A deeper understanding of secular stagnation?
Almost a year ago, Larry Summers delivered a speech at an International Monetary Fund conference that caused quite a stir among economists and other observers of the field. In the speech, the former Treasury Secretary and Harvard University economist resuscitated the idea of secular stagnation, or a prolonged period where inflation-adjusted interest rates need to be negative to spur strong economic growth. Other economists have commented on and built off the idea including Paul Krugman, our own Brad DeLong at the University of California-Berkeley, and Atif Mian and Amir Sufi, the authors of “House of Debt” and economics professors at Princeton University and the University of Chicago, respectively.
But mainstream economists have not developed full-fledged models of secular stagnation, at least until this week.
Earlier this week, the National Bureau of Economic Research released a paper by economists Gauti Eggertsson and Neil Mehrotra, both of Brown University, which builds a model of secular stagnation. The model looks at how a variety of factors, including income inequality, can result in a desired interest rate that needs to be negative in order to generate sufficient demand. For example, the higher savings rates of the rich would increase the supply of savings and push down the desired interest rate.
If the economy needs a negative inflation-adjusted interest rate then there’s a problem, because central banks are unable to drop nominal interest rates below zero. Conventional policy tools wouldn’t naturally move the economy away from this situation of secular stagnation. Without a change, the economy would stay in the current rut. Think of Japan: it experienced a large recession in the early 1990s that turned into a decade-long period of stagnation.
According to Eggertsson and Mehrotra, though, policymakers can move an economy out of this nasty equilibrium. They look at how monetary and fiscal policy can help boost economic growth in a period of secular stagnation. They find that monetary policy can help boost the economy only if the central bank credibly commits to a higher inflation target. This result is interesting given Summers’s claim that monetary policy may not be helpful in just such a situation. In this way, the model supports a critique of Summers’s original formulation of secular stagnation best articulated by the Economist’s Ryan Avent.
Yet backing up Summers on another of his suggested methods to escape secular stagnation—increased public spending—Eggertsson and Mehrotra find that fiscal policy is helpful as well. By increasing the amount of public debt, fiscal policy increases the natural rate of interest spurring investment, which will help the economy gain traction.
Eggertsson and Mehrotra have done a great service by building up a full model of secular stagnation. But questions still arise. Both Tyler Cowen and Ryan Decker, a graduate student at the University of Maryland, have concerns about certain mechanisms in the paper. Resolving these issues will not only strengthen Eggertsson and Mehrotra’s paper, but further our understanding of a potentially critical economic problem.