Summers, Secular Stagnation and Aggregate Demand Deficiency

The foundations of a coherent theory of activity levels were first put forth by Kalecki and Keynes in the 1930s. Their economic theory states that an economy’s output levels are determined by aggregate demand and that there are no economic forces which ensure full employment of labour or the full utilization of capacity. In other words, aggregate supply adapts to aggregate demand. This principle was then extended to the question of economic growth, most notably by Roy Harrod. Subsequent work in this line of enquiry suggests that growth is demand led, as opposed to the mainstream/neoclassical view of economic growth as supply driven.

The idea of secular stagnation, recently articulated and advocated by Larry Summers, will be critically appraised in this blog post amidst the above backdrop. Here, we almost exclusively focus on Summers’ 2014 paper in Business Economics titled ‘U.S. Economic Prospects: Secular Stagnation, Hysteresis, and the Zero Lower Bound’. The principle (also simultaneously a policy prescription) of secular stagnation can be stated as follows: since interest rates have reached their lower bounds and aggregate activity levels are depressed, the solution is expansionary fiscal policy. Why are aggregate activity levels depressed? Secular stagnation suggests that negative fluctuations re-quilibrate the economy to a position characterised by lower output and employment levels. Moreover, ‘the amplitude of fluctuation appears large, not small’ (p. 65).

Macroeconomic equilibrium is characterised by equality between actual and potential output. According to Summers, ‘essentially all of the convergence between the economy’s level of output and its potential has been achieved not through the economy’s growth, but through downward revisions in its potential.’ (p. 66) This is because of aggregate demand insufficiency. ‘The largest part [of the downward trend in potential] is associated with reduced capital investment, followed closely by reduced labor input.’ (p. 66) To put it differently, aggregate demand deficiency leads to the unemployment (and underemployment) of labour and underutilization of capacity.

Despite Summers’ correct identification of the problem, his marginalist conceptualization forces him to connect this with the ‘equilibrium or normal real rate of interest’ which equilibrates saving and investment. As a consequence, he argues that a ‘significant shift in the natural balance between savings and investment’ (p. 69) has occurred. This post will only state that the idea of the rate of interest being sufficiently sensitive to changes in planned saving and investment is one that has been severely criticized and rightly so. [A follow-up post will examine this matter more closely.]

Towards the end of the paper, Summers makes a point which Keynes (and Kalecki) made in the 1930s: ‘We are seeing very powerfully a kind of inverse Say’s Law. Say’s Law was the proposition that supply creates its own demand. Here, we are observing that lack of demand creates its own lack of supply’ (p. 71). However, Summers states this as a contingent principle and not a general proposition as it is in Keynes (or Kalecki). This is not surprising given Summers’ economics being marginalist in nature.

Therefore, since demand creates its supply, Summers advocates public investments and vocally states the counterproductive nature of fiscal austerity. Furthermore, he hypothesises that ‘increases in demand actually reduce the long run debt-to-GDP ratio’ (p. 73). Lastly, he favours policy measures which place ‘substantial emphasis on increasing demand as a means of achieving adequate economic growth.’