Reduce Inequality to Fight Secular Stagnation
Larry Summers’ IMF speech on secular stagnation partially shifted the attention from the crisis to the long run challenges facing advanced economies. I like to think of Summers’ point of as a conjectures that “in the long run we are all Keynesians”, as we face a permanent shortage of demand that may lead to a new normal made of hard choices between an unstable, debt-driven growth, and a quasi-depressed economy. A number of factors, from aging and demographics to slowing technical progress, may support the conjecture that globally we may be facing permanently higher levels of savings and lower levels of investment, leading to negative natural rates of interest. Surprisingly, another factor that had a major impact in the long-run compression of aggregate demand has been so far neglected: the steep and widespread increase of inequality. Reversing the trend towards increasing inequality would then become a crucial element in trying to escape secular stagnation.
The generalized increase of inequality that began in the early 1980s is well documented. Redistribution took different forms, but in all cases benefited mainly the rich and the very rich (the top one percent of the population). Inequality in turn, interacting with institutional differences, may go a long way in explaining the accumulation of global imbalances that are a side effect of secular stagnation: Excess demand and trade deficits in the US and in other countries (most notably peripheral Eurozone countries), financed by excess savings from other regions of the world. The transfer of resources from low to high propensity-to-save individuals, resulted in a reduction in the average propensity to consume, and increased aggregate savings, with two major, related effects: first a large mass of liquidity that with the help of low interest rates fuelled a series of speculative bubbles and misallocation of savings. The second effect is a chronic deficiency of aggregate demand, which would then permanently lower the growth rate of the economy. Therefore, inequality and the ensuing lower propensity to consume, contributed to the drift towards secular stagnation described by Larry Summers.
Inequality therefore may have contributed, along with demographics and slowing innovation, to the slow drifting of the global economy towards secular stagnation. But how could inequality, and the resulting compression of aggregate demand, lead in some areas to excess savings, and in others to excess debt? The answer to this apparent paradox lies in different institutional settings and policy responses. Starting from the mid-1990s in the US private borrowing surged, thanks to a weakly regulated financial system, and to the belief that some sectors (financial, real estate) would grow indefinitely. Consequently, consumption and investment remained high, even if financed through debt and bubbles. In most of Europe (the exception being Spain and the United Kingdom) stricter regulation and tighter monetary policies made borrowing more difficult while fiscal policies were constrained by the treaties. This led the second largest economic block of the world to rely on export-led growth. Thus, US demand was financed by savings from the EU (but also from East Asia, and oil producing countries), and in turn lifted these areas’ growth with its imports. This delicate balance was sooner or later doomed to break.
If Summers’ conjecture is right, the pattern we observed leading to the crisis is bound to be repeated in the future, as different areas of the world will react differently to the trend towards secular stagnation. A durable rebalancing of the global economy can only happen if we manage to escape the chronically depressed aggregate demand that according to Summers has become the new normal.
In the current situation income distribution may turn out to be the easiest lever to pull in order to fight secular stagnation. Demographic factors, or innovation trends, are hard to govern and to orient. A reduction of inequality can instead be obtained by acting on multiple levels, starting with the return to more progressive tax systems. Furthermore, the social insurance role of the government should be revamped. Last, but not least, a renewed focus on the provision of public goods, particularly intangible ones such as education and health is desirable. At the European level, we should aim to real coordination of tax policies, so as to avoid tax competition and social dumping, which benefit high incomes and capital. Taken together, these measures would reduce income and consumption inequality, thereby stabilizing the economic cycle and reducing aggregate savings. This would allow for growth rates that may be less remarkable than in the past, but certainly more sustainable and equitable.