Thursday, December 12, 2013

Secular Stagnation: Back to Alvin Hansen

In December 1938, one of the most eminent economists of the time, Alvin E. Hansen, delivered the Presidential Address, titled "Economic Progress and Declining Population Growth," at the annual meetings of the American Economic Association. Looking at the economy of the late 1930s, Hansen wrote:"This is the essence of secular stagnation--sick recoveries which die in their infancy and depressions which feed on themselves and leave a hard and seemingly immovable core of unemployment." The idea of "secular stagnation" has received considerable attention in the last month after it was involved in a talk given by Larry Summers at an IMF conference as a framework for thinking about the discomfiting state of the economic recovery. A round-up of some commentary and responses to the Summers talk is available here. In this post, I'll sketch out what Hansen actually said, give a sense of why the "secular stagnation" hypothesis was widely disregarded in recent decades, and suggest how I see the modern lessons.

(Note: Hansen's speech was published in the American Economic Review in March 1939. The AER isn't freely available on-line, but many readers will have access through a library subscription to JSTOR or through their own membership in the American Economic Association. Full disclosure: I have worked since 1986 as the Managing Editor of the Journal of Economic Perspectives, which is another journal published by the AEA.)

Hansen argued that an economy needed strong and healthy levels of investment if it was to maintain full employment. He wrote: "For it is an indisputable fact that the prevailing economic system has never been able to reach reasonably full employment or the attainment of its currently realizable real income without making large investment expenditures."

Hansen listed three factors that he thought had been especially important in encouraging the needed levels of investment in earlier decades of U.S. history: "[F]or our purpose we may say that the constituent elements of economic progress are (a) inventions, (b) the discovery and development of new territory and new resources, and (c) the growth of population. Each of these in turn, severally and in combination, has opened investment outlets and caused a rapid growth of capital
formation." Hansen pointed out that population growth had slowed down and that US territory was no longer expanding. Thus, he argued: "We are thus rapidly entering a world in which we must fall back upon a more rapid advance of technology than in the past if we are to find private investment
opportunities adequate to maintain full employment. ... It is my growing conviction that the combined effect of the decline in population growth, together with the failure of any really important innovations of a magnitude sufficient to absorb large capital outlays, weighs very heavily as an explanation for the failure of the recent recovery to reach full employment."

Indeed, Hansen argued that in some cases, new technologies might even lead to less need for invention: "Moreover it is possible that capital-saving inventions may cause capital formation in many industries to lag behind the increase in output." In a modern context, one can imagine certain ways in which the growth of information technology makes capital investment more effective and efficient--and thus reduces the need for certain other kinds of investment spending.

Further, Hansen was skeptical about whether either monetary or fiscal policy could provide a long-lasting answer. He was skeptical that lower interest rates could encourage the large and vigorous investment levels that he felt were needed: "Less agreement can be claimed for the role played by the rate of interest on the volume of investment. Yet few there are who believe that in a period of investment stagnation an abundance of loanable funds at low rates of interest is alone adequate to produce a vigorous flow of real investment. I am increasingly impressed with the analysis made by Wicksell who stressed the prospective rate of profit on new investment as the active, dominant, and controlling factor, and who viewed the rate of interest as a passive factor, lagging behind the profit rate. This view is moreover in accord with competent business judgment. ... I venture to assert that the role of the rate of interest as a determinant of investment has occupied a place larger than it deserves in our thinking. If this be granted, we are forced to regard the factors which underlie economic progress as the dominant determinants of investment and employment."

Hansen also considered the possibility of what we would today call expansionary fiscal policy: tax cuts and increased government spending, especially on infrastructure. While he cautiously favored such steps, he also worried that continual rises in government debt were troublesome, too. "Consumption may be strengthened by the relief from taxes which drain off a stream of income which otherwise would flow into consumption channels. Public investment may usefully be made in human and natural resources and in consumers' capital goods of a collective character designed to serve the physical, recreational and cultural needs of the community as a whole. But we cannot afford to be blind to the unmistakable fact that a solution along these lines raises serious problems of economic workability and political administration. ... Public spending is the easiest of all recovery methods, and therein lies its danger. If it is carried too far, we neglect to attack those specific

maladjustments without the removal of which we cannot attain a workable cost-price structure, and therefore we fail to achieve the otherwise available flow of private investment." 

Thus, a short summary of Hansen's theme was that a healthy full-employment economy needs strong profit-oriented incentives for investment spending, and  because he was not confident that the economy of his time could produce such incentives, secular stagnation was the result.

When we look back at Hansen's speech of late 1938, we see the issues of his time a little differently. Of course, Hansen does not have access to the luxuries of 20:20 historical hindsight and modern economic statistics. For example, Hansen discusses a slowdown in population growth, which was certainly a fair reading of the trends at that time, but completely missed that US fertility rates were about to take off less than a decade later at the start of what we call the "baby boom." 

