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Secular Stagnation and the Natural Rate of Interest

Updated: May 18, 2022

One of the most interesting features of global financial markets over the last 20 years has been the inexorable decline in long-term real interest rates (see chart below of yields of index linked bonds of maturities over five years across various developed markets). As is evident, this is a global trend, though not all countries have 20 years of history.

"Our lives continue to be made better, whether with respect to medical advances, battery storage, energy production, car and airline safety, or online shopping"

The decline has reignited the debate about ‘secular stagnation,’ a term coined in the late 1930s by American economist Alvin Hansen to refer to the feeble recovery in the US economy that followed the Great Depression. Hansen argued that weak trends in population growth and technological innovation meant that the low growth would continue for many years.

That there is a vibrant debate about whether global growth is stagnating or not is itself instructive, as it suggests the study of economics has not advanced much in recent decades – surely we should know the answer to this question! Earlier this year, Prospect Magazine ran a series of four articles on the subject, two by proponents of the stagnation thesis and two by opponents. They were all written by well-respected economists, and consequently all were persuasive.

The economists arguing in support of the stagnation thesis were former US Treasury secretary Larry Summers and Northwestern University professor Bob Gordon. Representing the other side of the debate were GaveKal co-founder Anatole Kaletsky and University of Illinois at Chicago professor Deirdre McCloskey.

Of the four articles, I found Anatole Kaletsky’s the most convincing. Here is an excerpt:

“Cuts in public spending and tax hikes, motivated by irrational paranoia over public borrowing, have been so severe that it has not been possible to offset their effects through low interest rates. Inadequate demand, combined with labour deregulation and globalisation that would have been healthy if conditions had been normal, have squeezed wages downwards, reducing incentives for investment and aggravating inequality, which in turn has exacerbated the weakness of consumer demand.

“To make matters worse, inflation is systematically exaggerated in official figures. If the true level of inflation since 2008 has been negative, as appears quite likely, then even zero interest rates were too high to stimulate rapid growth.”

In Kaletsky’s world, the fall in long term real interest rates in recent years was indeed the result of lower growth but this lower growth, particularly since the Great Financial Crisis, was due to cyclical factors (poor monetary and fiscal policy) rather than structural ones.

On the subject of structural factors such as innovation, Kaletsky sees evidence of technological progress everywhere. Robert Gordon, on the other hand, “assumes that the weak economic statistics are proof that, however much new technology we see around us, progress has slowed down.” I can’t help but side with Kaletsky, seeing as I do the extraordinary ways in which our lives continue to be made better, whether with respect to medical advances, battery storage, energy production, car and airline safety, or online shopping.

That being said, it does not appear likely that governments are going to change course with respect to public spending policy any time soon, and instead will continue to pander to growing protectionism within their electorates. This may well mean that economic growth in the medium term continues to weaken.

In such a world, one can either accept the resulting lower returns from bonds and equities, and the lower future consumption that they imply, or one can try to achieve higher returns by investing more actively – seeking out those areas of equity markets such as smaller companies or certain emerging markets that are likely to perform better over time. We would strongly espouse the latter.

Published in Investment Letter, August 2016

The views expressed in this communication are those of Peter Elston at the time of writing and are subject to change without notice. They do not constitute investment advice and whilst all reasonable efforts have been used to ensure the accuracy of the information contained in this communication, the reliability, completeness or accuracy of the content cannot be guaranteed. This communication provides information for professional use only and should not be relied upon by retail investors as the sole basis for investment.

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