The forces that drove rates, inflation, and growth lower for the last four decades remain as strong as ever, but there is hope for change.
Current markets alternate between worries about supply-chain bottlenecks that will fuel inflation and fresh COVID variants that undermine recovery. But the far more important questions are, what comes after the pandemic and what might shake off 40 years of ever-lower growth and interest rates? There is a sea change underway in fiscal and monetary policy that just might deliver higher and more durable growth.
“Secular stagnation” captures most of the forces that contributed to declining investment returns in recent decades. Initially described by economist Alvin Hansen after the Great Depression and refreshed by former Treasury Secretary Lawrence Summers after the 2008 Global Financial Crisis, the theory identifies a constellation of structural factors and policy choices that tilts the global economy into saving too much and investing too little.
With excess savings, growth slows and central banks struggle to meet their inflation targets. Meanwhile, low growth weakens incentives to invest, and interest rates—literally the price of money—sag as supply exceeds demand. Indeed, in recent years, the “neutral rate” that economists describe as supporting full employment without inflation may be so far below zero that central banks must resort to negative policy rates supplemented by abundant asset purchases.
U.S. INTEREST RATES
Source: Bloomberg. As of September 24, 2021.
Secular stagnation is just one of several theories that attempt to explain the long-term decline in rates and returns, but the trends are undeniable and anyone putting money to work has to ask hard questions about what might reverse them once the challenges of COVID-19 fade.
The most powerful driver of excess savings and lower demand may be demographics. Aging populations, especially in rich countries, have been saving voraciously as they prepare for retirements that may extend much longer than they initially expected. In countries like China, where the social security infrastructure remains incomplete, savings rates hover near 45%. At the same time, falling birth rates in the developed world have undercut growth expectations. This has long been true in Europe, Japan, and China. Last year, the U.S. birth rate dropped 4% with the lowest number of babies born since 1979.
“Governments have been spending their way out of the pandemic, but with populist forces on the rise and fiscal conservatives on the retreat, there may be a chance to boost aggregate demand beyond the current recovery.”
Globalization has contributed to the imbalance as well. The integration of financial markets has encouraged developing countries to accumulate savings in reserves and sovereign wealth funds for when the next crisis hits. At the same time, global supply chains have undercut wage growth of workers who must now compete in a much larger, far-flung labor pool. The rapid advance of technology, for all its magic, further exacerbates the trends with relentless innovation that mimics human activity and undercuts wage demands. Just as robotics have hollowed out jobs in industry, the combination of cheap data storage, mobile networks, and artificial intelligence threaten to replace a vast army of clerical and administrative workers.
So what might change after the pandemic? Demographic trends are slow to shift. Trade continues to grow, extending economic integration in spite of fears that lockdowns and escalating U.S.-China friction mark the end of globalization. At some point, technological innovation will start creating more jobs than it destroys, but that may still take time.
But all is not lost. The global forces that undermine wage growth have also conspired with the expansion of automation, the weakening of trade unions, and finance-friendly tax reforms to drive down labor compensation as a share of GDP. Mounting political sentiment in the U.S. and Europe, however, is fueling fresh demands for government spending that will redress this income inequality. If it’s large enough and lasting enough, it will also encourage more investment and less saving.
SHARE OF LABOR COMPENSATION AS A PERCENT OF GDP
Source: Federal Reserve Bank of St. Louis. As of September 24, 2021.
Governments have been spending their way out of the pandemic, but with populist forces on the rise and fiscal conservatives on the retreat, there may be a chance to boost aggregate demand beyond the current recovery. Meanwhile, central banks look committed to running the recovery hotter for longer, whether through a commitment to higher “average” inflation over time in the U.S. or a “symmetric” target in Europe. These dramatic responses even have Summers on watch for higher inflation, but it’s hard to see that as a serious risk without believing that the forces of demographics, globalization, and technology have all suddenly abated.
Government spending is not in itself a panacea, especially if it just pulls forward future demand without generating sustainable longer-term growth. Government debts will be manageable if the money is spent well, but it must be spent well, for example raising the quality of human capital with easier access to education and health care. The impact will also be more lasting in the context of plans to invest in infrastructure that boosts digital innovation and helps mitigate the effects of climate change. Quantitative Easing also risks delivering diminishing returns the longer it’s in place, creating the risk of asset bubbles, too.
But, without any reprieve from persistent economic headwinds, then these may be unavoidable risks. Ample government spending that transfers resources to those who will spend it, paired with productive and green infrastructure programs, may be the best hope to correct the savings and investment imbalance that has shaped an era of “secular stagnation.”
It may be our only hope for a sustainable period of rising rates and returns.