Thinking of the Secular Stagnation Hypothesis: It is Japan that is facing the serious problem of low investment returns

Faculty Fellow, RIETI

The possibility of the U.S. economy being trapped in "secular stagnation" has been at the center of debate among American economists and policymakers since November 2013, when former U.S. Secretary of Treasury Lawrence Summers, currently a professor at Harvard University, suggested the idea in his address at a conference of the International Monetary Fund (IMF).

Summers presented the hypothesis that the U.S. economic recovery from the 2008 financial crisis has been slow because the equilibrium real interest rate—i.e., the level of real interest rates that is consistent with full employment—has been kept below zero for so long. As one specific factor behind the slow recovery, he cited a decrease in investment demand resulting from slower growth in labor force and productivity.

The secular stagnation hypothesis in the United States dates back to 1938. Alvin Hansen, then professor at Harvard University, described the weak recovery from the Great Depression and the prolonged unemployment problem as "secular stagnation," which he attributed chiefly to declining demand for investment caused by a slower population increase. Summers' argument basically follows Hansen's old theory of secular stagnation in its definition of secular stagnation and focuses on declining demand for investment and demographic factors.

Some economists are critical of his view. Professor John B. Taylor of Stanford University believes that the current slow recovery is a result of failed economic policies in the 2000s. He argues that excessive monetary easing and lax financial regulations prior to 2005 were responsible for the development and collapse of the housing bubble, while policy responses and their consequences thereafter—i.e., a jumble of new rules and regulations, the accumulation of government debt, and discretionary monetary policy—are the cause of the tardy recovery.

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How can we evaluate these arguments from a long-term historical perspective? Since the secular stagnation hypothesis focuses on trends in investment and real interest rates, the upper chart in the figure below shows the investment rate (measured as the ratio of gross fixed capital formation to the gross domestic product (GDP)) and the real interest rate (calculated as the difference between the yield on long-term U.S. Treasury bonds and the growth rate of GDP deflator) from the mid-19th century through the present. Data obtained from multiple sources, including the Historical Statistics of the United States and reports from the Council of Economic Advisers, have been used because no single set of continuous data covering the entire period is available.

First, let's take a look at the trends in recent years, upon which Summers focuses. The investment rate, which began to fall after the 2008 financial crisis, hit bottom in 2010 and has been on an uptrend since then. However, it still remains below the pre-crisis level. Meanwhile, the real interest rate has fallen below 1%, which is significantly lower than the level observed prior to the crisis.

A decline in the investment rate under a lower real interest rate implies a decrease in the expected rate of return on investment, which represents the prospect of how much revenue will be generated by capital investment. Summers' secular stagnation hypothesis is based on this phenomenon.

Now, let's extend the time scope and look at the situation in the latter half of 1930s, the period in which Hansen came up with his theory of secular stagnation. Back then, the real interest rate was around 0% and the investment rate at around 10%. Compared with this, the current performance of the U.S. economy is fairly good.

Meanwhile, data from the 1950s through the 1970s indicate that the situation in recent years is not necessarily so anomalous in the history of the U.S. economy. During that period of time, it was not rare to see the real interest rate falling to around 0% to 1%, and the investment rate at around 15% to 17%, a level comparable to that seen today. Given these observations, it is at least premature to characterize the current state of the U.S. economy as secular stagnation.

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What about the situation of the Japanese economy? The long-term movements of the investment rate and the real interest rate in Japan, plotted on the lower chart in the figure, are distinctively different from those of the United States.

Figure: Investment Rates and Real Interest Rates in the United States and Japan
(Investment rate = Ratio of gross fixed capital formation to GDP)

Figure: Investment Rates and Real Interest Rates in the United States and Japan<br />(Investment rate = Ratio of gross fixed capital formation to GDP)
[Click to enlarge]
Note: Created by the author based on data obtained from multiple sources including the Historical Statistics of the United States.

First, the investment rate showed a long-run upward trend from the 1930s through the first half of the 1970s, followed by a continuing downward trend from the latter half of the 1970s to date.

