A Tale of Two Theories

by Jean Pisani-Ferry Jean Pisani-Ferry is a professor at the Hertie School of Governance in Berlin, and currently serves as Commissioner-General for Policy Planning for the French government. 01.09.2015
PARIS – Global growth disappoints again. A year ago, the International Monetary Fund expected world output to rise 4% in 2015. Now the Fund is forecasting 3.3% for the year – about the same as in 2013 and 2014, and more than a full percentage point below the 2000-2007 average.

In the eurozone, growth in the latest quarter was underwhelming. Japan has returned to negative territory. Brazil and Russia are in recession. World trade has stalled. And China’s economic slowdown and market turmoil this summer have created further uncertainty.

True, there are bright spots: India, Spain, and the United Kingdom are beating expectations. The United States’ recovery is solid. Africa is doing well. But, overall, it is hard to deny that the global economy lacks momentum.

This is partly because trees cannot grow forever: China’s economy could not continue to get 10% bigger every year. And in part, it is because growth is not unconditionally desirable: Citizens may be better off with a little less of it, and more clean air.

But many countries are still poor enough to be endowed with strong growth potential, and many others, though rich, have not yet recovered from the global financial crisis. So there must be something else holding growth back.

There are essentially two competing explanations. The first, the Secular Stagnation Hypothesis, has been proposed by Larry Summers. Its key premise is that the equilibrium interest rate at which demand would balance supply is currently below the actual interest rate.

This seems paradoxical, because interest rates are close to zero in most advanced economies. But what matters is the real rate of interest, that is, the difference between the market rate and inflation. Aggregate economic balance may require a negative real interest rate; but with inflation at an all-time low – the IMF expects it to be negative this year and next in the advanced economies, and zero in the emerging economies – this is not feasible.

There are several reasons why the equilibrium interest rate could have reached negative territory. Some are structural: saving is high globally, especially in Asia but also in Europe, where aging countries like Germany put money aside for retirement. At the same time, the new digital economy is less capital-intensive than the old brick-and-mortar economy. This may be accentuated in the future by the advent of the so-called sharing economy.

Other factors are temporary. In several countries, debt-financed housing booms have left households and companies over-leveraged; and governments have reduced deficits to contain their own debt. As a result, there are likely to be too few investors and too many savers.

The Secular Stagnation Hypothesis is worrying, because it gives few reasons to believe that things will improve by themselves. True, debt deleveraging is not without limits. But it is impeded by slow growth and, thanks to high unemployment and weak global demand, persistently low inflation. Worse, over the longer term, low investment undermines productivity, while protracted unemployment destroys skills. Both reduce future potential growth.

A vicious circle, it seems, is at work. The way to break it, according to Summers, is to sustain monetary stimulus and boost demand aggressively through fiscal policy.

The alternative explanation for the persistence of weak global growth has been best formulated by the Bank for International Settlements, an organization of central banks. The BIS maintains that excessively low interest rates are a big reason why growth is disappointing.

This explanation may seem even more paradoxical than the first, but the logic is straightforward: Governments often try to escape the hard task of improving economic efficiency through supply-side reforms and rely on demand-side fixes instead. So, when confronted with a growth slowdown caused by structural factors, many countries responded by lowering interest rates and stimulating credit.

But cheap credit promotes bad investment and excessive debt, which borrowers often are unable to repay. More fundamentally, investment is a bet that cannot pay off if growth is structurally depressed. Artificial growth promotion only ends in tears.

Furthermore, the BIS claims that credit may well aggravate structural deficiencies. Housing bubbles and investments in dubious projects result in a waste of resources and a misallocation of capital that ultimately dampens potential growth. The best example is perhaps Spain in the 2000s, where students left university before graduating to take part in the real-estate frenzy. Amassing useless concrete and losing human capital, the country lost twice.

So here, too, the logic points to a vicious circle: Slower growth leads to artificial remedies and further erosion of long-term growth potential.

The BIS argues in favor of fiscal restraint, debt restructuring if needed, and swift normalization of monetary policies – quite explicitly criticizing the US Federal Reserve’s caution and the European Central Bank’s aggressive stance.

Both theories are internally consistent. Both also fit only some of the facts.

The Secular Stagnation Hypothesis accounts well for the mistakes made in the eurozone in the aftermath of the global recession, when sovereigns attempted to deleverage while companies and households were unwilling to spend, and the ECB was keeping monetary policy relatively tight. The BIS’s explanation reads like a summary of the woes of China, where growth has slowed from 10% to 7% or less, but the authorities still push investment amounting to almost half of GDP and promote all sorts of low-return projects.

So which theory fits the facts better globally? So far, it is odd to claim that advanced countries have stimulated demand excessively. Persistently low employment and near-zero aggregate inflation do not suggest that they have erred on the side of profligacy. True, financial recklessness remains a risk, but this is why regulatory instruments have been added to the policy toolbox. So the BIS’s call for across-the-board monetary normalization is premature (though this does not mean that reforms should wait).

In the emerging world, however, the mismatch between growth expectations and actual potential has often become a serious issue that demand-side stimulus and endless debt accumulation cannot cure. Rather, governments should stop basing their legitimacy on inflated growth prospects.



Copyright: Project Syndicate, 2015.
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