James Morley

The major Australian banks have recently cut fixed mortgage rates below 5%. They have done so without any prompting from the Reserve Bank of Australia (RBA), which may actually start raising the policy rate within the next six months, especially if inflation continues to run around the top end of its 2% to 3% target range.

Why, then, did the Australian banks cut their mortgage rates?

One possible reason lies in an obscure old macroeconomic theory of “secular stagnation”  which has been gaining credence recently throughout the financial industry worldwide.

In a speech at the International Monetary Fund last November, Larry Summers, Harvard economist and former US Treasury Secretary, resurrected this old theory, originally developed by another Harvard economist, Alvin Hansen, in the late 1930s.

When a consumption-led recovery in the midst of the Great Depression started to falter, Hansen was inspired by the then nascent Keynesian idea that the economy as a whole could persistently suffer from inadequate demand in the absence of a massive policy intervention.

US population growth had slowed dramatically during the Great Depression and Hansen believed this was a “secular” (that is, long-term, non-policy) source of decline in private investment in new capital infrastructure.

According to his very Keynesian theory, this weak investment brought consumption down with it and, like John Maynard Keynes, Hansen did not believe in the ability of wage and price adjustment to restore the economy to full employment in the face of inadequate demand. Instead, he believed that fiscal policy would have to take up the slack, which it did with the onset of World War II.

The baby boom after the war meant that the theory of secular stagnation was largely forgotten. But Summers sees similar forces at work in recent times and he considers secular stagnation as a leading explanation for why the US housing bubble in the 2000s didn’t result in an overheated economy at the time.

One might question the idea that the US economy didn’t overheat prior to the Global Financial Crisis. But real GDP growth and inflation were actually quite moderate by historical standards throughout the 2000s. Summers speculates that this was because economic growth would have been much slower in the absence of a bubble due to secular stagnation.

This story is somewhat related to former Federal Reserve chairman Ben Bernanke’s “global savings glut” hypothesis about why interest rates remained so low throughout the 2000s. In Bernanke’s view, there were too many savers, especially from Asia, chasing too few high-return and often risky investments. This “chase for yield” put downward pressure on interest rates and fuelled the US housing bubble.

So what is the prediction of secular stagnation for the future and why might it explain the Australian banks’ recent cuts in mortgage rates?

The basic prediction of the theory is that economies throughout the world will continue to stumble along with anaemic growth and no inflationary pressures for the foreseeable future. At best, there will be more moderate growth from time to time, but it will occur due to periodic financial bubbles triggered by a chase for yield and low interest rates.

Faced with slow economic growth and low inflation, central banks will contribute to these bubbles by lowering their policy rates or making large-scale asset purchases (aka quantitative easing) when rates hit the zero lower bound.

In cutting their mortgage rates, the Australian banks appear to have bought into the secular stagnation theory and are clearly betting on continued downward pressure on interest rates driven by a global chase for yield.
Can anything to be done about secular stagnation or, perhaps, is its relevance to the current economic situation overstated?

Similar to Hansen in the 1930s, Summers argues that public investment in infrastructure provides the best way to address inadequate demand. He notes that current low interest rates also mean that the cost of financing public infrastructure investment is unusually low.

Would this fiscal policy approach work? Japan is an obvious place to look at in terms of what might happen in the face of demographic-led stagnation. And the results are not particularly promising.

Japan has undertaken massive debt-financed infrastructure spending and this has not exactly produced a booming economy. Of course, unemployment has remained low and deflation, not inflation, has been the greater problem. So perhaps things would have been even worse in the absence of Japan’s massive fiscal interventions.

Meanwhile, it’s not really clear how relevant secular stagnation is for the rest of the world, including Australia. Indeed, in an odd way, the possibility of secular stagnation means that we should at least briefly celebrate when we see Australian inflation running at the top end of its target range.

This is not to say that the RBA should abandon or revise up its inflation target. But higher inflation is an indication that the secular stagnation hypothesis may be incorrect, while the RBA can always raise its policy rate to bring inflation down again in the future.

Of course, the Australian banks currently betting on low interest rates won’t be quite as happy if this scenario were to play out.

James Morley is a professor of economics and an associate dean at UNSW Australia Business School. A version of this post appeared on The Conversation.