Hansen was concerned that technological progress had slowed in the 1930s, and that the age of new inventions driving forward the economy was over. In retrospect, the notion that technological innovation stopped in the 1930s seems clearly incorrect. Indeed, Alexander Field makes a very plausible case in his 2012 book, A Great Leap Forward: 1930s Depression and U.S. Economic Growth, that the 1930s experienced a great deal of technological growth. At a macro level, Field points out that essentially the same number of people were employed in 1941 as in 1929, using what seems to be the same value of capital stock, and yet real output was one-third or more higher in 1941 than in 1929--implying substantial productivity growth even with the period of the Great Depression taken into account. If one just looks from 1933 to 1941, real U.S. GDP gained 90% over those eight years. At the micro level, Field points to high and rising R&D investment during the 1930s, dramatic improvements in roads and rail, and a long list of technological improvements in areas like chemicals, electricity generation, cars, planes, and many more. Here's an readable interview with Field laying out his views.

In contrast, Hansen seemed to perceive the later 1930s as nothing but the long aftermath of the the Great Depression. But current dating of business cycles suggests that that the Great Depression ended in March 1933. After a few years of fairly vigorous recovery, the Federal Reserve, chasing a premonition of a shadow of a ghost of possible inflation that no one else could see, decided to raise interest rates, triggering a severe recession starting in May 1937 that lasted through June 1938. Field and others have argued that the U.S. economy was on a strong and healthy path of recovery before and after the Fed-induced recession of 1937-38. By the late 1960s, when unemployment was less than 5% from March 1965 through June 1970, the idea that the U.S. economy was necssarily trapped in secular stagnation looked plain unrealistic. 

Yet here we are in late 2013, more than four years after the Great Recession technically ended in mid-2009, but without a real resurgence of catch-up economic growth that has followed other recessions. We also have the disturbing example of Japan's economy, which suffered a financial crisis and melt-down in real estate prices back in the early 1990s, and has now been stuck in slow growth for more than two decades. Hansen's spirit would surely point out that a surge of population growth or an expansion of territory are unlikely. Thus, much turns on investment spending. 

Here's a figure generated by the ever-useful FRED website maintained by the St. Louis Fed. It shows Gross Private Domestic Investment (GDPI) divided by GDP. Investment often drops during recessions, and sometimes between recessions, but the investment drop during the Great Recession was especially severe, and the bounceback even to usual levels is not yet complete. Moreover, the investment surge of the mid-2000s was largely in residential real estate, and whatever the other virtues of such investments, additional houses don't do much to raise future rates of productivity growth. 

FRED Graph

From Hansen's secular stagnation point of view, the key problem of the U.S. economy is how to make it more likely that firms will invest heavily in expectation of large profit opportunities. This perspective doesn't rule out using monetary or fiscal policy to stimulate the economy in the short run, but neither does it see these as long-term answers. Such an economy would of course rely on strong government support of R&D spending and educational achievement. It would also be an economy where a large share of profits flowing to the financial sector would be troubling, because it suggests that nonfinancial firms are not perceiving profitable opportunities for real investments in plant, equipment and technology. It's an economy where we would think seriously about finding ways to ease the tax and regulatory burdens on investment. Here are some words from Hansen's 1938 speech that ring true to me today:

"The problem of our generation is, above all, the problem of inadequate private investment outlets. What we need is not a slowing down in the progress of science and technology, but rather an acceleration of that rate. Of first-rate importance is the development of new industries. There is certainly no basis for the assumption that these are a thing of the past. But there is equally no basis for the assumption that we can take for granted the rapid emergence of new industries as rich in investment opportunities as the railroad, or more recently the automobile, together with all the related developments, including the construction of public roads, to which it gave rise. Nor is there any basis, either in history or in theory, for the assumption that the rise of new industries proceeds inevitably at a uniform pace. The growth of modern industry has not come in terms of millions of small increments of change giving rise to a smooth and even development. Characteristically it has come by gigantic leaps and bounds. Very often the change can best be described as discontinuous, lumpy, and jerky ... And when giant new industries have spent their force, it may take a long time before something else of equal magnitude emerges. ... [A] vigorous recovery is not just spontaneously born from the womb of the preceding depression. Some small recovery must indeed arise sooner or later merely because of the growing need for capital replacement. But a full-fledged recovery calls for something more than the mere expenditure of depreciation allowances. It requires a large outlay on new investment, and this awaits the development of great new industries and new techniques. But such new developments are not currently available in adequate volume ..." 

I worry that the current U.S. economic policy agenda is all about fiscal and monetary policy, along with financial regulation and health insurance. I hear relatively little discussion focused directly on an agenda for creating a supportive environment for private domestic investment.