The writer is a senior fellow at Brown University and former chief economic adviser, government of India. Josh Felman also contributed to this article
The Biden administration’s fiscal stimulus plans have come under attack from macroeconomists worried that they will trigger inflation. The unprecedented size of the package, at $1.9tn, certainly warrants anxiety. Yet some of the fiercest attacks have come from proponents of the secular stagnation hypothesis. This is curious because the hypothesis implies that higher inflation is a feature — not a bug — of any strategy to revive growth.
The secular stagnation hypothesis argues that low investment has depressed aggregate demand, dragging down growth and inflation. Based on this diagnosis, economically advanced countries have for decades been trying to boost aggregate demand, so far without much success.
As Japan headed for deflation in the mid-1990s, the Bank of Japan heeded Paul Krugman’s advice that it should “credibly commit to being irresponsible” and embarked on a series of fiscal packages and quantitative easing in an effort to break low inflation expectations. But this enormous effort managed neither to change inflation dynamics nor raise growth sustainably.
In the aftermath of the 2008 financial crisis, the US Federal Reserve and the European Central Bank also tried adventurous monetary policy. They too came up short, consistently undershooting their inflation targets even as they elevated asset prices to frothy levels, encouraged firms to take on dangerous amounts of leverage and distorted capital allocation globally.
Just when all seemed lost, President Joe Biden raised the stakes, announcing a huge fiscal stimulus aimed at jolting the US economy out of its malaise. For non-adherents to secular stagnation, this is a mistake. In their view, the economy is already close to its potential and shortages abound, so large demand injections will generate high inflation.
More difficult to understand is the sharp criticism from the proponents of secular stagnation. After all, the Biden strategy is nothing more than the credible commitment to irresponsibility, applied to fiscal policy. Besides, advocates of secular stagnation have long seen higher inflation as desirable.
According to adherents, the essence of the macro dilemma is that the equilibrium real rate of interest — the real rate of return required to keep the economy’s output equal to potential output — has turned significantly negative, while nominal policy rates cannot be reduced much below zero. So central banks are caught in a trap: as long as inflation is low, real policy rates will remain too high. But precisely because rates are too high, aggregate demand will remain weak, and inflation will remain too low. The only way to escape this trap is if an exogenous event sparks moderate inflation, reducing real policy rates to their equilibrium levels. And that is exactly what the Biden packages might do.
But what if the stimulus proves excessive? In that case, it could resolve another policy dilemma. For some time, interest rates have been stuck at minimal levels despite the accumulation of financial distortions because central banks are reluctant to tighten when inflation is low. The costs of acting (slowing growth) are immediate and visible while the benefits are notional and in the future (preventing financial crises). So raising rates is not incentive-compatible.
However, if fiscal policy stokes demand sufficiently to make inflation a clear and present danger, then central banks might finally tighten monetary policy. Higher inflation could be the deus ex machina which gives central banks a reason to act that the broader public will accept.
Over the longer term, stagnationists see other benefits from moderate inflation. Nominal interest rates could be increased, so central banks would have more room to lower interest rates before they run into the zero lower bound. For this reason, the IMF’s former chief economist Olivier Blanchard long ago called for a 4 per cent inflation target. At the time, the proposal attracted little support. But today, with actual inflation reaching 5 per cent in the US, if only temporarily, a higher inflation target becomes more reasonable.
So, if higher rates of inflation are both necessary and desirable to exit from secular stagnation, why are its leading advocates suddenly worried? Perhaps they believe the era of stagnation is ending of its own accord, sparked by a productivity turnround. Or perhaps they fear moderate inflation could set off a wage-price spiral that the Fed will find difficult to control, as occurred in the 1960s and 1970s, leading to a wrenching recession. Whether their fears are well founded remains to be seen but, at least for now, secular stagnation is an orphan.