Low Interest Rates and 'Secular Stagnation'

SMITH BRAIN TRUST — In Switzerland, some customers are watching their bank accounts shrink each month, even if they don't make any withdrawals. In Denmark, when you repay your loan, you don't add interest to the payment, you subtract interest. The banks are literally paying people to borrow money. 

This is the strange new world of negative interest rates. In December, the European Central Bank cut its interest rates to minus 0.3 percent, and some national banks followed their lead. In the United States, the Fed last month nudged rates upward from 0 to roughly 0.25 percent, a controversial and much-discussed decision, but if you take into account inflation, currently running at just over 1 percent, the real rate of interest here is slightly negative, too.

Interest rates at zero, let alone below zero, should make individuals and businesses eager to make productive expenditures. Yet low interest rates don't seem to pack the punch they used to. Some economists, including Haluk Ünal, a professor of finance at the Robert H. Smith School of business, believe that the problem is "secular stagnation": a fundamental slowdown in the U.S. and global economy. "Secular stagnation is the long-term trend of declining growth rates and interest rates across developing countries," Ünal says.

Basically, it means that the "equilibrium" real interest rate — the "price" for money that would lead investors to think it was safe to borrow for spending or investment — is deeply negative, whereas banks are  limited by the "zero bound." Banks simply can't get to the equilibrium rate. What's more, when the equilibrium real rate is negative and the nominal rate is bound at zero, the ability of central banks to manage the economy is limited, whether that means boosting it or applying the brakes when inflation accelerates. 

In this context, "secular" means long-term and systemic. Ünal points to several economic indicators that collectively add up to a systemic slowdown. The average rate of annual expansion following the most recent U.S. recession, 2.2 percent, is far lower than during earlier recoveries, for instance. (The average rate from 1991 to 2001 was 3.6 percent.) In the United States and Europe, the labor-force participation rate has been dropping, a combination of an aging population and tax incentives to retire.

"Productivity could solve this problem, but productivity is going down despite our technological innovation," Ünal says. So far, at least, for Silicon Valley­‑era innovation — smartphones, apps, software — has not yet translated into higher per-worker output.

A side effect of secular stagnation is an asset bubble, Ünal believes. The search for yield in a low-interest rate environment may cause investors to bid up companies to unrealistic levels. Indeed, the data show that companies have been taking their cash out of money-market funds, for example, and putting them into riskier assets. In other words, stagnation has profound effects on financial stability.

To break out of the cycle of stagnation, Ünal says, "there must be investment demand, and that investment demand should be triggered by consumption."  In his view, one key solution must come from overseas: "The bottleneck comes from China. China makes a lot of money by selling goods outside China, but they don't return it to the global economy in the form of consumption." As a result, U.S. car factories are working at a fraction of their potential capacity.

The United States could try to stimulate domestic consumption through tax cuts (and deficits) or, over the longer term, investment in infrastructure. "But we cannot do it alone here," Ünal says. "This is a global problem."

Ünal's framework for analyzing the global economy raises one key question. If the equilibrium interest rate is below zero, why did the Fed raise rates? Ünal, who disagreed with the decision, suggests that the Fed was weighing investor psychology along with economic models. "If the Fed had not raised interest rates, people would take it as a sign that the economy is not improving," he says. Still, the U.S. central bank, he notes, has kept the door open to lowering rates again, to where he thinks they belong.

Some commentators have suggested that secular stagnation should be distinguished from the narrower issue of a savings glut (centered in China). But Ünal argues that the two phenomena are not opposing explanations but rather deeply interwoven. "An aging, unproductive workforce is also going to be one that saves more than it consumes," he says.