In a companion paper, “Six Impossible Things Before Breakfast,” we present evidence that asset markets are generally priced for “secular stagnation,” and argue that this requires a number of extreme assumptions on the part of investors. However, we didn’t really explore the root causes and consequences of secular stagnation in that paper. We remedy that with this paper, which is a deep dive into the murky world of secular stagnation, its sources, and its impact.
The rise of populism has been one of the broad themes to emerge over the last few years. This has left many within the establishment scratching their heads as to the cause of their fall from grace. From our perspective, the rise of populism has its roots in the same sources that have given rise to so-called “secular stagnation.” That is, a broken system of economic governance. This system – which we will hereafter refer to as “neoliberalism” – arose in the mid-1970s and was characterised by four significant economic policies: the abandonment of full employment as a desirable policy goal and its replacement with inflation targeting; an increase in the globalisation of the flows of people, capital, and trade; a focus at a firm level on shareholder value maximisation rather than reinvestment and growth; and the pursuit of flexible labour markets and the disruption of trade unions and workers’ organisations.
The orthodox view on secular stagnation seems to adopt one of two perspectives: either that secular stagnation is caused by a situation where the real interest rate has to be negative in order to generate a return to growth (a demand-side explanation), or that something has gone very wrong with the nature of productivity in the economy (a supply-side explanation).
We have been outspoken critics of this framework1 of thinking. Rather than being the result of some unobservable figment of economists’ imaginations (as we believe the natural rate of interest to be), or some strange exogenous productivity event,2 we argue that it is the policies that have been pursued that have led to the observed “stylized facts” of secular stagnation (Exhibit 2). The neoliberal regime has given rise to: lower inflation; lower growth rates; lower investment rates; lower productivity growth; increasing income and wealth inequality; diminished job security; and a serious deflationary bias in the world economy that was only temporarily “plugged” by dangerously high levels of private sector debt accumulation. These are long-term trends that have been visible for decades, but they were severely exacerbated by the collapse of the global debt bubble in 2008-09.
As the citizens of various countries around the world gradually woke up to the fact that the quick-fix solutions put in place after the crisis merely kept a lopsided and increasingly dysfunctional system ticking over, they rebelled. It was then that they started to cast votes for various populist political candidates in an apparent effort to shake up the system. Without such a splash of cold water to the face, there is every chance that the system would march on regardless of its dysfunction until it decayed to such an extent that it simply collapsed – not unlike what happened in the non-democratic Soviet Union. If we are to prevent our own sickly Brezhnev era from slipping into a terminal state, we must understand clearly the causes of our current morass.
The Four Pillars of Neoliberalism
Inflation targeting and the NAIRU
The first of the four key pillars of neoliberalism is the abandonment of full employment policy and its replacement with inflation targeting. After the Second World War governments around the world realised that they could easily generate full employment through spending and taxation policies. This realisation came because of the economic experiments undertaken during the war – experiments that were necessitated by the war but that were consciously structured in line with the economic approach outlined in Keynes’ 1936 book The General Theory of Employment, Money and Interest. As Nicholas Kaldor wrote, “The formal obligation to maintain high and stable levels of employment… emerged as a joint impact of the Keynesian revolution in economic thought and the Second World War.”3
These policies were remarkably effective, and the decades after the war are generally known today as capitalism’s Golden Age. The Golden Age was characterised by high rates of employment, economic growth, and an equitable distribution of income and wealth. In the mid-1970s, however, these policies were abandoned because they were thought to be causing inflation. This was an incorrect assessment, as the inflation was actually generated by oil shocks imposed by the OPEC cartel in response to US foreign policy in the Middle East combined with poor labour relations in the English-speaking countries that led to class conflict and strikes over who should bear the brunt of these higher oil prices.
But the economics profession at the time did not realise this. Their theories told them that it was the full employment policies that were generating the inflation, and so they encouraged policymakers to abandon these policies and instead have the central bank attempt to control inflation through the use of monetary policy. The impact of these policies in the US could not be clearer, as shown in Exhibit 3.
In these charts we see three periods: 1948-69 is the Golden Age of Keynesian full employment policy; 1970-82 is the crisis period of rising inflation due to OPEC oil price hikes and poor labour relations; and, finally, 1983-2015 is the period of inflation targeting. We can see immediately that after the crisis period the economy stabilised at a more normal level of inflation (although not quite as low as in the Golden Age). But unemployment did not. In fact, unemployment never went back to its Golden Age average – it stayed permanently elevated. This was simply due to the fact that governments stopped targeting full employment and instead turned their attention to inflation.
The rationale for this policy choice was the economic theory of the “Non-Accelerating Inflation Rate of Unemployment” (NAIRU). The NAIRU is supposedly the rate of unemployment at which inflation supposedly starts to accelerate ad infinitum. It is another one of those many wonderful “unobservables” that seem to dominate economic thinking. We cannot observe the NAIRU directly and so we do not know when we are crossing it. The NAIRU is only obvious after the fact; by the time it shows up in the statistics it is too late! It is a bit like a sailor in the medieval era confronted with the terrifying prospect that there might be dragons beyond a certain point on the map. The dragons are not an observable fact, but by the time they show up our poor sailor figures he will already be lunch. So he thinks it safer to stay within the known boundaries despite the fact that dragons are silly and imaginary.
