Secular stagnation versus secular reflation

2 Jun 2016

Larry Summers has been dining out on some throwaway remarks at an IMF economic forum that included the phrase “secular stagnation” for two-and-a-half years now. In his recent article in Foreign Affairs, Summers defines secular stagnation as occurring “when neutral real interest rates are sufficiently low that they cannot be achieved through conventional central bank policies. At this point, desired levels of saving exceed desired levels of investment, leading to shortfalls of demand and stunted growth.” 
This is mere conjecture! There is no definitive measure of the neutral real interest rate. As my colleague Graeme Chamberlin argues in the latest North America Economic Perspective, the estimates derived by San Francisco Fed economists Thomas Laubach and John Williams reflect some strong priors. By giving factors such as global saving patterns and investor risk appetite greater weight, the drop in the neutral real rate is accentuated. A zero real rate, espoused by Janet Yellen and Lael Brainard, is a convenient artefact in that it gives more scope for inactivity.
By restoring a central role to the trend, or sustainable, growth rate as a determinant of medium-term inflation pressures, it becomes clear that the US Federal Reserve’s own estimate of the neutral real rate is skewed to the downside. In other words, the thesis of secular stagnation rests upon a skewed calibration of the neutral rate. In effect, Summers is jobbing backwards from his default advocacy of fiscal stimulus.
Yet, the weight of history lends scant support to the secular stagnation hypothesis. Writing in their annual Global Investment Returns Yearbook, Elroy Dimson, Paul Marsh and Mike Staunton find “that financial shocks beget, not secular stagnation, but secular reflation. By secular reflation, we mean at least a decade in which short- and long-term interest rates stay habitually below nominal GDP growth and high-grade bonds are not really bonds anymore: delivering trend returns that are close to zero or even negative.”
How does this happen? Typically, because financial repression is play in two acts. After nominal interest rate suppression comes unanticipated inflation. Real interest rates fall in Act 1 and in Act 2. However, real bond returns are healthily positive in Act 1 and diabolically negative in Act 2. Act 2 begins when inflation complacency is at its peak and policymakers are at their most desperate in their quest for economic recovery. In Act 1, the balance sheets of households and firms strengthen and those of the government and long-term savings institutions weaken. The chart illustrates these trends for the UK. When inflation strikes, the tables are turned: the present value of distant commitments comes tumbling down and likewise the present value of dubious future income streams.
The Whole of Government Accounts for the UK were released last week, showing another 10% of GDP deficit for the net liability ratio in 2014-15, which now stands at 115% of GDP or £2.1trillions. Only inflation can save us now!

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