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It seems at first to be a puzzling scenario, and you might wonder whether it is possible at all: output can be at potential but still not be sustainable. Yet a chapter of the International Monetary Fund’s latest World Economic Outlook illuminates just this scenario. We may even be living in it.
Output is “at potential” when it does not generate inflationary or deflationary pressure. Sustainability — and I am referring here to financial sustainability, not the environmental kind — is something else entirely. Output is financially sustainable when spending patterns and the distribution of income are such that the fruit of economic activity can be absorbed without creating dangerous imbalances in the financial system. It is unsustainable if generating enough demand to absorb the output of the economy requires too much borrowing, real rates of interest rates that are far below zero, or both.
To see how that predicament might arise, start by imagining an economy that is balanced in the sense that the amount of money which households and businesses wish to save is exactly the same as the amount they wished to spend on physical investments. So far, so good. But suppose growth of potential output then fell sharply. The level of desired investment would also fall, because the needed capital stock would be smaller. But the amount that people wished to save might not fall, or not by as much; in fact, if people expect to be poorer in future, they might even wish to save more. If so, real interest rates might need to decline sharply, to restore balance between investment and savings.
Such a decline in real interest rates might also trigger a rise in the price of long-term assets and an associated surge in credit. These effects would offer a temporary remedy to the faltering demand. But if the credit boom later collapsed, leaving borrowers struggling to refinance debt, demand would then operate under a double burden. The medium-term consequences of excess debt and a risk-averse financial sector would aggravate the longer-term consequences of the weaker potential growth.
The WEO illuminates one important aspect of such a story. Potential output, it argues, is indeed growing more slowly than before. In the advanced countries, the decline began in the early 2000s; in emerging economies, after 2009. (See charts.)
Before the crisis, the principal cause of the slowdown in the advanced economies was a decline in the growth of “total factor productivity” — a measure of the output generated by a given amount of capital and labour. One explanation was the waning of the beneficial economic impact of the internet. Another was the decline in the rate of improvement in human skills. After the crisis, potential growth fell still further, partly because of the collapse in investment. The ageing of the population has also been important.
In emerging economies, too, demographic factors have been at work: the decline in the growth of the working-age population is particularly dramatic in China. Capital growth is also falling after a huge investment boom in the 2000s, again particularly in China. Growth of total factor productivity might also fall in the longer run, as the rate of catch-up on advanced economies slows.
This decline in potential growth leads directly to the debate about the savings glut and secular stagnation. Two important distinctions emerge: between the local and the global, and between the temporary and the permanent. The global slowdown in potential growth casts light on both.
Ben Bernanke, former chairman of the US Federal Reserve, rightly argues that ultra-low real interest rates should not be determined purely by local conditions. In an economy where desired savings exceed desired investment, it should be able to export excess savings via a current account surplus. That is what Germany has been doing.
Yet difficulties arise. First, as the Nobel laureate Paul Krugman notes, the real exchange rate may just not fall far enough. If so, the economy might suffer from permanent stagnation instead. Second, the rest of the world might be unable to run offsetting deficits sustainably. This was what happened in the run-up to 2007. The deficits run by the US, Spain and a number of other countries as a counterpart to the surpluses of China, the oil exporters, Germany and other high-income economies turned out to be frighteningly unsustainable.
Now turn to the no less fundamental distinction between temporary and permanent excesses of desired savings over investment. The main difference between Mr Bernanke and Lawrence Summers, former US Treasury secretary, is over precisely this.
Mr Bernanke suggests that the conditions generating ultra-low real interest rates are temporary. Obvious examples are the now-vanished surpluses of oil exporters. Again, the pre-crisis current account surpluses of China have largely disappeared. The crisis-induced slump should also be temporary.
Against this, Mr Summers suggests that at least some of the conditions predated the crisis and are likely to be longer lasting. Among these was the weakness of private-sector investment in high-income economies.
The IMF’s point about slowing potential growth supports Mr Summers. Lower potential growth might then also be less sustainable growth. If so, we might find that the world economy is characterised by weak investment, low real and nominal interest rates, credit bubbles and unmanageable debt in the long term.
Such a disappointing future is not inevitable. But we cannot assume we will enjoy a brighter one. National, regional and global reforms are needed to accelerate potential growth and reduce instability. What form these might take is a subject for another day.
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