U.S. Economic Prospects: Secular Stagnation, Hysteresis, and the Zero Lower Bound

"...To reverse Keynes a bit, if you die in the short run, there is no long run. So my preoccupation this morning will be with a set of temporary but, I believe, ultimately long-term concerns…. there is room for doubt about whether the cycle actually cycles. Today, it is increasingly clear that the trend in growth can be adversely affected over the longer term by what happens in the business cycle. And today, there are real questions about the efficacy of monetary policy, given the zero lower bound on interest rates…. three propositions. First, as the United States and other industrial economies are currently configured, simultaneous achievement of adequate growth, capacity utilization, and financial stability appears increasingly difficult. Second, this is likely to be related to a substantial decline in the equilibrium or natural real rate of interest. Third, addressing these challenges requires different policy approaches than are represented by the current conventional wisdom…Figure 1 shows that the economy is now 10 percent below what in 2007 we thought its potential would be in 2014. Of that 10 percent gap,5 percent has already been accommodated into a reduction in the estimate of its potential, and 5 percent remains as an estimate of its GDP gap. In other words, through this recovery, we have made no progress in restoring GDP to its potential… Making the best calcula- tions one can from the CBO’s estimates of potential (and I believe quite similar results would come from other estimates of potential), one can see from Figure 4 that this is not about technological change. Slower total factor productivity than we would have expected in 2007 accounts for the smallest part of the downward trend in potential. The largest part is associated with reduced capital investment, followed closely by reduced labor input. Let me emphasize that this is not a calculation about why we have less output today. It is a calculation about why it is estimated that the potential of the economy has declined by 5 percent as a consequence of the downturn that we have suffered. The record of growth for the last five years is disturbing, but I think that is not the whole of what should concern us. It is true that prior to the downturn in 2007, through the period from, say, 2002 until 2007, the economy grew at a satisfactory rate. Note that, there is no clear evidence of overheating. Inflation did not accelerate in any substantial way…. Did it do so in a sustainable way? I would suggest not. It is now clear that the increase in house prices shown in Figure 5 (that can retrospectively be convincingly labeled a bubble) was associated with an unsustainable upward movement in the share of GDP devoted to residential investment, as shown in Figure 6. And this made possible a substantial increase in the debt-to-income ratio for households, which has been reversed only to a limited extent, as shown in Figure 7…. In sum, I would suggest to you that the record of industrial countries over the last 15 years is profoundly discouraging as to the prospect of maintaining substantial growth with financial stability. Why is this the case? I would suggest that in understanding this phenomenon, it is useful at the outset to consider the possibility that changes in the structure of the economy have led to a significant shift in the natural balance between savings and investment, causing a decline in the equilibrium or normal real rate of interest that is associated with full employment…. imagine, as a hypothesis, that this decline in the equilibrium real rate of interest has taken place. What would one expect to see? One would expect increasing difficulty, particularly in the down phase of the cycle, in achieving full employment and strong growth because of the constraints associated with the zero lower bound on interest rates. One would expect that, as a normal matter, real interest rates would be lower. With very low real interest rates and with low inflation, this also means very low nominal interest rates, so one would expect increasing risk-seeking by investors... Is it reasonable to suggest that equilibrium real interest rates have declined?... reasonable hypothesis for at least six reasons… First, reductions in demand for debt-financed investment… a declining rate of population growth, as shown in Figure 8, means a declining natural rate of interest…. changes in the distribution of income, both between labor income and capital income and between those with more wealth and those with less, have operated to raise the propensity to save, as have increases in corporate-retained earnings…. is a substantial shift in the relative price of capital goods… Cheaper capital goods mean that investment goods can be achieved with less borrowing and spending, reducing the propensity for investment…. reasonable argument to be made that what matters in the economy is after-tax, rather than pre-tax, real interest rates, and the consequence of disinflation is that for any given after-tax real interest rate, the pretax real interest rate now needs to be lower than it was before… substantial global moves to accumulate central bank reserves, disproportionately in safe assets in general, and in U.S. Treasuries in particular…. Each of these factors has operated to reduce natural or equilibrium real interest rates….Stay patient...Reduce the actual real rate of interest...Raise demand" "U.S. Economic Prospects: Secular Stagnation, Hysteresis, and the Zero Lower Bound," Business Economics Vol. 49, No. 2. Available at:http://larrysummers.com/wp-content/uploads/2014/06/NABE-speech-Lawrence-H.-Summers1.pdf