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The economy continues to operate way below any estimate of its potential made before the onset of financial crisis in 2007, with a shortfall of gross domestic product relative to previous trend in excess of $1.5tn, or $20,000 per family of four. As disturbing, the average growth rate of the economy of less than 2 per cent since that time has caused output to fall further and further below previous estimates of its potential.
Almost a year ago I invoked the concept of secular stagnation in response to the observation that five years after financial haemorrhaging had been staunched, the business cycle was cycling back to what had been previously thought of as normal levels of output.
Secular stagnation in my version, like that of Alvin Hansen, the economist who coined the term in the 1930s, has emphasised the difficulty of maintaining sufficient demand to permit normal levels of output.
But with a high propensity to save, a low propensity to invest and low inflation, this has been impossible. Nominal interest rates cannot fall below zero, as they would have to for real interest rates to be low enough to enable saving and investment to be equated with the economy producing at its full potential. Furthermore, even if potential output can be attained, it would require interest rates so low that they risk financial instability.
Given the factors operating to reduce natural interest rates – rising inequality, lower capital costs, slowing population growth, foreign reserve accumulation, and greater costs of financial intermediation – it seems unlikely that the American economy is capable of demanding 10 per cent more output than it does now, at interest rates consistent with financial stability. So demand-side secular stagnation remains an important economic problem.
But, as the work of Robert J Gordon has shown, there may now be supply-side barriers that threaten to hold back the economy before constraints on the ability to create demand start to bind. Two ways of looking at the current situation point up the difficulty.
First, while I have emphasised that levels of GDP are far short of what pre-crisis trends would predict, the unemployment rate at 6.1 per cent (down from a 10 per cent peak) has reverted most of the way back to even relatively optimistic estimates of its normal level. In other words, even while economic growth performance has been very poor, it appears that demand has been advancing rapidly enough to substantially reduce slack in the labour market. Weak growth, along with substantial decreases in slack, suggests significant weakness in the growth of potential output.
To be fair, there is room to cavil about the unemployment rate as a measure of slack in the labour market. But the extent of apparent normalisation is even greater if one looks at measures of job openings and vacancies, new unemployment insurance claims, or the short-term unemployment rate.
Second, with Friday’s relatively weak employment statistics job growth has averaged 200,000 jobs a month over the past six months. If this continues, what would it imply for movements in the unemployment rate?
This depends on what happens to labour force participation, which has been trending downwards because of population ageing and long-term structural trends, even as the unemployment rate has declined sharply. Assume (optimistically, given recent trends) that the labour force participation rate for workers of a given age remains constant, and that the economy creates 200,000 jobs a month. The unemployment rate would then fall to about 4 per cent by the end of 2016.
While such a low unemployment rate is conceivable, it seems much more likely that employment growth would slow at some point, because of rising wage costs or policy actions, or because employers have difficulty finding workers. Then, the economy would be held back not by lack of demand but lack of supply potential.
Why has the economy’s supply potential declined so much relative to the pre-2007 trend? This will be debated in the years to come. Part of the answer lies in the damaging effect of past economic weakness on future potential. Part is the brutal demographics of an ageing population, the end of the trend towards increased women’s labour force participation, and the exhaustion of the gains from an increasingly educated workforce. And part is the apparent slowing of at least measured productivity.
To achieve growth of even 2 per cent over the next decade, active support for demand will be necessary but not sufficient. Structural reform is essential to increase the productivity of both workers and capital, and to increase growth in the number of people able and willing to work productively. Infrastructure investment, immigration reform, policies to promote family-friendly work, support for exploitation of energy resources, and business tax reform become ever more important policy imperatives.
The writer is Charles W Eliot university professor at Harvard and a former US Treasury secretary