By Stephen Lewis, Chief Economist of Monument Securities
With his talk of ‘secular stagnation’, Prof Summers has prompted a welcome reassessment of what ails the global economy. For five years, policymakers in the advanced economies have been taking measures of unprecedented vigour, with a view to restoring full employment, but the results have been uniformly disappointing. Early in the world economic downturn of 2008-09 we defined an economic depression as a state of affairs where economic activity was at a sub-optimal level and where the authorities were unable, through fiscal and monetary measures, to stimulate demand sufficiently to absorb spare resources. On that definition, the advanced economies have been in an economic depression since 2008. But it is one thing to fix a label on a process and quite another to explain why the process is occurring. This is what Prof Summers has tried to do with his theory that the advanced economies at least are in a state of ‘secular stagnation’ brought about as a result of a fall in the equilibrium real rate of interest deep into negative territory.
For some weeks, it seemed, there was reluctance on the part of those in policy circles to take on the heavyweight Prof Summers and advance an alternative explanation for the advanced countries’ poor economic performance over recent years. However, this week Mr Carney rose to the challenge. In his speech in New York, he argued that, even if ‘secular stagnation’ has a role in analysing recent history, the UK economy at least is showing signs of moving towards a healthier condition. As he put it, ‘the strength of the UK recovery and the fall in its unemployment rate suggest that the equilibrium real interest rate is now rising gradually back towards zero’. We should note, however, that the actual real interest may also be rising by virtue of a fall in the inflation rate, in which case the gap between the actual and the equilibrium rate may not be narrowing at all. In arguments such as these, much depends on the inflation rate used to translate nominal yields into real yields. If an improvement in economic conditions is taken as a sign that the real equilibrium interest rate must also be rising, talk of real interest rates is no more useful in explaining the economic process than labelling it a ‘depression’ To be useful, the real equilibrium rate would need to be open to independent measurement.
Mr Carney’s argument that current UK economic growth carries significance for the broader debate about the state of the global economy depends on the belief that ‘this time, it is different’. He readily acknowledged in his speech that, for four of the past five years, policymakers, investors and economists had agreed ‘the outgoing year was disappointing but the incoming one will be better’. Their hopes were continually dashed. But, he contended, this time for the UK it really will be so. The UK economy will cast off the shackles and move ahead with confidence. Why should this be? What is different this time? Mr Carney argued there had been a marked reduction in extreme uncertainty, significant progress in repairing the core of the financial system and an improvement in household balance sheets. From this, it seems Mr Carney believes that what caused the depression was an extremely high level of uncertainty about economic prospects, under-capitalisation of the banks and over-leveraged households. He does not need a theory about anything as intangible as the real equilibrium interest rate to explain what has been happening. At least, we shall be able to test Mr Carney’s hypothesis. While ‘extremely high level of uncertainty’ may appear, at first sight, a nebulous concept, he was using the term in the sense the Bank of England specified in its 2013Q2 Quarterly Bulletin, where it also explained how it calculates its ‘uncertainty indicator’. As for the banks, Mr Carney observed they had doubled their risk-weighted capital ratios in recent years. We should note this has been a continuous process; if it has been a factor in this year’s UK economic growth, there must have been a threshold level of bank capital which, when passed, helped liberate the economy. We may further object that a surge in bank lending has not been a conspicuous feature of the upturn in economic activity. With household de-leveraging, Mr Carney did not say why it had stopped, so is presumably not entitled to claim it as a fundamental change in direction rather than a pause. The Bank of England Governor did not point to the FLS, to Help to Buy, to PPI mis-selling compensation (that unorthodox way of channelling bank funds to the household sector) or to the post-Olympics effect on tourism as factors in the UK upturn. Focus on these, which appear as important proximate causes of the economic revival, might have cast doubt on the durability of the recovery. All the same, Mr Carney’s general causes are at least more concrete than the ‘real equilibrium rate of interest’ of Prof Summers.
Even so, Prof Summers has drawn attention to a very important point. He has maintained that the real equilibrium rate was falling even before the financial crisis came to a head. On the Carney view, it was the crisis that precipitated the depression by heightening economic uncertainty, crippling the banks and leading households to retrench. For Prof Summers, the crisis was merely an incident in a longer-run process that began some twenty years ago. There is one telling piece of evidence that backs up Prof Summers’s view. This is that even in the years before the crisis, it was clear that ever-stronger growth in the volume of credit was needed to support a given increase in GDP. At any rate, credit grew increasingly rapidly relative to both real and nominal GDP measures. At the time, the phenomenon was explained as a consequence of ever more sophisticated credit intermediation, but the result holds even when credit transactions conducted between financial sector intermediaries are excluded from the calculation. It suggests the source of the economic malaise is to be found within the financial sector.