This is the first in what I intend to be a monthly series on macro-economics. Each will feature a review of something interesting appearing in the literature or talking-head sphere recently, plus a possible trade.
This month I want to look at comments by Larry Summers at the IMF conference (video). The idea presented goes by the name 'secular stagnation,' which is wonk speak for long term low economic growth. This is not a new idea - Krugman has been hinting at it for years - but has still captured a lot of attention among the economist crowd.
Summer starts by recalling conditions pre-crisis: monetary policy was easy and perhaps too easy; there was lots of low quality lending; housing had created bubble wealth beyond any reality. However, unemployment was not exceptionally low, inflation was mild and in effect an enormous boom had failed to create excessive aggregate demand. This was followed by the crisis, creating a sudden drop in economic growth from which we've had mild lingering recovery.
He compares this, by analogy, to a sudden failure in electricity. Clearly, any meaningful period without electricity would tank the economy. But once electricity was restored, all the factories, services, computers, and such would be turned back on. In fact, they would be extra busy restocking inventories and completing backlogs of work not done during the lack of electricity. Thus GDP after the lights come back on would be somewhat higher than before, and we'd quickly get to roughly the same trends as before (perhaps with more backup generators).
However, this is not what happened after the financial crisis. Economic activity has not rebounded and employment levels remain low - as if someone decided not to turn all the lights back on. Summers did not say it directly, but clearly the financial crisis did not act like resource shock, with a rebound once the panic ended.
Summers then suggested a possible explanation for both the lack of inflation before the crisis and lack of employment after. He suggests that maybe the rate of interest required to get full employment turned negative sometime in the 2000s. If so, then even easy money plus a wealth bubble would manage to barely get full employment and certainly not inflation plus very low unemployment. And then without the bubble one gets lingering unemployment, low participation, and low growth even with extraordinary monetary policy. Most economists have been discussing the zero lower bound as a temporary state that we should get out of as quickly as possible, but certainly won't last a very long time. Summers suggests that economists and policy makers may need to contend with the zero lower bound for a long time. He noted that Japan's GDP is now far below what anyone in the 80s predicted it would be.
How could this happen? Summer's evaded that part, but I'll give some guesses. The most obvious starting point is deleveraging. If everyone stops eating out in order to repay debt, then some waiters will be out of work (which ironically means it's hard for them to repay debt). There was clear evidence of private sector deleveraging for a few years, but the last year or two has had much less. Another possibility is rising inequality - consumption rates are higher for the poor than for the rich (the poor use extra income to spend, the rich use extra income to buy assets). This tendency can be seen in mostly flat revenues but increasing equity prices. Clearly, expensive assets on low revenues will lead to few jobs and low yields.
If the situation persists, growth is likely to remain low for a long time. This is precisely the situation Japan had for two decades - and may or may not be exiting. A secular stagnation has a number of disturbing implications: long term reduced productivity as new workers struggle to get work to improve skills, persistently low revenues as those with jobs try to save more assuming low income growth, and again corresponding low yields.
Now I don't claim this is a likely outcome, but there is a trade that could be made here. A secular stagnation with persistently low employment and low yields will also have persistently low inflation - below Fed target. We can see that TIPS (NYSEARCA:TIP) typically trade with a breakeven of about 2% inflation compared to 10 year treasuries (NYSEARCA:IEF). If we are in stagnation, then we are likely to see less inflation, which makes a long treasury, short TIPS a winning position - regardless of the short-term fluctuations of rates.