Secular stagnation
The secular stagnation hypothesis, initially proposed by Alvin Hansen following the Great Depression and revived by Larry Summers against the background of a slow and insufficient recovery after the global financial crisis, captures the notion that an economy can permanently operate below its potential capacity due to excess savings or, put differently, a lack of aggregate demand. Unlike in normal recessions, the economy remains persistently depressed under secular stagnation without a natural recovery.
Normal recession are the result of economic shocks that temporarily reduce investment and consumption demand. However, the central bank can effectively stabilize the economy by lowering the nominal interest rate, thereby stimulating investment demand and reducing desired savings. If instead structural factors cause a persistent decline in investment demand or increase in desired savings, then stablizing the economy requires the price of funds, i.e. the real interest rate, to be permanently lower. And if these changes are sufficiently strong, the economy requires a negative real interest rate to operate at potential capacity. However, the effective lower bound on the nominal interest rate, together with anchored inflation expectations, imposes an effective lower bound on the real interest rate thereby preventing it from falling sufficiently. Put differently, holding cash becomes too attractive as a means of savings resulting in an excess supply of savings or equivalently a lack of aggregate demand, which prevents the economy from realizing its potential. Since the negative real interest rate is the result of structural factors rather than temporary shocks, there is no natural recovery and the economy is trapped in a secular stagnation equilibrium with a persistent output gap, subdued inflation and a binding effective lower bound on the nominal interest rate.
Japan is the prime example of a country suffering from secular stagnation during its "lost decades" following the burst of the bubble economy of the 1980s. Yet, the developments in the U.S. and several European countries after the global financial crisis are reminiscent of the Japanese experience. In my research, I analyze these similarities and try to derive lessons from the developments in Japan for policymaking in Europe and the United States based on the framework of Yoshiyasu Ono who was the first to formalize these insights into a dynamic modern macroeconomic model.
Credit booms, debt overhang, and secular stagnation (2018, EER)
Japan's long run stagnation began with the bust of an extraordinary credit and asset price boom, as did the Great Recession in the U.S. and Europe (see graph). In fact, Larry Summers argues that this credit boom was masking the underlying lack of aggregate demand in the U.S. economy by initiating unsustainable consumption spending of households, concluding that "the difficulty that has arisen in recent years in achieving adequate growth has been present for a long time but has been masked by unsustainable finances" and "it has been close to 20 years since the American economy grew at a healthy pace supported by sustainable finance". In Illing et al. (2018), we provide a theoretical foundation for these claims and an analytical framework to think about the interactions of credit market imperfections, deregulation, asset prices and aggregate demand.
Building upon a model with heterogeneous agents and endogenous credit constraints, we show that financially deregulated economies are more likely to experience persistent stagnation. Credit booms can mask this structural aggregate demand deficiency by temporarily stimulating consumption spending of borrowers. However, the resulting debt overhang permanently depresses spending in the long run and contributes to more severe stagnation as borrowers are forced to cut back on their consumption while savers prefer to hoard cash instead of spending. Hence, the contractionary long run effects of relaxing lending standards are the opposite of their expansionary, albeit non-inflationary, short run effects.
Figure: Real credit to the private non-financial sector, deflated by GDP Deflator and normalized to 100 in the year of the peak. Data source: Bank for International Settlements.
Structural unemployment, underemployment, and secular stagnation (2023, JET)
Despite decades of stagnation, Japan has performed remarkably well in terms of its employment record. In fact, the unemployment rate has been remarkably low by international standards throughout the stagnation years, peaking at around 5.5% in the early 2002 as illustrated in graph (a). However, the unemployment rate does not adequately reflect the slack in the labor market of a stagnating economy. Instead, it is involuntary underemployment such as part-time employment, non-regular employment or reduced working hours, that quickly dominates the total employment gap. As shown in graph (b), part-time employment has risen substantially in Japan starting in the late 1980s, much more so than in other OECD countries. Similar developments took place in the United States and Europe following the Great Recession. Surveying the empirical evidence, David Blanchflower argues that "underemployment has replaced unemployment as the main measure of labor market slack". In Hashimoto et al. (2020), we provide the theoretical counterpart to this empirical analysis and an analytical framework to think about the interactions between the labor market, financial markets and the goods market under demand shortage.
Introducing a search and matching friction into a stagnation model allows for two forms of underutilization of capacity: Structural unemployment and underemployment in the form of a shortfall of working hours below the level desired by households. The total employment gap in the labor market therefore exceeds the unemployment rate. Our analysis shows that economies can suffer from a persistent shortfall of income despite low unemployment. This also explains why wages growth and inflation remain sluggish in many advanced economies today despite historically low unemployment rates. From a policy perspecitve, our model suggests that traditional labor market policies should be used with great caution as they might reduce unemployment while at the same time resulting in a larger total employment gap. In contrast, we highlight the further need for policies in support of aggregate demand despite a seemingly decent employment record.
Figure: (a) Unemployment rate in Japan (in percent of the labor force). (b) Part-time employment in percent of total employment. Data source: OECD.