Will the pandemic trap economies in secular stagnation?

[This art­icle is a sum­mary of an in-depth ana­lys­is pub­lished at vari​ances​.eu, for the ori­gin­al art­icle click here]

It is a rare event: in 2020, eco­nom­ic activ­ity in the developed world fell by 5.3%. As such, the Cov­id-19 crisis could trap eco­nom­ies in “sec­u­lar stag­na­tion”, a pro­longed peri­od of slug­gish growth. Three factors sup­port this hypo­thes­is: a decline in poten­tial out­put, changes in house­hold and busi­ness beha­viour, and the accel­er­a­tion of the digit­al trans­ition, which is a major factor in inequality.

His­tory shows that deep reces­sions often have last­ing con­sequences on the main mac­roe­co­nom­ic vari­ables (GDP, pro­ductiv­ity, unem­ploy­ment), even after the ini­tial shock has fully dis­sip­ated. This is known as “hys­ter­esis”: the phe­nomen­on that caused the crisis (in this case the pan­dem­ic) dis­ap­pears, but the crisis con­tin­ues in the long term. 

This hys­ter­esis effect will play a par­tic­u­larly import­ant role in the case of work­ers who have been thrown out of work by numer­ous bank­ruptcies. If the work­ing pop­u­la­tion has been spared the vir­us, which mainly affects older people, then mass redund­an­cies could res­ult in a loss of employ­ab­il­ity of work­ers, who would then struggle to find a job after the crisis. But the adverse effects will also affect phys­ic­al cap­it­al accu­mu­la­tion and productivity.

Many developed eco­nom­ies entered this crisis in a vul­ner­able state, with his­tor­ic­ally low interest rates and huge debt bur­dens. Since the subprime mort­gage crisis, cent­ral banks lowered policy rates to almost zero and resor­ted to uncon­ven­tion­al policies (not­ably quant­it­at­ive eas­ing). But this did not trans­late into a sat­is­fact­ory recov­ery in activity. 

The eco­nom­ic rebounds were mod­er­ate and tem­por­ary, while under­ly­ing infla­tion remained stub­bornly low, long-term interest rates con­tin­ued their down­ward trend, and stock mar­ket valu­ations rose. Over­all, mon­et­ary policy since 2008 has paved the way for the accu­mu­la­tion of fin­an­cial vul­ner­ab­il­it­ies – explod­ing lever­age, excess­ive risk-tak­ing, asset bubbles – without provid­ing a sus­tain­able boost to activ­ity. And the Cov­id-19 crisis threatens to accen­tu­ate this dynam­ic. The cent­ral banks are now cornered: it is impossible for them to con­tin­ue lower­ing their rates.

The interest rate that cent­ral bankers seek to achieve is the ‘nat­ur­al’ interest rate – the the­or­et­ic­al real interest rate at which the eco­nomy is neither infla­tion­ary over­heat­ing nor defla­tion­ary depres­sion. It is estim­ated that this rate has fallen over the last few dec­ades to the point where it is close to zero, mak­ing con­ven­tion­al mon­et­ary policies inef­fect­ive. The explan­a­tion for this decline lies in the imbal­ance between too much sav­ing and too little investment. 

The cur­rent excess of sav­ings is partly due to the increase in inequal­it­ies – the mar­gin­al propensity to save of the most for­tu­nate being clearly high­er than that of the least for­tu­nate – but also to the efforts to reduce debt made since 2008, as well as to the age­ing pop­u­la­tion (older people hav­ing a great­er tend­ency to save in anti­cip­a­tion of their retire­ment). The fall in busi­ness invest­ment is, for its part, mainly a con­sequence of the weak­en­ing of growth poten­tial, syn­onym­ous with a decline in future real returns on investment. 

The sec­u­lar stag­na­tion hypo­thes­is assumes that cent­ral bank policy rates will remain so low that cent­ral banks will fre­quently be unable to reduce them suf­fi­ciently to com­bat reces­sions effect­ively. Con­strained by the effect­ive lower bound on rates, the eco­nomy can only move towards full employ­ment if gov­ern­ments increase the gov­ern­ment defi­cit or if mon­et­ary policy becomes highly expan­sion­ary, encour­aging the dis­tri­bu­tion of cred­it and the rise in asset prices that become the engine of growth. 

An eco­nomy suf­fer­ing from sec­u­lar stag­na­tion is not going to remain per­man­ently stag­nant. But the under­pin­nings of growth – the inflat­ing debt and asset price bubbles – increase the economy’s vul­ner­ab­il­ity to crises. Decline in activ­ity due to crises become stronger and longer than recov­er­ies, mech­an­ic­ally lower­ing aver­age GDP growth.

The Cov­id-19 crisis is likely to aggrav­ate the prob­lem of excess sav­ings. One reas­on for this is that “extreme” risk events – also known as “black swans” in the fin­an­cial sec­tor – often lead to a chal­lenge to old belief sys­tems. As eco­nom­ists have poin­ted out, “The greatest eco­nom­ic cost of the Cov­id-19 pan­dem­ic may be the res­ult of beha­vi­our­al changes that per­sist long after the imme­di­ate res­ol­u­tion of the health crisis ¹.”

The seis­mic shock of the pan­dem­ic could res­ult in a struc­tur­al increase in risk aver­sion of firms and house­holds, lead­ing to a reduc­tion in their invest­ment and con­sump­tion spend­ing, in order to build up a lar­ger sav­ings cush­ion for future crises. A fall in con­sump­tion, which means few­er oppor­tun­it­ies for com­pan­ies, gen­er­ally res­ults in a fall in invest­ment. Moreover, the inclu­sion of epi­demi­olo­gic­al risk is likely to increase the risk premi­um required to jus­ti­fy cer­tain pro­duct­ive invest­ments, fur­ther curb­ing the accu­mu­la­tion of phys­ic­al capital. 

Cov­id-19 could also con­trib­ute to sec­u­lar stag­na­tion by exacer­bat­ing socio-eco­nom­ic inequal­it­ies. The sec­tors most affected by the cur­rent crisis are those employ­ing an irreg­u­lar work­force (such as the hotel industry). But the expo­nen­tial devel­op­ment of the digit­al eco­nomy since the begin­ning of the pan­dem­ic is also a vec­tor of inequal­ity, for two main reas­ons: it favours highly qual­i­fied work­ers (this is known as « skill-biased tech­no­lo­gic­al change »), and leads to the robot­isa­tion of routine tasks, which were mainly car­ried out by low- or medi­um-skilled labour. 

How­ever, as the most afflu­ent are those with the highest propensity to save, the phe­nomen­on of excess private sav­ings at the ori­gin of the fall in the nat­ur­al rate of interest should become even worse.

Nev­er­the­less, sec­u­lar stag­na­tion is not an evil without a rem­edy: fisc­al policy has an import­ant role to play in its res­ol­u­tion, by absorb­ing excess private sav­ings via an increase in pub­lic defi­cits ². Moreover, the digit­al trans­form­a­tion could res­ult, as some pre­dict, in a pro­ductiv­ity boom that would boost eco­nom­ic growth.