What are the risks of secular stagnation for the eurozone? (Study)

Abstract:

– The weak economic growth outlook in the euro area, against a backdrop of low inflation and low interest rates, is fueling the debate around « secular stagnation »;

– Too much saving and too little investment, due to high debt levels and unfavorable demographic prospects, are holding back potential growth, while the scope for macroeconomic policy appears limited;

– An appropriate policy mix, supporting investment, strengthening the stability of the banking sector, combating income inequality, and improving coordination within the eurozone could help overcome these obstacles.

On secular stagnation, structural reforms, and long-term economic challenges, see articles by Guillaume Claveres, BertrandAchouet , andSimon Ganem.

The European Commission forecasts that potential growth in the eurozone is unlikely to exceed 1% per year between now and 2024, compared with an average of 1.5% over the period 1999-2008. Beyond the hysteresis effects of the double crisis between 2008 and 2012, it would appear that the eurozone is facing a gradual slowdown in its long-term growth. In this scenario, the eurozone would not return to its pre-crisis growth level, which some economists perceive as a risk of « secular stagnation. »

While these questions first arose in an attempt to explain the weak economic growth of advanced countries due to insufficient aggregate demand, it is also important to consider the effects of the crisis on economic structures and on the ability of aggregate supply to boost potential growth. In a context where conventional monetary policy tools no longer enable central banks to achieve their objectives, and where high debt levels are hampering the recovery of private and public investment, what economic policy levers can euro area countries use to avoid secular stagnation?

Three approaches to secular stagnation

Secular stagnation generally refers to a situation where an economy is faced with a combination of low growth and low inflation in a context of low interest rates. This definition, given by Hansen in 1938, resurfaced in 2013 in a speech by Lawrence Summers[1]. There are three different approaches to interpreting this concept.

The first approach focuses on the reasons for the decline in potential growth. Developed by Robert Gordon, this approach highlights several obstacles that developed economies will face in the future:

· Lower productivity gains from technical progress in new technologies;

· Demographic factors: the aging population and the resulting increase in the dependency ratio are likely to lead to an increase in savings. In the EU, the working-age population is expected to represent less than 60% of the total population in 2035 (compared to 67% in 2000), while the share of people over 65 in the population is expected to reach 26% in 2035 (compared to 16% in 2001);

· Education levels in advanced countries are not expected to undergo as significant a revolution as they did in the second half of the 20th century;

· The growth in income inequality in favor of households with the lowest marginal propensity to consume is also likely to lead to an increase in savings.

· High public debt in advanced economies may constrain fiscal policy and limit the public investment needed for growth (innovation, education, infrastructure, etc.).

These factors are significant barriers to investment (the investment rate fell from 21.6% in 2007 to 19.8% in 2015) and therefore to future job creation. To overcome these obstacles, the solution lies more in fiscal policies to support research, investment, greater labor market participation, and better wealth distribution.

Figure 1. Components of potential growth in the euro area, 1999-2025

Source: European Commission

The second approach emphasizes the ongoing deterioration in growth potential since the financial crisis. According to this approach, weak demand, hysteresis[3] and the legacy of the crisis are limiting production capacity. High long-term unemployment reduces the productivity of discouraged workers who see their skills and employability deteriorate, while corporate and banking sector debt limits the recovery of investment and capital formation.

Looking more specifically at the euro area, it is clear that the obstacles inherited from the financial crisis are still weighing on economic recovery. Unemployment, particularly among young people, remains too high in many countries, while the proportion of long-term unemployed is increasing, raising fears of hysteresis in unemployment. In addition, poor job prospects and the need to clean up the banking sector in the euro area are limiting investment and job creation. Beyond the positive effects of monetary policy on financial conditions and access to credit, cleaning up the banking sector is essential for reviving investment. The significant weight of non-performing loans on bank balance sheets is prompting some banks to limit risk-taking as much as possible and to focus primarily on improving their capital ratios. Here, the solution lies more in policies to support employment (fiscal policy, structural policies) and policies to promote the stability of the banking sector, such as progress towards the establishment of a banking union in the EU.

Figure 2. Corporate and household debt in the EU

Source: European Commission

The third approach focuses on the fact that current macroeconomic policies lack the leeway to stimulate growth. First, fiscal policies in the euro area are constrained by high levels of public debt, which do not allow for sufficient support for growth. Fiscal consolidation policies have limited demand growth and a rapid return to lower unemployment and higher investment rates.

