Secular Stagnation in the West?

A speech by former U.S. Secretary of the Treasury Larry Summers at a recent IMF conference has been the subject of considerable media debate. Martin Wolf devoted his weekly column in the Financial Times to discussing the details of Summer’s arguments.

Summers’s basic message was clear and depressing at the same time: The western world faces a long period of low growth, a “secular stagnation” similar to the lost decades in Japan.

Summers thinks the reason for the secular stagnation is “excess savings.” For many years, the world has saved more than it has invested, leading to ever lower interest rates, which still fail to establish a new equilibrium between savings and investment.

The most visible results of these imbalances, he maintains, are the persistent trade imbalances in the world. Countries such as China, Germany and Japan run surpluses (i.e., they save more then they invest). Meanwhile, the United States, UK and the periphery of Europe run deficits (i.e., they spend more then they earn, mostly on consumption). These imbalances are also behind the intense criticism Germany faced recently in view of the trade surplus it is running.

These excess savings have not lowered interest rates enough to stimulate investment, as interest rates need to be even lower than they are today to get investment flowing. Therefore, Summers expects a prolonged period of low growth.

Summers believes that the implications of such a secular stagnation would be fatal for economies, which already suffer from excessive debt burdens in the private sector and the government. Only with higher growth rates would it be possible to deal with these debt burdens. The lower the growth rates, the higher the probability of debt restructurings and defaults.

Finally, low growth would also further undermine the ability of governments to fulfill their promises for pensions and the health care systems of aging societies.

Simple facts and simple solutions?

The facts seem to underpin Summers’ arguments. The recovery of the western economies from the crisis remains sluggish, with all countries of the west below pre-crisis trend growth. Only the United States and Germany show a higher nominal GDP than before the crisis.

The growing debt burden in most countries is another such fact. These countries used the excess funds to finance consumption, not to invest more in the capital stock.

Even before the crisis, interest rates were very low due to the excess savings of some countries, such as China’s buying U.S. government bonds to suppress its own exchange rate and stimulate export growth. On the other hand, it is without doubt that the central banks, notably the U.S. Fed, followed a very loose monetary policy even before the crisis, therefore lowering interest rates as well.

The solutions to these problems as discussed in the media so far look simple. First, introduce negative interest rates – as discussed in Europe – to make investment attractive and saving money less attractive. Second, give incentives to corporations to invest and use the money to embark on credit-financed public spending on infrastructure and other investments.

One commentator in Europe even suggested implementing rules to not allow payments in cash, so that people cannot store money at home and thereby avoid the negative interest rates. He also suggested nationalizing the banks to force them to lend money. Wow, who could have imagined this?

Looking beyond the surface

On the surface Summers’ analysis seems to be valid, but only on the surface. We have to look more beyond the obvious when we look at the fiscal crisis in the western world.

We do not necessarily have a problem of excess saving – but rather one of excess debt. All savings by definition have a mirror image in debt and equity assets. Some of these debts are visible to the creditor, as when owning a bond from a corporation or a government. Other credits are given indirectly via banks and insurance companies.

This relationship between assets and debt is particularly true in our fiat monetary system, because all money is created by creating additional debt. Simply said: Money is debt.

The increase in debt (called receivables, savings, wealth or whatever) since 1980 is impressive: The debt of governments, non-financial corporations and private households more than doubled from 160% of GDP to about 350% of GDP today.

In real terms, corporations have more than three times, governments more than four times and private households more than six times as much debt as in 1980.

Eroding growth impact of debt

The impact of these additional debts on the real economy has eroded over time. In the first years after WWII, one dollar of additional debt led to $4.60 of new GDP. Between 1985 and 2000, only 24 cents of new GDP was created for one more dollar of debt.

Between 2001 and 2012, only 8 cents of new GDP was created for one more dollar of debt. Debt, then, has a deteriorating marginal impact on economic growth!

What lies behind this development? An ever-bigger kind of new credit was used to pay for consumption in the form of social welfare and consumer credit and to pay for speculation in financial markets and in real estate.

As the economic benefit of debt eroded and the real return in the form of additional GDP did not materialize, debtors had more and more difficulty earning the money to pay interest and to pay back the loans.

Debtors therefore started to roll over outstanding credit and to borrow the money they needed to pay interest. As Hyman Minsky would have said, they embarked on Ponzi finance. As a result, debt levels (and wealth!) continued to grow ever faster.

The debt repayment catch-22

As an ever-bigger part of new debt is only used to “pay” for the outstanding debt – to keep the illusion intact that the debt will be served in the end – the growth rate of the economy deteriorates further.

This makes it ever more difficult for the debtors to truly earn the money needed for debt service. If they start to save and pay back – deleveraging – the economy gets even more depressed. This can be seen in major parts of Europe today.

As debt grows, financial assets and wealth grow as well, because they are two sides of the same coin. The owners of the assets feel richer as their bank accounts and depots grow. In reality, the quality of their assets deteriorates, as the debtors are less and less able to truly serve their debt.

But as long as new credit is granted to “pay” the interest on the outstanding debt, the illusion of existing and growing wealth is maintained.

The long-term outlook

The continued growth of debt and assets leads to a concentration of wealth over time as only those who own assets benefit from interest payments and monetary stimulus in financial markets.

As the wealthy save more of their income compared to the average household and the poorer households have no more capacity to borrow for consumption, overall consumption stagnates or shrinks and leads to even lower growth in the real economy.

In an environment of low growth, deleveraging and increased uncertainty, it is rational for corporate managers to focus on mergers and acquisitions to consolidate their markets and to defend their margins instead of investing.

Governments at the same time have to reduce deficits as well and cannot invest as they run the risk of losing the confidence of the creditors.

In this context, it becomes clear that the proposal to stimulate private and public investments with negative interest rates and other incentives will not be enough. To avoid a secular stagnation with direct or indirect defaults, the west needs to implement drastic measures. These have to focus on:

• Reducing excess debt
• Increasing the growth potential of economies
• Reforming the financial system.

As previously discussed, there is no pain-free solution to the excessive level of debt in western economies. Neither saving and paying back nor growing out of the problem will work.

We will have to think about debt restructuring, probably financed by wealth taxes, as recently brought forward by the IMF. Since a big proportion of the wealth is an illusion, as debtors will never be able to serve their obligations, this seems to be a viable – although not popular – option.

In addition, the western economies need to embark on a program of fundamental reform.