One of the most serious challenges facing Western economies is a structural weakness in demand, caused by an ageing population. This weakness is at the root of a secular stagnation, characterised by low inflation, sluggish economic growth and chronic underemployment. Japan has been in this situation for 25 years and does not appear likely to emerge from it in the near future. The eurozone and, to a lesser extent, the United States have been in a similar situation for more than a decade. Whilst monetary policy is now ineffective, fiscal policy can stimulate demand. This requires the implementation of a massive stimulus package to temporarily ‘overheat’ the economy and put an end to persistently low inflation. As the Covid-19 pandemic draws to a close, many countries are launching fiscal stimulus plans on an unprecedented scale, thereby offering a unique opportunity to put an end to economic stagnation. The stimulus measures recently announced and implemented in the United States are part of such a strategy. The eurozone, by contrast, does not appear willing to take similar action.
Understanding secular stagnation
This paper describes the structural trends and economic mechanisms underpinning secular stagnation, before reviewing possible solutions, using the results achieved by the stimulus packages introduced in response to the Covid-19 crisis as an example.
Reference IPP Policy Brief No. 73
Presentation
Key Results
- In recent decades, an ageing population has led to structural weakness in demand, resulting in a slowdown in economic activity.
- To counter this trend, monetary policy has cut interest rates until they reached 0 per cent – the lower bound below which rates cannot be reduced any further to continue stimulating the economy.
- Secular stagnation refers to a situation characterised by zero interest rates, near-zero inflation and underemployment. Japan has been experiencing this stagnation for 25 years, whilst the eurozone and the United States have been in this situation since the 2008 crisis.
- Higher inflation encourages households to consume today rather than tomorrow. The optimal policy is therefore to raise inflation sufficiently to return to full employment.
- This can be achieved through a fiscal stimulus policy that temporarily overheats the economy, thereby triggering inflationary pressure on prices and wages.
- As the Covid-19 pandemic draws to a close, many countries are implementing massive fiscal stimulus packages, which offer a unique opportunity to escape the trap of too-low inflation. The United States thus appears willing to take the risk of excessive inflation to avoid suffering the same fate as Japan. By comparison, the Eurozone’s response appears more mixed.
Jean-Baptiste Michau