What is the economy’s new normal? Will it be secular stagnation as suggested by Summers (2013)? According to this view, the economy will be in a permanent state of recession because aggregate demand is below potential output. As the actual real interest rate exceeds the negative equilibrium real interest rate (the natural rate), investment activity is too low. In the secular stagnation view, the zero lower bound (ZLB) prevents an adjustment of the interest rate to the (negative) equilibrium rate. Consequently, the economy ends up in a liquidity trap (Krugman 2013).
Low inflation – a feature of secular stagnation – constrains the real interest rate to become negative. To get out of this bad equilibrium, several economists propose policies that raise inflation expectations (cf. Krugman 1998). Quantitative easing (QE) may contribute by boosting aggregate demand through wealth effects. That could raise inflation and result in a negative real interest rate.
However, others argue that QE is not a good remedy for secular stagnation. According to Bernstein (2013), liquidity injections by the central bank will only stimulate unprofitable activities and bubbles due to lack of investment opportunities in the real economy. Others point out that due to the unequal distribution of wealth, asset price inflation will only have limited effects on the real economy (cf. Dobb el al. 2013). Furthermore it is not obvious that low interest rates stimulate demand if households and firms are credit constrained and/or suffer from a debt overhang.
The ineffectiveness of QE has also been explained by the breakdown of the money multiplier at the ZLB (Krugman 1998). When economic agents are indifferent between holding base money and bonds, additional base money will be held as excess reserves by the banks. As reserves no longer constrain banks, credit supply does not rise in tandem with an expansion of base money (Martin et al. 2013).
The supply side view
Rajan (2013) argues that the debt-fuelled boom has created an economy that supplies too much of the wrong kind of goods. A sustainable solution would be to adjust the supply side through relative price adjustments and structural reforms.
Rajan’s view is particularly relevant for the Eurozone, where the recovery is held back by high levels of debt that reduce banks’ intermediation capacity through the balance sheet channel (high credit risk of borrowers makes banks reluctant to lend) and the bank-lending channel (rising non-performing loans erode banks’ capital position). The current gap between corporate borrowing rates on bank loans versus rates on bonds is in line with this view (see Figure 1).
The higher margin on bank lending reflects bottlenecks in the credit intermediation by banks. The contraction of bank loans to firms in the Eurozone since mid-2012 is another indication of this. Low credit supply by banks is arguably related to uncertainty about corporate balance sheets, in particular those of SMEs. These high credit risks explain banks’ preference for safe assets, such as government bonds.
Figure 1. Corporate borrowing costs in the Eurozone
Percentage (borrowing rate on long-term credit)
In stylised form, there is segmentation between the market of perceived safe assets and risky assets. It results in two equilibria (Figure 2). The market for safe assets clears at low or negative real rates, due to a negative risk premium (Bernanke 2013). In this framework, the low real rate is explained by temporary factors, such as safe haven demand and asset purchases by central banks and not by a negative natural rate. In the market for risky assets the supply of funds (S* in Figure 2.b) falls behind demand (I), due to high credit risks of borrowers, whose financial condition is impaired by the recession. As a consequence, banks are reluctant to lend and the market for risky assets clears at a positive real rate.
Figure 2. Multiple equilibria
Uncertainty over the extent to which banks are exposed to risky assets negatively affects their funding possibilities. This constrains banks to strengthen their capital base, which is needed to write-off bad assets and extend new loans. Hence, as long as the financial supply side issue is not adequately dealt with, the problem of low credit supply will linger. In the words of the secular stagnation view, the risk premium will keep the actual rate above the equilibrium rate.
Cleansing and strengthening banks’ balance sheets will reduce the uncertainties related to their asset quality. An important contribution to this will be the ECB’s comprehensive assessment of banks’ balance sheets and risk profiles (see ECB 2013). It addresses the supply side issue at the core by enhancing the transparency on banks’ financial health and setting in motion necessary corrective actions. This is an important condition to restore credit intermediation and reduce the risk premium on lending.
We think that the diagnosis of secular stagnation is doubtful or, at the very least, incomplete. The low growth, low inflation regimes in various regions in the world can have different causes. In the Eurozone, it arguably relates to a supply side issue rooting in the balance sheets of banks and their borrowers.
Expectations that monetary policy can solve this will be disappointed (Orphanides 2013). To avoid a secular credit crunch in the Eurozone, the debt overhang and asset quality problems should be adequately dealt with. The comprehensive assessment by the ECB will be an important contribution to this and can prepare the ground for a sustainable recovery.
Authors’ note: The views expressed are those of the authors and do not necessarily reflect official positions of DNB.
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