The recent macro-economic phenomenon of inversion of the yield curve in the US (yield on 10-year US treasuries falling below those of two years) has triggered recession fears. The yield inversion indicates that investors are predicting lower-than-expected inflation and slower growth. In normal times, it may not have been a problem, as the central bank (Federal Reserve) could have used an expansionary monetary policy to stimulate investment spending, and boost economic growth and inflation.

However, at a time when developed countries are adopting the unconventional monetary policy of keeping interest rates low (in the US and the UK) and even negative (Japan, France, Germany and Sweden), the situation differs and is perhaps grim. The further lowering of interest rates by central banks of the US and the UK may push their economies into a liquidity trap, thereby making monetary policy ineffective.

In such circumstances, an expansionary monetary policy raises the supply of money. But given that interest rates are already low/negative, the extra liquidity might not have any effect on aggregate demand, production and employment. All these variables would remain at low levels.

Consensus post the global financial crisis of reviving global output through unconventional monetary policy, or standard New-Keynesian stimulus policies, is therefore proving ineffective. Central banks cannot always revive economic output through monetary policy. This means that aggregate demand is not the real problem, and the present global slowdown is the result of negative aggregate supply shocks.

Secular stagnation

What caused the aggregate supply shock?

The failure of the monetary policy strengthens the doctrine put forward by economist Alvin Hansen in response to the Great Depression: that economies are suffering from ‘secular stagnation’. He argued that Western economies are experiencing a long-term slowdown due to the lack of investment opportunities, waning impact of the industrial revolution, and ageing of the population with little or no immigration.

The secular stagnation view was resurrected by economist Larry Summers in 2013, when he argued that it is almost impossible to boost growth by interest-rate policies. Summers said the present slowdown is a result of structural factors. Western economies are suffering from imbalances — high propensity to save, low to invest. The result is excessive savings and a drag on demand, reducing growth and inflation.

Saving and investment imbalances are the result of an increase in inequality, higher share of income going to few corporates, weakening of social safety-nets for displaced workers, ageing and poor population. These are making the median income stagnate, lowering consumption spending and pushing the population towards higher savings (they expect a grim future and that the government will not provide a safety net).

Supply shocks

Reduced investments are the result of the declining working-age population, slower labour force growth, technological disruptions and no new investment opportunities. Due to lack of investment opportunities, the excess savings are getting concentrated into existing assets, creating asset bubbles.

A decade of secular stagnation has pushed the economies (developed and emerging) back into the mercantilist era of ‘beggar thy neighbour’ policies. The two largest economies — the US and China — are fighting a trade war, which can soon translate into a currency war. International coordination to fight the economic slowdown is at its weakest, not seen since end of World War II. The lack of effective coordination, resurrection of tariff barriers (protectionism), and the US-China trade war acted as a negative aggregate supply shock. These supply shocks could further reduce global growth, exacerbate stagnation and may result in stagflation. For instance, the US-China trade war may alter the cost of producing goods and services by increasing the prices of imported intermediate goods and technological components, thereby disrupting the global value chains.

Such a shock to the global value chains is likely to push both cost and prices upward. The supply shock will lower the economic output and push up prices — resulting in stagflation. In past episodes of stagflations, the central banks responded by increasing the interest rates. Such an option is unlikely to work in the present era, as the crisis is structural. The reality is, with the world becoming more interconnected, ‘beggar thy neighbour’ policies will have drastic global effects. When a country intervenes through unconventional monetary policies, the primary effect is exchange rate depreciation. It makes exports hyper-competitive, driving down domestic production and profits in emerging economies like India. Such policies are likely to dampen India’s exports and its plan to be a global manufacturing hub.

The writer is with the EAC-PM. Views are personal

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