Is the economy suffering from "secular stagnation"?

Recently, an old term connected to an old worry in the U.S. has reentered economic research and discourse: "secular stagnation"

The term secular stagnation originated with Alvin Hansen in the late 1930s. Hansen, a Harvard economist, was worried that slower population growth and a slower rate of technological progress would result in less investment and reduced economic growth. He believed that strong growth in investment was needed to maintain full employment, and with investment growth waning the only solution would be for the government to run a persistent budget deficit and make up for the lost investment demand.

Hansen's prediction did not come true -- the baby boom eliminated worries about population growth, and technological growth remained strong. But it did inspire considerable discussion and criticism when it was first proposed.

Recently, Larry Summers, until recently a top economic adviser to President Obama, has revised the secular stagnation thesis based on evidence such as this graph showing U.S. GDP running consistently below its potential:

Act-pot

Summers believes we are in a situation where savings is greater than investment -- that is, the demand for investment funds and the supply of funds are not in equilibrium. In such a situation, when investment demand is low, the economy will experience higher than normal rates of unemployment.

Normally, when this happens there is downward pressure on the inflation-adjusted interest rate (what economists call the real interest rate). The fall in the real interest rate causes investment to increase because its cheaper to borrow money to finance new ventures, and it causes saving to fall since the reward for saving -- interest income -- is smaller. This continues until saving and investment are again brought into balance, and at that point the economy will return to full employment.

But what if there is something that stops the interest rate from falling? For example, what if when the Federal Reserve's target interest is just above zero, as it is now, and cannot fall further? In such a case, economic output will be persistently below potential (as in the graph above), unemployment will be persistently elevated and the problem will not cure itself in an acceptable amount of time.

The solution, according to Summers, is for government to undertake massive infrastructure investment and fill the investment void in the private sector. With interest rates at rock bottom, infrastructure investment will be cheap to finance, and it will provide needed jobs for the unemployed.

Summers may or may not be correct about secular stagnation -- time will answer that question -- but it has certainly sparked a lively conversation within the economics profession and beyond.

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