Larry Summers’s secular stagnation speech at the IMFin November last year set the economic world ablaze as the Harvard professor warned that asset bubblesmight be necessary for developed economies to reach their potential growth. Now it seems he may have changed his mind.
Secular stagnation is a situation in a rich country where real economic growth has ground to a halt or remains at a very low level due to chronic underinvestment in future potential. The lack of investment leads to falling per capita incomes over time and stagnant demand. In order for such an economy to stave off high unemployment it is necessary to pump up asset bubbles in order to mimic the effects of growth. What it needs, in other words, is repeated bouts of spending to increase demand whether from the private or public sector.
However, in an article in the Financial Times over the weekend Summers said that the strength of the U.S. labour market may point to impending supply-side chokes rather than a problem of demand. He writes:
It seems much more likely that employment growth would slow at some point, because of rising wage costs or policy actions, or because employers have difficulty finding workers. Then, the economy would be held back not by lack of demand but lack of supply potential.
If all economic indicators were running below potential, for example with high unemployment, low inflation and GDP below potential, you would identify the problem as being insufficient demand. The appropriate response then would be for monetary and fiscal policy to remain accommodating in order to allow the economy to reach its potential as quickly as possible.
What Summers is suggesting is that the U.S. labour market, as illustrated by the unemployment rate, is actually already nearing a level consistent with most of the slack already having been used up. That is, workers do not seem to be facing an abnormally difficult market in which to find jobs if they wish to do so. As he says, hints of similar labour market tightness can be seen by looking at “job openings and vacancies, new unemployment insurance claims, or the short-term unemployment rate”.
So what does this mean? Firstly, it means that some of the damage from the financial crisis may be irreversible. Whether due to an insufficient size or poorly targeted policy response to crisis in the initial stages of the credit crunch, a permanent hit to productivity in affected sectors like financial services or more likely some combination of both at least a portion of the American economy’s potential may have been lost. If true, this could mean that interest rates will have to rise faster than many currently expect in order to head off wage-growth driven inflation.
Secondly, Summers is saying that in order for the economy to get back some of that lost potential it will require deeper structural reforms than the secular stagnation thesis would have indicated. This could mean additional spending on infrastructure and education, but also addressing politically challenging issues such as immigration reform and a review of corporate tax rates. Failure to achieve meaningful change in these areas could ensure that the damage from the recession leaves a permanent scar.
Summers says that if the current trend were to continue the unemployment rate would then fall to about 4% by the end of 2016 – a scenario he thinks would be unlikely as rising wage costs or policy action (presumably to head off inflation or to close the budget deficit) would hold it back. History, however, offers a warning about making assumptions about the impact of an improving job market on the inflation outlook.
His words reminded me of a warning given by the San Francisco Fed president Janet Yellen in December 1996, when the unemployment rate had fallen to 5.4%:
To my mind, labour markets are undeniably tight … But while I think we cannot rule out the possibility that this long expansion is about to end with a period of stagflation and that that is a significant risk over the term of this forecast, that outcome is by no means a certainty.
All of the policy ideas Summers puts forwards would lay a solid base on which to build a lasting recovery and, to my mind at least, would be sensible at almost any time but especially when government borrowing costs are as low as they currently are. But it appears to me that, at present, the situation is at least consistent with his secular stagnation thesis in the absence of obvious inflationary pressures.
If the U.S. government is going to spend it should do so wisely and not wildly, but they should not be cowed by recent developments in the labour market.