The threat of secular stagnation

In my previous essay I referred to the possibility of secular stagnation (viz. a prolonged period of low economic growth) in the global economy and stated that it would be virtually impossible for the South African economy to be buoyant under those circumstances.I also made an earnest appeal for this possibility to be taken into consideration in the national budget, and the medium-term budget released on 22 October did in fact acknowledge that the government is faced with structurally lower tax revenue and will have to adapt.

Even the IMF, whose pronouncements are usually rather careful, warned in its latest World Economic Outlook that the global economy might never again achieve the growth rates that prevailed prior to the financial crisis. Among others, it pointed to the low levels of investment as a cause of lower economic growth, and on the other hand as confirmation of expected lower growth in the future.

Some economists (e.g. Robert Gordon and the IMF) define secular stagnation as a decline in the potential growth rate of an economy (the maximum growth rate an economy can sustain in the medium term without driving inflation upwards), which could be the result of a slowdown in technological development and consequently productivity growth, a stagnant population and the concomitant ageing of the population, stagnation in the contribution of education to the development of human capital, increasing inequality that has deprived the middle class of income growth, and unsustainable public debt and public services.

A second group of economists (e.g. Lawrence Summers and Paul Krugman) defines secular stagnation as an economy experiencing a growth rate below its potential growth rate owing to insufficient demand (which in turn could be the result of unsustainable debt levels) and the inability of conventional macroeconomic policy to stimulate demand.

The consensus among this group is that interest rates will not only have to remain low to combat secular stagnation, but that negative real interest rates are in fact necessary. However, it is difficult to accomplish the latter when inflation is very low. And continued low interest rates could also increase the risk of financial instability; in fact, conventional macroeconomic policy cannot simultaneously achieve the goals of satisfactory growth, full employment and financial stability.

A third group emphasises one-off but permanent damage to the economy's potential output owing to some or other crisis, causing a sharp downturn in economic activity. For example, a crisis could result in prolonged unemployment, leading to a decline in the labour force.

One could quite easily believe the current economic stagnation is simply the result of the 2008 global financial crisis and that it will soon be a thing of the past (time is after all the great healer). The extraordinary measures introduced by policymakers to prevent a second Great Depression may have been successful in doing that, but have left us with a legacy that will take a long time to eliminate.

In particular, the still high debt levels in many countries and the repressive effect of the reduction of debt levels on economic activity come to mind. However, in reality the global debt-GDP ratio is still rising (see accompanying graph) and the interaction between debt reduction and low nominal economic growth is hampering the normalisation of debt levels. Consequently total global debt, excluding the financial sector, has risen by 38 percentage points to 212% of GDP since 2008.

n the developed countries, financial sector and household debt levels have declined, but at the cost of a sharp increase in public sector debt. These countries' total debt, excluding the financial sector, amounted to 272% of their GDP in 2013. If the financial sector is included, this figure increases to 385% of GDP.

Developed countries therefore still have much to do to normalise debt levels and until then the credit channel as a stimulus for economic activity will be impaired, while the ability of macroeconomic policy to stimulate the economy will still be hampered for a long time.At the same time, emerging-market countries have experienced a sharp rise in debt levels. China has recorded the biggest increase, namely 72 percentage points, since 2008, with the result that its total debt amounted to 217% of GDP in 2013 compared to an average level of 151% for emerging-market countries (127% for South Africa).

As far as Chinese companies are concerned, 32% of new debt is currently being used to redeem the interest on outstanding debt, according to the Financial Times, while Chinese households spend $1 290 per annum on average to service their debt, which amounts to nearly 20% of per capita GDP of $6 800.

Therefore the risk of a debt crisis in China cannot be ignored. Even if China was able to avoid a financial crisis in the Western sense of the word, it is facing a difficult process of adaptation.

Lant Pritchett and Larry Summers furthermore ask the question whether the current optimism about the Chinese (and Indian) economies is realistic. They refer inter alia to previous instances of observers having been overoptimistic about the future of a specific country and what it would have meant for the global economy, for example Japan in the 1980s.Pritchett and Summers state that if one looks at the history of global economic growth, only two conclusions can safely be drawn:

The biggest errors in growth forecasting occur when the recent performance of an economy is extrapolated. The mistake made by forecasters is to regard an economy's growth rate as a permanent feature instead of a passing phase.How large a state will South Africa be able to afford?

The growth rate of all countries gradually shifts to the world average. In their own words: "Regression to the mean is perhaps the single most robust and empirical relevant fact about cross-national growth rates."

They also point out that rapid accelerations and slowdowns in growth are typical of developing countries and that the risk of negative scenarios is often underestimated. Hence they caution against over-optimism about China and India's economic outlook. If the above also applies to China and India (as they believe), one should expect these countries' growth rates to gradually revert to the world mean of 3,5%.

South Africa's policymakers appear to be aware of the negative effect stagnation in the developed countries, especially Europa, could have on the South African economy. This supports the argument in favour of the politically motivated project to strengthen the ties between South Africa and other emerging-market countries, in particular the BRICS group.Although greater diversification in foreign economic relations is a good idea as such, the question whether the solution for South Africa lies in stronger ties with China is debatable

It is generally accepted that structural reforms are the only answer to secular stagnation. These include the following:

Improving the education system

Investing in physical infrastructure

Removing barriers to labour mobility

Increasing incentives for low-skilled workers to enter the labour market

Improving the business climate to make it easier to start up a business.

The structural reforms that should be given priority will differ from economy to economy, while political feasibility will (unfortunately) also play a role.

References:

Coen Teulings and Richard Baldwin (eds.): Secular Stagnation: Facts, Causes and Cures. Centre for Economic Policy Research. VoxEU.org e-book. 2014.
Luigi Buttiglione, Philip R. Lane, Lucrezia Reichlin and Vincent Reinhart (eds.): Deleveraging? What Deleveraging? 2014 Genève Report on the World Economy. International Center for Monetary and Banking Studies. September 2014 Lant Pritchett and Lawrence H. Summers: Asiaphoria Meets Regression to the Mean. National Bureau of Economic Research. Working Paper w20573. October 2014.International Monetary Fund: World Economic Outlook. October 2014