Paul Krugman steps in to clarify the distinction between stagnation in growth rates brought upon by a reduced growth in supply – population, technology, participation – and demand. His piece was prompted by Gavyn Davies’ reporting on some econometrics that hope to establish whether or not we are experiencing secular stagnation.
First, on Krugman. I don’t think he quite gets the policy implications of the two right. In particular, he says that the only thing to do if we have supply-side stagnation is to live within our reduced means [if indeed they are reduced; lower population growth doesn’t mean slower growth in GDP per head]. By contrast, if the stagnation is induced by persistently weak demand, then we need higher expected (thus actual) inflation, or looser fiscal policy, or both.
However, if stagnation is supply-side induced, then more inflation is warranted. Let’s suppose that the nominal interest rate consistent with the economy running at full capacity will equal roughly the real growth rate plus the inflation rate. Higher inflation will be needed, or other wise there will be less room to cut nominal interest rates to fight contractions in demand that will come, superimposed on the slower supply side growth. Less room to cut rates will mean more and longer episodes at the zero lower bound and more recourse to unconventional monetary instruments of uncertain effect and cost. And this preventative higher target inflation is needed for the same reason that it would be needed to guard against a future bout of demand-side secular stagnation – allowing deeper and more prolonged monetary stimulus. So, in fact, the monetary policy implications of the two growth pathologies overlap somewhat.
Second, on Gavyn Davies. He reports results from a dynamic factor model that show how the underlying, ‘long run’ growth rates of Western economies have been slipping for a long time, and that the poor performance is not just a feature of the crisis. [Long run in quotes here, because now the long run is something that moves around in the short run]. The factor estimated in the econometrics picks up the thing that the many manifestations of output – not only national accounts data, but survey data, whatever gets thrown into the pot – have in common. That thing in common seems to be growing at an ever slower rate. Whether the econometrics helps identify the cause depends on what kind of macro theory you buy into.
If you are a sticky price New Keynesian, and you have digested the analysis of the zero bound and how economies can get trapped there (and taken recent history to vindicate you), and/or you have bought the conjectures of Summers and others about persistently weak demand, and the emerging theoretical support from Eggertson’s recent working paper, then you will not find econometrics like this helpful in identifying causes. Why? Because you will be someone who thinks that there can be both persistent demand and supply side influences on output.
If you are a flex price macro person you will think the zero bound pretty much irrelevant to the real side of the economy. And persistent – in fact any – departures of demand from supply won’t make sense to you. So the secular stagnation hypothesis, and the necessity of a large and protracted fiscal stimulus to counter it, will not make sense either. Your reading of a factor model for output will simply be one that distinguishes between high and low-frequency, equilibrium influences.
This factor model’s chart of long-run output growth will only be indicative of its causes if you are a sticky price macro person who hasn’t yet bought the demand-side secular stagnation hypothesis. In that case you’ll take the view that low-frequency changes in the growth rate of output will be caused by the supply-side. Since at low frequencies (over long periods) prices can change, equalising demand and supply.