by Aidan Kang, CFA
Senior Writer
UPDATED: February 20, 2023

Alvin Hansen introduced the notion of “secular stagnation” in the 1930s. Hansen’s hypothesis has been brought back to life by Larry Summers in his November 2013 secular stagnation speech. The speech generated a huge amount of discussion, and for good reason. Summers’ provocative hypothesis is that the Great Recession was symptomatic of a longer-term problem: persistently inadequate demand that is evidenced by low real interest rates.

The basic idea and implications have been fleshed out by many: here is some backround reading by Ryan AventJohn CassidyGavyn Davies, and Paul Krugman. A brief summary of the hypothesis goes something like this: A normally functioning economy would lower interest rates in the face of low current demand for goods and services in order to induce households and businesses to get loans and spend. When interest rates fall in a normally functioning economy, households borrow to buy cars or re-do their kitchens, and businesses find it profitable to invest. A lower interest rate helps boost demand.

But what if the interest rate needed to generate sufficient demand is negative? In other words, what if the economy needs to charge people for saving in risk-free assets such as U.S. Treasuries in order to get them to spend? Many find this idea counter-intuitive: real interest rates are basically zero, but this argument says they are still too high.

Why would interest rates be stuck at too high a level? Why can’t they become negative? Nominal interest rates can never be negative because of currency — the U.S. government promises a nominal return of 0% if you hold cash and so no one would accept a nominal interest rate below 0% on another government security. Of course, real interest rates can become negative if we have inflation. But inflation may be hard to get, especially if a central bank has built a reputation for fighting inflation. If real interest rates need to be very negative to boost demand, but prevailing interest rates are around zero, then we will have too much savings in risk-free assets — what Paul Krugman has called the liquidity trap. In such a situation, the economy becomes demand-constrained.

The liquidity trap helps explain why recessions can be so severe. But the Summers argument goes further. He is arguing that we may be stuck in a long-run equilibrium where real interest rates need to be negative to generate adequate demand. Without negative real interest rates, we are doomed to economic stagnation.

Like most provocative ideas at their initiation, it is still mostly abstract based on informal modeling. There will no doubt be push-back from economists who are skeptical of demand-driven economic cycles, and we are likely to see more modeling and testing among researchers trying to flesh out the idea further. This is absolutely necessary. And hopefully it will be fruitful.

In our view, what is missing from the secular stagnation story is the crucial role of the highly unequal wealth distribution. Who exactly is saving too much? It certainly isn’t the bottom 80% of the wealth distribution! We have already shown that the bottom 80% of the wealth distribution holds almost no financial assets.

Further, when the wealthy save in the financial system, some of that saving ends up in the hands of lower wealth households when they get a mortgage or auto loan. But when lower wealth households get financing, it is almost always done through debt contracts. This introduces some potential problems. Debt fuels asset booms when the economy is expanding, and debt contracts force the borrower to bear the losses of a decline in economic activity.

Both of these features of debt have important implications for the secular stagnation hypothesis. We will continue on this theme in future posts.