The upward trend was brought on by a series of major episodes in the history of the Japanese economy, which include an extremely expansionary fiscal policy instituted by prewar Finance Minister Korekiyo Takahashi, wartime government programs to expand production capacity, postwar reconstruction, and the subsequent long-run high growth. Noteworthy here is the fact that the real interest rate remained at a very low level almost throughout this period. Japan's real interest rate was significantly negative during the war and stayed mostly within the 1% and 3% range during the postwar high growth period.

These trends in the investment rate and the real interest rate are, in large part, a reflection of the government's economic policies in each phase of the history. In the first half of the 1930s, Japan pursued low interest rates and moderate inflation under the so-called Takahashi policy geared toward offsetting deflationary pressure caused by the lifting of the ban on gold exports and an austerity policy. During the wartime period, inflation accelerated against the backdrop of the government's direct intervention to control the allocation of credit by private-sector banks and the issuance of government bonds through direct and private placement with the Bank of Japan (BOJ) for the purpose of financing the war.

Then, in the postwar period, the government implemented the so-called "artificially low interest rate policy" following the subsiding of the reconstruction boom-driven hyperinflation and throughout the high growth period, by means of regulating interest rates primarily on bank deposits. In other words, from the early 1930s through the first half of the 1970s, the period in which the investment rate was on the upward trend, the real interest rate was kept low and investments were stimulated generally by means of government policy, though specific measures varied from time to time.

Meanwhile, the shift to the downward trend in the investment rate in the mid-1970s coincided with an upturn in the real interest rate, which occurred against the backdrop of the development of the government bond market and the liberalization of interest rates prompted by massive issues of government bonds from 1975 onward. In other words, the transition to the downward trend in the investment rate was triggered by the end of the low interest rate policy regime that had been maintained since the 1930s in varying forms.

However, it should be also noted that the real interest rate turned into a moderate downward trend in the 1980s, while the investment rate continued on its downward path.

In terms of debate over Japan's monetary policy, the real interest rate was stuck at a higher than desired level because of deflation which is often blamed as a cause of Japan's lost two decades. In fact, however, the real interest rate dropped from an average of 4.1% in the latter half of the 1980s to 2.7% in the latter half of the 2000s. That is, the downward trend in the real interest rate and that in the investment rate have occurred concurrently in Japan for more than 30 years since the 1980s.

This means that the expected rate of return on investment has been on a declining trend over a long period of time. As such, the term "secular stagnation" is more apt for the Japanese economy than for the U.S. economy.

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As Summers points out regarding the case of the United States, lowering the already low real interest rate by increasing inflation as a way to deal with secular stagnation presents a risk of creating financial bubbles. Furthermore, promoting investments by keeping real interest rates at an excessively low level may hamper economic efficiency.

If Japan is to avoid these outcomes, there are two possible policy options to emerge from its secular stagnation. The first option is to raise the expected rate of return on investment. The government's new growth strategy announced in June 2014 can be seen as a policy along this line.

The second option, which would not necessarily be inconsistent with the first one, is to boost consumption as a contributor to economic growth. A lack of investment means too much savings. Indeed, besides the lack of sufficient investment, Summer points to weaker consumption resulting from increasing inequality in income distribution as a factor behind secular stagnation.

Japan also has been witnessing growing inequality in income distribution since the 1980s. At the same time, however, Japan is also undergoing demographic aging, a larger and longer-term trend. Reflecting the lifetime pattern of income and consumption, the aging of a country's population leads to a lower savings rate at the macroeconomic level. And this phenomenon is already present in Japan. Promoting investment excessively under this situation would cause an increase in the current account deficit.

One possible direction for the Japanese economy is to transform its structure into one built around consumption by the elderly as a growth engine, for instance, by developing consumer goods and services attuned to the needs of the growing elderly population and shifting resources to industries that provide such goods and services.

>> Original text in Japanese

* Translated by RIETI.

July 16, 2014 Nihon Keizai Shimbun

August 11, 2014