Monetary policy cannot solve secular stagnation

Larry Summers crystallized an important development and question in a recent speech given at the IMF research conference: has the world economy entered a period of “secular stagnation”? Is there a permanent fall of the equilibrium real interest rates? Prior to the crisis, the global economy could generate just enough demand thanks to significant bubbles in a number of major economies, excess borrowing by low-income households and the like, to balance the large amount of global savings. With the erupting crisis, high household borrowing and the house-price bubbles became visible as unsustainable sources of global demand. Households and corporations since the beginning of the crisis have attempted to deleverage while expansionary fiscal and monetary policies have tried to compensate for the lack of demand. Yet, five years later, growth remains sluggish and inflation rates are low or falling.

Monetary policy has hit the zero lower bound. Several central banks, including the Federal Reserve and the Bank of Japan have embarked on unconventional policies, so called quantitative easing (QE), to bring the real interest rate down further and thereby generate new investment demand. Can QE solve the problem of weak demand, lead to more investment and ultimately trigger more global growth? The IMF’s chief economist, Olivier Blanchard, has pub lished a blog post arguing that the effects of unconventional monetary policy are “very limited and uncertain”. It would therefore be advisable to have higher inflation rates in normal times, which makes it possible that in a crisis to drive down nominal interest rates more so that real interest rates fall even further.

While I agree with Blanchard’s technical argument, it seems to me that the central question remains how the pre-crisis demand shortage could have been addressed to generate higher inflation rates. If there is an insufficiency of demand even in normal times, this problem would need to be addressed. The answer can hardly be more bubbles so that inflation rates go up. Using monetary policy to drive the real interest rate permanently to low, or perhaps, even negative rates is certainly difficult and can create significant distortions in the economy. The second question concerns what the right policy response should be now. I argue that structural policy and, in particular, improved investment conditions and a better internationally integrated financial system, are the right way forward.

What role can quantitative easing play? I am not quite as negative on QE as Olivier Blanchard but certainly agree that it cannot fundamentally solve the problem.

Start with the euro area. The euro area is still at risk of falling into deflation. Euro area core inflation rates, i.e. inflation rates excluding volatile energy and food prices, have been falling since late 2011. Inflation expectations two years ahead are hardly above one percent and even at the five-year horizon, the market-determined inflation forecast is 1.3 percent. This has consequences. Lower-than-expected inflation redistributes wealth from debtors to creditors and increases the burden of the debtors. Thus, disinflation in the euro area undermines private and public debt sustainability, in particular in the periphery where the debt overhang is greatest. It is therefore a real risk for the euro area as a whole.

Prior to the crisis, inflation rates in the periphery were well above 2 percent, while the German inflation rate was below 2 percent. The EU experience in this respect was different from the US experience. Easy monetary conditions with negative real interest rates generated bubble-driven growth in the periphery and pretty high peripheral inflation rates. As part of the ongoing adjustment process, inflation rates had to fall in order to regain competitiveness relative to the euro-area core. But in this process, the ECB failed to achieve its mandate, the stabilisation of euro-area inflation at close but below 2 percent. Some in Germany fear that higher German inflation would devalue German savings. But in a monetary union, the value of money is defined at the union level. The ECB should therefore act to fulfill its mandate and restore inflation to close to 2 percent, accepting higher inflation rates in Germany.

But will the ECB action be enough to prevent further disinflation in the euro area? Will it be enough to generate enough demand to end the recessionary tendency, which is still plaguing the euro area? The ECB’s current rate reduction will mostly support the banks in the euro-area periphery while relatively little new lending will reach corporations and households. In the core of the euro area, the rate cut will basically go unnoticed.

Many analysts have now called on the ECB to do more. The most obvious step would be for the ECB to reduce haircuts on collateral and introduce funding for lending schemes. This would support further lending to SMEs. More controversially, there is a discussion on QE. Undoubtedly, a massive government bond purchase program throughout the euro area would push interest rates down, in particular in the euro area periphery. Yet as long as banks remain structurally weak, lending may remain subdued. In the core of the euro area, bank lending is almost unconstrained already, and at rates that are close to zero. A further reduction in the interest rate of bonds will have marginal effects.

Monetary policy cannot solve secular stagnation. Instead, improved investment conditions and a better integrated international financial system are the right way forward.

An alternative and politically less contentious way of doing QE for the ECB might be to buy a large portfolio of corporate bonds. This would directly bring down funding costs for all large corporations. But the problem of access to credit for small companies would remain largely unresolved. So QE in the euro area will have an effect, but not so much because of the zero lower-bound problem, but rather because it would reduce the high spreads of the periphery relative to the euro-area core. ECB monetary policy will therefore need to be complemented by significant restructuring of banks’ balance sheets and their restoration to health. In addition, the right conditions for more growth in Germany and France would need to be put in place, including better conditions for investment, less state intervention and adequate public investment.

Turning next to Japan, the importance of structural reforms also becomes apparent. Since the election of Shinzo Abe as prime minister, Japan has embarked on a QE program of unprecedented scale. The effect has been a much weaker yen together with an increase in inflation. Yet, one year later, core inflation still remains in deflation territory. A further weakening of the yen would likely eventually push up inflation, but the effect would mostly come from the external sector, i.e. the fact that more gets exported and imports become more expensive. An export-led growth and anti-deflation strategy, however, cannot work forever. To return to growth and eventually increase inflation, the third arrow of Abenomics will matter much more: improving investment conditions, creating new business opportunities, increasing competition in the economy and deepening trade integration. These factors will drive new investment much more than slight changes to the nominal interest rate.

Finally, turning to the US, monetary policy has, of course, been very supportive and has helped avoid a slide into deflation. In addition, the US recovery has been helped by very significant debt reductions in the household sector thanks to non-recourse mortgages and other similar things. However, before the crisis, the build-up to many of the problems in the US economy were linked to very expansionary monetary policies. The massive bubbles that resulted from the combination of lax monetary policy and an inadequate financial regulatory system should certainly be considered a problem, not a solution.

The overall lesson of “secular stagnation” as outlined by Larry Summers seems to go in a different direction. In normal times, it is not monetary policy, let alone QE, that can help address an equilibrium negative real interest rate. The European and US experiences suggest that long periods of easy monetary conditions can result in significant bubbles with major financial and later real implications. Instead, the importance of structural policies is underlined. The fundamental question is why globally the equilibrium interest rate has been falling. Is it global demographics? Certainly, population growth is starting to fall in many countries, especially in the more advanced economies. Yet, the global population is still increasing. This would suggest that globally there should still be ample investment opportunities if framework conditions are put right. This is where the role of the integration of Asian economies into the global economy becomes central. More than half of the world population is concentrated in a small circle in Asia, including China and India. The more they are integrated into the global economy, the more they should increase global investment demand. To achieve this, a well-working financial system is critical. It would need to prevent excessive risk taking while channelling savings to the right countries and deployments.

Clearly, a critical question is if and how saving and investment patterns will change in Asia. Itwill also be critical how sustainably capital accounts are opened up. But I am also convinced that Europe should be able to create much better investment opportunities to solve its stagnation.