just to make up lost ground. But even so, this doesn't fully explain the kind of persistent economic weakness we've seen here and most everywhere else. Look at Japan. Its own bubble burst in the 1990s, and since then even zero interest rates haven't been enough to save it from first one, and then two, lost decades. The same is happening to Europe today. Bad recoveries, it seems, have a way of turning into bad economies that never get better.
It's brought back the specter of "secular stagnation." That's the idea, first proposed by Alvin Hansen in 1938, that an economy can get stuck in a never-ending slump if slower population growth means slower investment. Now, the baby boom thankfully proved him wrong, but what if he's right this time? That's the question Larry Summers has been asking for a year now. As he points out, the U.S. economy has needed lower and lower interest rates just to get the investment it needs so that virtually everyone who wants a job can get one — and even then, it's taken bubbles to get us there. But interest rates can't go only lower -- they're effectively at zero. As a result, the not-so-great recovery might be followed by a future that's just as bad.
Hold on. What does it mean that the economy "needs" low rates -- indeed, negative once you account for inflation -- to get to full employment? That shouldn't happen in a world, like our own, where investments have positive returns. Companies should always want to invest, hiring workers in the process.
Well, the answer is one part psychology and another part supply and demand. People, you see, just might be too scared to invest in anything that doesn't look super-safe, unless there's a bubble that looks super-profitable.
But this isn't just a mental problem. Real rates might also be negative, because there's more supply of lendable funds but less demand for investment. Or, in English, there's more money chasing fewer opportunities. It's still a hard story to tell, but economists Gauti Eggertsson and Neil Mehrotra have come up with the first real model of it. And here, according to them, are the three reasons secular stagnation might be more than just a scare story this time:
1. Deleveraging. Imagine a country where households went deeper and deeper into debt, until they couldn't anymore because their biggest piece of collateral — their homes — had collapsed in value. Call it, "America." Well, suddenly they'd have to start paying back what they owe, which would increase savings and push down rates. And, as Eggertsson and Mehrotra argue, this can cast a long shadow, since young people who take on less debt today can save even more when they're older — keeping rates low for quite awhile.
2. Inequality. The rich are different from you and me. They have more money to save. Not only that, but they can afford to save it, too. That's not as true, economists Atif Mian and Amir Sufi point out, for poor households that are much more likely to spend what they have. So if more and more money is going to the people at the top, like it has the past 30 years, then that means there's more and more money being saved, all else equal. And that, of course, pushes interest rates down a little more.
3. Declining population growth. If the workforce doesn't grow as much, then the economy won't either, and we won't need to build as many new houses or offices — which only hurts economic growth even more. It's an accelerator effect. In other words, Alvin Hansen was right that lower population growth can lower investment demand enough for the economy to stay stuck in a permaslump. He was just wrong that it would happen in 1940s America. But it's a real concern now that the Baby Boomers are about to retire. Japan, once again, is the canary in this deflationary coal mine: Its working-age population started declining in 1997, and that, the IMF says, has helped push its inflation rate into negative territory. That's left interest rates at zero, and the economy to languish.
Let's put it all together. The best we can say is that something happened, and now the economy needs bubbles or negative real rates to get people to invest enough. It'd be nice if we could be more specific than that, but we can't really. What we can say, though, is this is a problem that might not go away anytime soon. Household deleveraging and low population growth should keep pushing rates down for awhile.
Now let's back up. Why are negative real rates such a bugaboo? Well, because the Federal Reserve might not be able to give them to us. The Fed can't cut rates below zero and it won't let inflation go above 2 percent, so the lowest real rates can go is -2 percent. But if the economy needs lower ones than that — say -7 percent, like it did during the crisis — it will just collapse.
It's a grim picture of a recession stamping on a human face — forever. But it wouldn't be too hard to save ourselves from this dystopian future. All it would take is a higher inflation target that would let real rates go lower, and help households reduce their debt burdens. Immigration reform that boosted the workforce wouldn't hurt either.
Stagnation, in other words, is a choice.