secstags

Secular Stagnation Arithmetic by Krugman

Still playing around with the question of secular stagnation. Based on some recent conversations, it seems to me that it’s useful to put some numbers to the issue – to quantify, at least roughly, the hole that seems to have developed in sustainable demand.

In doing all this, the key point is NOT to focus on events since crisis struck; this is not a case of taking a business-cycle slump and imagining that it will last forever. Instead, the argument is that the sources of demand during the good years – the Great Moderation from 1985-2007 – are not going to be available even when the aftereffects of crisis have faded away.
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CBO thinks that we’re looking at potential growth around 1 percentage point slower than it was during the Great Moderation. To think about how this affects demand, consider the simple “accelerator”, in which producers, other things equal, invest enough to keep the ratio of capital to output constant as the economy grows. Here’s the ratio of fixed assets to GDP:

It’s somewhat above 2. This says that other things equal, a 1 percentage point drop in potential growth would reduce investment spending by 2 percent of GDP.

So between the end of rising leverage and slowing potential growth, we seem to be depressing aggregate demand by 4 percentage points. That’s a lot!
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The average real rate during the GM years was 1.9 percent. Given the factors I’ve described, it seems hard to avoid the conclusion that the average real rate looking forward will have to be negative. If inflation stays relatively low, e.g. 2 percent, this would mean an economy that often, perhaps usually, finds itself in a liquidity trap.

What might change this scenario? One key point could be trade. Before the 1980s, the US had more or less balanced trade. During the Great Moderation era, it ran an average current account deficit of 3 percent of GDP. Eliminating that deficit somehow would reverse most of my shortfalls. I would say, however, that the most likely way to reduce the deficit would be via a weaker dollar, achieved through low real interest rates, achieved in turn with a higher inflation target.