Of course, the big question is what is driving this economic stagnation. Larry Summers has identified several factors. Most importantly, many countries have started to increase their savings over the last two decades. These economies include emerging markets in South-East Asia (especially China), the oil-exporting countries and ageing industrialized countries like Germany and Japan, for example. Interestingly, China is also ageing rapidly. A lot of the amassed savings in these countries actually ended up flowing into the US in the years preceding the crisis, fuelling the local housing bubble. There is a large literature on how international capital flows and global imbalances have significantly contributed to the outbreak of the financial crisis.
In addition to the increased desire for savings, we have most likely experienced a global slow-down in investment demand. It is useful to look at a concrete example here. Nowadays, companies like Twitter and Facebook have the same market capitalisation as large car manufacturers, for example, which have hundred thousands of people employed all over the world in large factories. Twitter on the other hand basically just employs a few hundred tech nerds in a small office building and the only thing they need are some high-tech computers and a decent internet connection. So in the “new economy” there is much less investment needed to achieve the same amount market capitalisation. Since many startups nowadays do not need large factories anymore, we have seen a large reduction in demand for physical investments.
The combination of increased savings from many countries together with the reduction in investment demand has led to a significant decrease in global real interest rates (the real interest rate r is equal to the nominal interest rate i minus the inflation rate p: r = i - p). Contrary to popular belief, Central Banks actually do not have any influence of over long-term real interest rates, which are determined by structural factors in the economy, such as the desire to save and invest by people and companies. Global real interest rates have fallen from maybe 2-3% in the early 1990ies in many industrialised countries to almost 0% nowadays. Together with almost zero inflation this implies that nominal interest rates are stuck at zero as well.
This is extremely problematic because Central Banks normally use nominal interest rates to steer the economy and keep aggregate demand and inflation stable. If we had much higher interest rates in the US and the Eurozone, Central Banks would have cut them by now with all the stock market turmoil that is going on in international financial markets. In 1987, for example, the US stock market crashed by almost 25% within a short period of time. However, the FED cut the nominal interest rates by 2% and the real economy was basically unaffected. Nowadays, they cannot do that anymore since interest rates are already stuck at zero. This means that every minor negative economic shock has the potential to adversely affect the economy since the FED, the ECB & Co. cannot react. Central Banks could potentially restart QE (Quantitative Easing, i.e. printing money), but they are unwilling to do that because of political constraints. Furthermore, QE is a very crude tool compared to changes in the interest rate. The effects of QE are and have been definitely positive, but it is much harder to know in what doses one should inject money into the economy.
Since secular stagnation is a demand-side phenomenon, there are basically two big complementary ideas on how to cure it. At the moment, most industrialised countries can basically borrow money for free (at zero interest rate). For that reason now would the best time to take on some additional government debt and invest it into infrastructure and education. This would very likely lead to higher aggregate demand in the short-run. Additionally, a higher stock of infrastructure and a more educated workforce would also increase the economy’s long-run potential to produce stuff. However, most governments currently do the opposite, cutting government spending and thus depressing the economy in the short-run as well as lowering its long-run potential.
The second measure would be to change the mandate of Central Banks. Lawrence Summers and Brad DeLong already worried in the early 1990s that the at that time newly adopted 2% inflation target by Central Banks in many advanced economies would be too low. Many macroeconomists argue that Central Banks should either aim for a higher inflation target, such as 4%, or implement a nominal GDP level target.
Credibly switching to a 4% inflation target right now and achieving such an inflation rate would probably lead to a decent economic recovery in the short-run. Some workers might perhaps see their real wages erode slightly in the first one or two years after the new regime has been implemented. However, a swift recovery would also put many other workers who have left the labor force back to work. Loose monetary policy and a high-pressure labor market are actually by a wide margin inequality-reducing and beneficial for the working class.
One should emphasise that in the long-run workers are obviously not worse off under a 4% inflation target than under a 2% inflation target. They would simply ask for higher nominal compensations as well as slightly more frequent wage adjustments so that real wages remain by large unchanged.
The whole point of going to the higher inflation place is to achieve higher nominal interest rates. Normally, nominal interest rates should be at least 4% or more with a 4% inflation rate. Central Banks would then have enough manoeuvrability to decrease interest rates by a a few percentage point if needed in the face of a big negative economic shock. They clearly cannot do such a move right now with interest rates being stuck at zero. Moreover, the microeconomic costs of somewhat higher inflation (such as menu costs, i.e. companies must change their prices more frequently in a higher inflation environment) are relatively tiny compared to the large macroeconomic costs that occur if the economy plunges into a nasty recession because monetary policy is constrained by the zero-lower bound on interest rates. Or in other words, macroeconomic disasters trump microeconomic inefficiencies by a wide margin. The last few years have made abundantly clear how devastating recessions in terms of welfare loss really can be for an economy and that is why an alternative monetary target should actually be the first priority of policy makers nowadays. Unfortunately, “retargeting" Central Banks is at the moment seriously considered in academic circles only. Well, not quite. The Bank of Japan implemented a regime change with the initiation of Abenomics. They basically followed Paul Krugman’s advice, about 20 years after he had given it, to do "whatever it takes” to reinflate the domestic economy. The early results have been quite promising. A preliminary analysis suggests that the monetary arrow of Abenomics might have boosted Japanese GDP over the last years by as much as a couple of percentage points, that is a few hundred billion USD. So maybe, if we are lucky, the FED will follow suit and realize in a decade from now that the current monetary regime will not work well in the secular stagnation world of low real interest rates and weak global demand. However, I cannot see any hope for a regime change at the ECB. So the Eurozone is basically totally screwed.
DeLong and Summers on the undesirability of a 2% inflation target:
Hausman and Wieland on Abenomics:
Krugman on Japan’s liquidity trap:
Summers on secular stagnation: