The Debt Supercycle Versus Secular Stagnation

Kenneth Rogoff has been advancing theories that the current environment of disappointing growth rates is the result of a "debt supercycle", not "secular stagnation". He recently summarised his arguments within the article "Debt supercycle, not secular stagnation". Although would agree that some version of a "debt supercycle" theory is correct, I am unconvinced about Rogoff's description of the mechanisms. Meanwhile, I doubt that he will succeed in winning the argument - he is pushing against the unmoveable object that is the circular logic of the natural rate of interest.

A Traditional View Of The Debt Supercycle

I will first start with an overview of how I would characterise a debt supercycle. There appear to be differences from how Kenneth Rogoff views this concept, but his description appears too narrow. It is based on the description of the concept used by one of my old employers, BCA Research, as well as the related theories of Hyman Minsky. The concept has been around for decades.

The period before the rise of the welfare state was characterised by sharp depressions. The price level was famously stable (on average) - there were sharp deflations which restored the price level after the inflation that occurred during the expansion. The fall in prices would typically force the liquidation of borrowers. As a result, socially acceptable debt levels were quite low. The liquidation of the Great Depression was the last example of this sort of process.

From the perspective of the debt supercycle theory, what is important was that it did not exist within this earlier era. Debt levels were forced back to low levels during the depressions. The economy appeared to be self-correcting, and this belief is embedded in mainstream economics, which has taken private debt semi-seriously within Dynamic Stochastic General Equilibrium models only after the Financial Crisis.

The advent of the welfare state changed the environment. The automatic stabiliser of the central government deficit prevents depressions (only the raw incompetence of euro zone policy makers has allowed depression conditions to take root in a developed economy).

A side effect of depression prevention is that debt is no longer liquidated. Although there are periodic recessions, private sector debt levels are still high coming out of them. During the expansion, more debt is layered on top.

This is where the borrower hierarchy given by Minsky comes in (hedge borrowers, speculative borrowers, and Ponzi borrowers). Since borrowers are not culled during the downturn, aggressive lenders do not pay the price of lowering credit standards. Since they are expanding lending faster than more conservative lenders, lending standards deteriorate over time.

So far, I have described what is happening in the private sector. But the reaction of the authorities to this environment is also important. The emission of debt by any entity within the economy for consumption or investment in real goods and services adds to nominal incomes. (The purchase of existing assets with debt has at best an indirect influence on growth.*) We do not need fiscal policy to get a "multiplier" on deficit spending; private sector deficits will do the job as well. An absence of private sector debt expansion is dangerous for growth, and so massive efforts are made to prevent a liquidation of borrowers. This takes the form of lender-of-last resort operations, regulatory forbearance within the banking system, and discretionary counter-cyclical fiscal policy.

The Financial Crisis of 2007-2009 (which morphed into the eurozone crisis of 2010-) was only the latest and largest of these periodic financial crises that have hit since the mid-1960s. The argument was that the unwillingness of the authorities to allow the liquidation of borrowers was one factor that led to the inflationary bias of policies in the 1970s.

The Rogoff Version Of The Supercycle

I will first note that I have not studied all of Kenneth Rogoff's writings on this topic, so I will keep my comments here somewhat brief. I have read a few of his articles (including the one linked to earlier), and my comments here are based on those writings. It may be that there are some subtleties that I have missed.

Rogoff's version does not appear to have as well-developed a "narrative structure" as does the description of Minsky. His appears to be based mainly upon the empirical work he took with Carmen Reinhart in the book This Time Is Different. They looked at centuries of data to try and see if there are statistical commonalities around financial crises. Their argument is that after a financial crisis, slow growth is typical, and somehow pre-ordained by the laws of statistical repetition.

I am unimpressed with this empirical work. Lumping together random financial crises from a wide variety of institutional systems is theoretically incoherent. It ignores the key structural break that the welfare state represents.

The United States has had periodic financial crises since the mid-1960s. What sets the current one apart has been an unwillingness of policymakers to loosen policy to increase the growth rate. The private sector is unable to generate enough momentum to push nominal GDP growth rates above a 4% annual rate. Rogoff pins the blame on regulatory changes that favour "safer" borrowers. Given the scale of lending to shale fracking, I find it hard to accept that lenders are actually that conservative. The reality is that there is no appetite to repeat the extremes of subprime residential lending of the last cycle, and there is no other sector that is large enough to offset the bias towards slow growth within the economy.

Will Lose The Argument Versus Secular Stagnation

Mainstream economists will most likely judge the secular stagnation view as winning the debate. The secular stagnation story is that the natural interest rate has fallen for some reason or another, and this is the explanation for slow growth.

Nobody spends too much time thinking about how the natural interest rate is estimated. Unfortunately, the techniques used will just tell us that if growth is "below potential", then the natural rate of interest is lower than whatever the current interest rate is. The fact that this is circular is its greatest strength: it is impossible to defeat a non-falsifiable viewpoint in a debate.

Rogoff's argument is that once the "deleveraging cycle" is over, the economy will re-accelerate. In his view, this would represent a victory for the debt supercycle story over the secular stagnation explanation. Unless some sector of the economy suddenly develops a desire to emit large quantities of debt, he is most likely wrong in that assessment. He is relying upon his mismatched historical aggregated data, without looking at the underlying economic mechanisms.

In summary, he has put himself in a largely indefensible position, even though his view is probably closer to being correct.

Policy Recommendations

He contrasts his policy recommendations with those of the "secular stagnationists". Although I might closer to his view of the mechanisms behind slow growth, his recommendations are dubious.

He attempts to justify austerity policies.

However, those who would argue that even a very mediocre project is worth doing when interest rates are low have a much tougher case to make. It is highly superficial and dangerous to argue that debt is basically free. To the extent that low interest rates result from fear of tail risks a la Barro-Weitzman, one has to assume that the government is not itself exposed to the kinds of risks the market is worried about, especially if overall economy-wide debt and pension obligations are near or at historic highs already. Obstfeld (2013) has argued cogently that governments in countries with large financial sectors need to have an ample cushion, as otherwise government borrowing might become very expensive in precisely the states of nature where the private sector has problems. 

This logic is extremely weak. The first problem is that government's have limited control over their debt levels. As we have seen in the post-Financial Crisis period, austerity policies slow growth and may in fact ultimately raise debt levels.

Mainstream fiscal analysis largely ignores the desire of the private sector to raise its stock of financial assets. If there are important actors that insist upon accumulating such assets, the only way of deflecting those desires is for the private sector to increase its debt issuance.

The second problem with this logic is that an out-of-control financial system can easily accumulate a stock of bad debts that dwarfs the existing stock of government debt. This was the case in Ireland, Spain and Iceland. None of those countries were considered to have "high" debt levels going into the crisis, so having "fiscal space" proved to be ultimately worthless.

He also attempts to reinforce Carmen Reinhart's dubious theories about financial repression.

Alternatively, if one views low interest rates as giving a false view of the broader credit surface (as Geanokoplos argues), one has to worry whether higher government debt will perpetuate the political economy of policies that are helping the government finance debt, but making it more difficult for small businesses and the middle class to obtain credit.

This is an attempt to revive loanable funds doctrine, but using financial repression as the mechanism for crowding out. There is absolutely no foundation for this theory, and it is contradicted by the post-war experience. The strong growth of the 1950s and 1960s was largely financed by highly regulated banking sectors. The real estate construction boom that was necessitated by the baby boom was mainly financed by Savings and Loans that followed the straightforward 3-5-3 rule.** By contrast, the "sophisticated" modern financial system was unable to finance a smaller construction wave in the 2000s without blowing itself up. (Warren Mosler enjoys making this observation.) Given adequate aggregate demand, the private sector will find financing for profitable projects regardless of the level of regulation.

Footnotes:

* Technically, an economy can grow in nominal terms even with falling debt levels. But this is an unusual situation, as it requires entities to have cash levels that are falling relative to their incomes. Therefore, it will not be sustained in practice.

** Pay 3% on deposits, lend at 5%, on the golf course by 3 pm.

See Also:

• Book Review: Secular Stagnation: Facts, Causes and Cures.
• The article "Wage-led Growth" by Engelbert Stockhammer. This summarises some of his research on wage-led growth, including the 2013 book he wrote with Marc Lavoie. This research programme argues that the slowdown in growth ("secular stagnation") is driven by the drop in the wage share of total income.

(c) Brian Romanchuk 2015