Tuesday, July 15, 2014

Follow up to My Washington Post Piece on Secular Stagnation

I have an new article in the Washington Post where I make the case against secular stagnation. My argument is based on three observations. The details of these arguments and evidence for them are spelled out in the piece, but here is a quick summary.

First, the prima-facie evidence most secular stagnation advocates point to is misleading. They see the long-decline of real interest rates since the early 1980s as supporting their view. Their real interest rate measures, however, do not account for a trend decline in the risk premium. Once that is done there is no downward trend in real interest rates. And this measure--the 10-year real risk-free interest rate--is the one at the heart of the secular stagnation story. 

This long-run measure of the natural interest rate is currently negative, but only because of the current slump--its deviations tracks the CBO's output gap--and appears to be simply deviating around a roughly 2% trend. Based on this evidence, there is no reason to believe it has permanently turned negative.

Second, claims about a trend decline in technical innovation and productivity growth are overstated. It is getting increasingly hard to measure economic activity with GDP in an increasingly digitized economy. This means productivity gets under measured. Moreover, there is reason to be believe we are on the cusp of a rapid growth spurt as noted by Erik Brynjfolsson and Andrea McAfee in The Second Machine Age: Work, Progress, and Prosperity in a Time of Brilliant Technologies. If so, the return to capital will rise and so will investment demand This should put upward pressure on the natural interest rate.

Third, the demographic outlook is not so dire. Baby boomers are no longer the largest U.S. cohort and around the globe the outlook for the prime-age working population is improving. This too implies a higher return to capital, more investment spending, and upward pressure on the natural interest rate.

One thing I did not get to fully explain in the article is why the growth of productivity and the labor force should affect the natural interest rate. To do this, we need to first recognize there was a trend and cyclical component to the 10-year real risk-free interest rate. This is equivalent to saying there is a long-term and short-term natural interest rate, with the latter gravitating around the former. So we need to distinguish how these different components are determined. Also, I left out a third determinant of the natural interest rate: household time preferences. My assumption in the article is that this part is relatively steady and all the interesting developments come from changes in productivity and labor force growth. 

So with all that said, below is an explanation of long-term and short-term natural interest rate determinants. It is drawn from an earlier post:
[T]he long-term nominal natural interest rate is determined by trend changes in the expected productivity growth rate, the population growth rate, and household time preferences... Productivity matters because it affects the expected return to capital and expected household income. Faster productivity growth, for example, translates into a higher expected return on capital and higher expected household incomes. In turn, these developments should lead to less saving/more borrowing by firms and households and put upward pressure on the natural interest rate. The opposite would happen with slower productivity growth. Population growth matters because it too affects the expected return to capital. More people means more workers and output per unit of capital. For example, the opening up of China and India's labor supply to the global economy, meant a higher expected return to the global stock of capital over the past decade. That should put upward pressure on interest rates and vice versa. Finally, for a given level of expected income, a change in households time preferences means a change in their desire for present consumption over future consumption. This, in turn, affects households' decision to save and borrow. If households, say, start living more for the moment there would be less saving, more borrowing, and upward pressure on the natural interest rate.

Some like Paul Krugman and Larry Summers believe these determinants have changed enough such that the long-term nominal natural interest rate has been negative. I am not convinced and hope to explain why in a subsequent post (if you cannot wait, see my views in this twitter discussion). In my view, then, the important question is whether the short-run nominal natural interest rate has been negative since the crisis started.

So what do we know about the short-run nominal natural interest rate? It is shaped by aggregate demand shocks that create temporary deviations of the economy above or below its  full-employment level (i.e. output gaps). For example, a large negative aggregate demand shock that temporarily weakens the economy will put downward pressure on interest rates. This happens because firms do less investment spending and therefore less borrowing in anticipation of lower future profits. It also happens because households, particularly credit and liquidity constrained ones, save more and borrow less in anticipation of lower future incomes. In short, aggregate demand shocks that create output gaps will also push the short-run nominal natural interest rate in a procyclical direction. This is a natural process that allows the economy to heal itself. What is not natural is when interest rates are prevented from fully adjusting to their market-clearing levels. That happens when interest rates are pinned down at the ZLB. See this earlier post for a graphical representation of this ZLB problem.
I hope that helps. Be sure to read the article at the Washingont Post.

PS. Josh Hendrickson and John Cochrane provide critiques of the formal modeling of secular stagnagtion by Gautti Eggertson and Neil Mehrotra.


