Last month, I argued that we may be in a period of secular stagnation in which sluggish growth, output and employment at levels well below potential, and problematically low real interest rates might coincide for quite some time to come. Since the beginning of this century, US GDP growth has averaged less than 1.8% per year. Right now the economy is operating at nearly 10%—or more than $1.6 trillion—below what was judged to be its potential path as recently as 2007. And all this is in the face of negative real interest rates out for more than 5 years and extraordinarily easy monetary policies.
It is true that even some forecasters who have had the wisdom to remain pessimistic about growth prospects for the last few years are coming around to more optimistic views about growth in 2014, at least in the US. This is encouraging, but optimism should be qualified by the recognition that even optimistic forecasts show output and employment remaining well below previous trends for many years. More troubling, even with the current high degree of slack in the economy and wage and price inflation slowing, there are increasing signs of eroding credit standards and inflated asset values. If we were to enjoy several years of healthy growth with anything like current credit conditions, there is every reason to expect a return to the kind of problems we saw in 2005-2007 long before output and employment returned to trend or inflation accelerated.
The secular stagnation challenge then is not just to achieve reasonable growth, but to do so in a financially sustainable way. What then is to be done? Essentially three approaches compete for policymakers’ attention. The first emphasises what is seen as the economy’s deep supply side fundamentals—the skills of the workforce, companies’ capacity for innovation, structural tax reform, and assuring the long-run sustainability of entitlement programmes. All of this is intuitively appealing, if politically difficult, and would indeed make a great contribution to the economy’s health over the long run. But it is very unlikely to do much over the next 5 to 10 years. Apart from obvious lags like those with which education operates, there is the reality that our economy is constrained by lack of demand rather than lack of supply. Increasing our capacity to produce will not translate into increased output unless there is more demand for goods and services. Training programmes or reform