The other problem with the NAIRU is that it does not do what it is supposed to do. When economists try to actually estimate the NAIRU they tend to do a terrible job. In the 1990s, for example, most economists put the NAIRU in the US at around 5-6%. But because central banks ignored their economists and allowed the economy to continue to grow, unemployment fell much lower without substantial inflationary pressures. The ship set sail and the dragons never appeared. It was all a bit of a farce. Exhibit 4 lays out the NAIRU debacle of the mid to late 1990s.
In this chart the orange dotted line represents the average NAIRU estimates produced by the Federal Reserve for that year. The blue line is the actual realised unemployment rate in that year. The blue bars represent the amount of employment that would have been “lost” if the Federal Reserve had taken the NAIRU estimates seriously, used them as a policy target, and succeeded in hitting this target. Finally, the beige bars are the actual CPI inflation rate and the red line represents the Federal Reserve target inflation rate.4 This chart tells a strange story – at least, if you believe that economists can estimate a NAIRU. In 1995 and 1996 the actual unemployment rate is very close to the NAIRU estimate and yet
inflation is above target. Then in 1997 and 1998 unemployment falls substantially below the NAIRU estimate and yet inflation falls below the target level. In 1999 inflation begins to pick up again, and in 2000, when it breaks through the target rate, the Federal Reserve hikes interest rates and creates a recession. But it seems far more likely that something else was causing this inflation and that the Federal Reserve research team was focusing on the NAIRU while ignoring what was actually leading to inflation. All the evidence suggests that the complete opposite of what the Federal Reserve economists expected to happen actually happened: As unemployment began to fall below the NAIRU in 1997 and 1998, inflation actually fell. It did not rise as the Federal Reserve economists would have predicted. Not only did the NAIRU prove empirically useless, but if the Federal Reserve had taken it seriously between 1997 and 1999, substantially more US workers would have been needlessly unemployed than actually proved to be the case.5
The NAIRU was a failure, although many still adhere to the principles involved. Even the economic equivalent of Mr. Magoo, Alan Greenspan, has written that the NAIRU “was continually revised and did not offer a stable platform for inflation forecasting or monetary policy.”6 But even though many policymakers distrusted the NAIRU, it provided a rationale for their desired policy actions. It also gave governments a rationale to stop taking responsibility for full employment policy. In short, it provided the ideological justification for the high unemployment period of inflation targeting.
Globalisation and the free movement of… everything!
In the neoliberal era, politicians also advocated for the free movement of capital, labour, goods, and services. The free movement of labour has certainly gotten a lot of coverage in the news media. It is clear to us that this is the complaint that has driven many people to the populist parties. People seem to zero in on the issue of migration in order to articulate their frustration with the system. They perceive migrants as taking their jobs and driving down wages. Insofar as taking jobs goes, it is not hard to see where this perception comes from. Exhibit 5 plots five-year net migration into the US adjusted by the average number of people unemployed in the five-year period in question.
Looking at this chart, it is not hard to see why people tend to blame their economic problems on migrants. We have already seen that unemployment has reached structurally higher levels after the Golden Age of capitalism. This has been accompanied by increases in net migration into the US. It is not difficult to understand why unemployed people would tend to take this correlation to imply causation and blame their joblessness or job insecurity on migration.
But the key impact that globalisation has had on working people is not to encourage the free movement of labour, but rather to encourage the free movement of goods and services. This has both pros and cons. On the pro front, the US consumer has benefited from lower prices. The cons include reduced domestic demand and job losses.
This is reflected in the rhetoric of many populist campaigners who tell their constituents that globalisation has served to take their jobs and create unemployment. This assertion is by no means without merit. Exhibit 6 plots trade broken down into its components in the US as a percentage of GDP since 1900.
We can see from this chart that the new neoliberal-globalisation regime that emerged in the mid-1970s was not simply aimed at increasing trade. While it is true that trade has increased since this time, the trend that really stands out is how rapidly imports have increased as a share of GDP. Exports have increased in this period, but not by nearly as much. The real story here is that the globalisation-neoliberal regime has led Americans to buy more and more goods from abroad without being compensated for this by having foreigners buy more American goods in return.
In fact, this is a structural tendency of the US economy itself that was noted just before the globalisation-neoliberal regime began. In 1969 the economists Houthakker and Magee noted that “disparities in income elasticities [for trade] appear to be significant in the case of [the US].”7 This meant that the US had a tendency to suck in more imports as it grew than the rest of the world absorbed in the form of US exports. The Houthhakker-Magee finding strongly suggested that if trade increased as a percentage of US GDP it would have a detrimental effect on the balance of trade.
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