  1. It seems to me that there is a demographic necessity to move production 20 to 30 years into the future, when the difference between consumption needs and productivity of the baby boomers will be at its widest. Investing in more productive widget manufacture today can't meet that need, because boomers can't buy the widgets today. They need widgets in 30 years, and the widget manufacturer can't just take their money & wait, because by then, boomers will be buying widgetpluspro 3.0, and the widget factory that had their capital will be gone. This means that for the past 15 years, capital has been desperate for places to rest with little competitive pressure. Housing is a clear outlet for this need. When boomers are completely out of the labor force but are still consuming, we will get back to investing in productivity. High equity premiums, low interest rates, and high home prices are simply reflections of these needs.
    So, it looks to me like markets are reflecting the needs of the populace. The problem is that, in trying to understand our subconscious collective wisdom, so many have become convinced that this is a problem, and the housing market has been misinterpreted as inflationary or as a bubble, so we have spent the past decade instituting policies, including money supply management, that prevent markets from solving this time-mismatch problem. This seems like a simple and common problem of second guessing markets when we might be better off second guessing our models.
    ...Not that you asked for my opinion....

  2. good post and good article... thumbs up.

  3. I like your statement that increasing digitization makes economic activity harder to measure in monetary terms, so we are under-measuring productivity. I believe this is true but did not know it was conventional wisdom already.

    I'm very curious what definition of productivity we should use here. The ones I know about use monetary metrics so don't reflect un-monentized production any better than GDP. I agree we need metrics of productivity and value that apply independent of monetization, but don't know where to find those.

    Also I wonder if a rapid growth spurt (or actually long term growth acceleration if you agree with Brynjolfsson and McAfee) implies an increase in the natural interest rate. If capital requirements for innovation are low, and perhaps even falling (due to digitization), and if many innovations that raise productivity cannot be monetized (due to digitization) resulting in relatively low (monetary) return on investment, maybe the natural rate will remain low or even fall with rapid and accelerating growth!

    1. Jed, on one hand digitization does lower the capital requirements for innovation. We see that in smart phone apps. On the other hand, the kind of sustained rise in economic growth envisioned by Brynjofsson and McAffee is one that will require huge capital investments. For example, it will take a lot of investment spending to get a smart highway grid and cars for diverless future. And more robot automation won't be cheap. In my view, this latter effect will dominate.

      I am not sure our shared views of digitization making measuring productivity tougher is conventional wisdom, but there are some observers who share it. Over time, I think this will become more apparent and then it will become conventional wisdom. In terms of how to better measure productivity, I don't know. Great question and one that hopefully digitization itself will one day answer.

  4. David, interesting post. Scott, in contrast, today said he accepts the "great stagnation hypothesis."

    Here's a post on forecasting inflation you might be interested in. It's the 3rd in a series of three posts prompted by Scott Sumner's question to the author yesterday:

    "...Does the model forecast P better than alternative approaches, like TIPS spreads?"

    That last one is more of a true prediction, but the 1st two (immediately preceding posts) are about forecasting comparisons (e.g. with TIPS). What do you think of that prediction and/or comparisons of forecasting performance? Do you have an alternative model that you prefer? Do you have an alternative prediction?

  5. digital/tech expansion for me, secular stagnation for thee. David, you're right, GDP doesn't cut it because different groups are experiencing different economies. For some, the US has been in secular stagnation for decades, for others its a growing economy. We need to be thinking about how to deal with this in terms of political solutions. It may be a little like 19th century when agrarian incomes were in stasis while industrialization made others have rising living standards. Same with inflation - a one size fits all inflation rate is outmoded too. Death to macro.
    what do you think ?

  6. lots of "natural" this and "natural" that in this post. Justification by faith alone?

  7. Inflation is the most important factor influencing interest rates operating as it does thru the supply of and demand for loan funds. But there have been other significant influences. (1) The DIDMCA of March 31st 1980 provided the legal basis to turn 38,000 financial intermediaries into 38,000 commercial banks. (2)Regulation Q interest rate ceilings were removed. (3) The introduction of the payment of interest on IBDDs was implemented, (4) Financial innovation, etc. I.e., unless you account for the use or non-use of voluntary savings as well as current account flows, any interest rate forecast analysis will be flawed.

    As far as I have read, I'm the only one that picked the very top (Sept 1981) and very bottom (June 2012) in long-term bonds.