Second, the combination of increased savings and lower investment is causing the equilibrium interest rate (the interest rate that balances savings and investment needs) to fall. Some economists even believe that this rate is currently negative in the euro area. In a context of very low inflation, conventional monetary policy, constrained by already very low interest rates, cannot reach the equilibrium interest rate. This results in excess savings and a level of investment that is too low to contribute significantly to growth. This mechanism is illustrated in Figure 2. In this case, monetary policy must find ways to circumvent the zero lower bound constraint, while fiscal policy must find room for maneuver to support growth without undermining the stability of public finances.

Figure 3. Equilibrium interest rate and zero lower bound

Source: ECB

These three approaches coincide on one point: a distinction must be made between short-term stagnation, i.e., low interest rates and the need to boost investment, and long-term stagnation, which combines a structural decline in demand with a deterioration in production capacity.

What levers are available for economic policy in the eurozone?

While the eurozone has several characteristics that raise fears of a slowdown in long-term growth, governments and the central bank still have room for maneuver to overcome these obstacles through appropriate macroeconomic policies.

Fiscal policy

More accommodative fiscal policies (in the form, for example, of tax breaks for households and businesses or increased public investment) are essential to boost demand, employment, and investment prospects for businesses. Fiscal policy support must, at least in part, take over from an over-indebted private sector (134% of gross value added of non-financial corporations in the second quarter of 2016) and stimulate economic recovery. In a context of high private debt, fiscal consolidation policies are weighing negatively on domestic demand growth and thus limiting the market prospects for businesses, which are postponing their investments. Added to this is the fact that capacity utilization rates remain below their pre-crisis levels in the euro area, which also contributes to postponing investment and hiring decisions by businesses. Initiatives such as the European Fund for Strategic Investments should help to increase growth potential by targeting investments in infrastructure, innovation, and education. According to Rogoff, the low interest rate environment provides an opportunity to limit the cost of these investments to public finances.

However, the room for maneuver remains limited, which reinforces the importance of increasing the efficiency of public spending in order to preserve the stability of public finances. Public transfers play a key role in protecting low-income households. Social protection spending and housing assistance for these households should help offset rising income inequality and thus support demand through private consumption.

Monetary policy

While conventional monetary policy tools are showing their limitations, the European Central Bank (ECB) still has several options for trying to circumvent the ZLB constraint and thus restore a balance between savings and investment that is more conducive to growth.

Firstly, unconventional methods of quantitative easing with purchases of private bonds (almost €10 billion in September 2016, out of a total program of around €80 billion) and the ECB’s refinancing operations for the banking sector since 2015 should help to lower interest rates and stimulate economic activity through exchange rates and the revival of credit.

Secondly, the ECB’s forward guidance policy aims to raise inflation expectations and stimulate a recovery in investment by allowing financial markets to anticipate that monetary policy will remain accommodative in the medium term.

Finally, the introduction of negative interest rates on commercial banks’ reserves held with the ECB should also make it possible to circumvent the zero lower bound. The effective floor for interest rates could in fact be below zero. This negative interest rate aims to lower interbank market rates and thus encourage investment by reducing the cost of credit. However, there is still a limit, as excessively negative interest rates pose risks to the profitability of the banking sector.

Structural policies

Firstly, it is important to strengthen the stability of the European banking sector by making progress in establishing the various pillars of the Banking Union. Single supervisory and resolution mechanisms and deposit guarantees in the EU can improve the transmission of monetary policy by supporting credit supply and restoring confidence in the interbank market. The establishment of a single system for restructuring over-indebted financial institutions and regular reviews of the quality of financial assets is essential, given the importance of bank credit in the financing of European companies.

At the macroeconomic level, the reallocation of production factors to the most productive sectors could lead to productivity gains, while migration flows to Europe, if accompanied by mechanisms for integration into the domestic labor market, could help limit the negative effects of demographic trends on long-term growth.

Conclusion

Several causes have been put forward to explain the current weak economic growth in the eurozone. In summary: too much savings and too little investment, due to high debt levels and unfavorable demographic prospects, are holding back potential growth in a context of limited room for maneuver for macroeconomic policies. In the euro area, most of the obstacles may appear to be temporary (debt, low inflation) and are mainly a legacy of the financial crisis.

However, population aging, the structural slowdown in productivity gains, and the negative impact of hysteresis phenomena on production capacity raise fears of a slowdown in long-term growth prospects. That said, appropriate macroeconomic policies to support investment, strengthen the stability of the banking sector, combat income inequality, and improve coordination within the eurozone could help overcome these obstacles.

Bibliography:

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· Glaeser, E L (2014), « Secular joblessness, » VoxEu blog

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· Summers (2015), « Demand-side secular stagnation, » American Economic Review, Vol. 105, No. 5, pp. 60-65

· Wolff, G B (2014), « Monetary policy cannot solve secular stagnation alone, » Bruegel blog