Peter Praet: Is secular stagnation the new economic reality?
Remarks by Mr Peter Praet, Member of the Executive Board of the European Central Bank, for
the policy panel entitled "How to deal with potential secular stagnation?" at the Secular Stagnation
and Growth Measurement Conference, Bank of France, Paris, 16 January 2017.
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1
The term "secular stagnation" was coined by Alvin Hansen before World War II.
Among the driving factors of the slowdown he predicted were limited population growth and lack
of innovation. A decade or so later, we had the baby boom and one of the strongest economic
expansion the world has ever experienced - in French, "Les Trente Glorieuses" started. This
experience should certainly invite all of us to be prudent with the concept of "secular
stagnation". Let's not forget that a similar panel ten years ago would have been discussing "the
Great Moderation".
Over the past 10 years, euro area growth has been particularly weak, with the level of GDP
only having surpassed its pre-crisis peak level in the third quarter of 2015. Short-term
growth prospects were periodically revised downwards, and recent estimates of euro area
potential growth are approximately 1%, compared to 1.5%-2% in the pre-crisis period.
These developments have raised the question of whether this low growth environment is in
fact the new economic reality. Central to this debate is whether the slow growth can be
attributed to cyclical - and hence ultimately transitory - factors related to the financial crisis,
longer-term structural factors, or a combination of both, whereby cyclical factors have over time
turned into permanent factors, for example via hysteresis effects.
Longer-term structural factors have certainly been at play in the euro area. The decline in
potential output growth pre-dates the financial crises, in fact going back to the mid-1990s, and
reflects a long-term slowdown in the growth of total factor productivity. This decline went largely
unnoticed. To some extent this oversight can be explained by the fact that in the decade leading
up to the crisis the overall macroeconomic environment had been stable. Remember our
debates during the Great Moderation and all the good reasons that were put forward to explain
macroeconomic stability!
Today we can look back at this period and see the expectation gaps that we could not clearly
identify in real-time. In various parts of the euro area, firms', households' and governments' future
income expectations had become disconnected from underlying growth, leading to an
accumulation of excess debt. Those over-optimistic expectations were in turn reinforced by this
renewed, yet complacent sense of economic prosperity.
So when the cycle did finally turn in 2008, several euro area countries were confronted with
pronounced "balance sheet recessions": downturns created by the need for both private and
public sectors to deleverage. This has produced a set of circumstances - a protracted slump -
that are observationally equivalent to those that one would associate with secular stagnation. But
it is important that we distinguish this from the longer-term slowdown in potential output, since it
remains ultimately a cyclical phenomenon and hence amenable to different policy tools.
So how should policymakers respond to this mix of challenges? To be effective, the policy
response should be comprehensive, consistent, well-sequenced and
incentive-compatible.
Monetary, fiscal, structural and macro-prudential policies all have a role to play. With such a
policy mix, I see no reason why we cannot lift both actual growth and trend growth back to more
satisfactory levels.
Given the distance-to-frontier of many euro area economies, there is significant scope for a
productivity catch-up with the right supply-side policies. And insofar as demand-side policies
support the cyclical recovery, and thereby address the headwinds created by protracted balance
sheet adjustments, they can prevent further damage being done to the productive side of the
economy through hysteresis effects. In this sense, secular stagnation is not predestined, but is a
possible outcome of bad macroeconomic policies.
In fulfilling its role in this comprehensive response, monetary policy is confronted with three key
challenges. These challenges are related to measurement uncertainty, policy instruments and its
relationship with other policy areas.
First, measurement uncertainty. In theory, monetary policy should track the equilibrium real
interest rate. The equilibrium real interest rate can be viewed as the interest rate consistent with
saving and investment being in balance and output being at potential, with neither upward nor
downward pressure on inflation. In practice, however, the equilibrium real interest rate is an
elusive concept, or more precisely an unobservable variable - like the output gap - whose
estimates are subject to significant uncertainty.
ECB staff estimates of the equilibrium real interest rate point to a significant decline over the past
10 years, even into negative territory. At face value, such estimates are consistent with the
secular stagnation hypothesis. But as policymakers, can we really base our actions on such an
intangible variable? My answer is no. This is why the ECB has always followed a comprehensive
monetary policy strategy, based on two pillars, and has in practice always looked at a broad
range of indicators to assess its monetary policy stance.
Second, policy instruments. Proponents of the secular stagnation hypothesis typically argue
that a low equilibrium real interest rate makes monetary policy ineffective, since interest rates
cannot fall low enough to absorb the excess of saving over investment. And though several
central banks have shown the zero lower bound is not, in fact, a constraint to the interest rate
instrument, there is an effective lower bound on interest rates, which is probably not too far from
zero.
So does that mean central banks have reached the limit of their actions? Again my answer is no.
Instead we have used non-standard measures to flatten the term structure of interest rates and
lower financing costs in the economy directly. And the ongoing economic recovery is testament
to their effectiveness. What this shows is that theoretical constraints can be lifted in practice,
because the economy is much more complex than models can capture.
Third, the relationship of monetary policy with other policy areas. This is the thorniest issue.
There is always a risk for a central bank of becoming the only game in town, even though large
parts of the growth challenge are clearly beyond its remit. The drivers of long-term growth are
innovation, technology diffusion, which is to say, productivity growth. To manage this risk, central
banks should always staunchly stick to their mandate. This is the only way for them to do their
part effectively while ensuring that the overall policy response remains comprehensive,
consistent, well-sequenced and incentives-compatible.