Secular Stagnation and Income Inequality

by George Hatjoullis

The expression ‘secular stagnation’ is being widely used at present often without much understanding. In some vague way it refers to concern that the global economy may have entered a sustained period of below potential growth and, most probably, on average, zero growth. The emphasis is on excess capacity. For the layperson such an idea seems counterintuitive. Technological advance is creating new products and needs, as well as boosting potential productivity and profitability. Large parts of the global population have yet to experience material consumption let alone become satiated. Why then should stagnation, in the sense of excess capacity, set in?

The answer was alluded to in the Economics series that constitutes a part of this blog. It is not stagnation in the conventional sense. It is a reflection of the fundamental flaw in the market economic system coupled with extreme income inequality. The Economics series highlights that the owners of the means of production need to consummate their profitable production by selling the produce. In any one year the output belongs to labour and the owners of the means of production. However, if these stakeholders do not wish to realise their claims on GDP ( that is, they want to save) some of the output remains unsold or ‘surplus’. The unsold output must either be borrowed by the private sector or state sector or bought up by dissaving by those that have accumulated claims on GDP (e.g. pensioners). In the event that this borrowing and dissaving is persistently less than the ‘surplus’ GDP, the economy can settle into a secular stagnation or what Keynes called an unemployment equilibrium. The interesting question is in what circumstances such a persistent state can arise?

The stakeholders in current GDP do not have equal shares. In times of extreme inequality of income distribution the share of labour tends to decline and the vast bulk of the claims accrue to relatively few economic agents. These agents wish to save a disproportionate amount of these claims. This leaves a larger and larger share of GDP to be taken up by borrowing or dissaving. At present both state and private sectors seem disinclined to borrow and those holding accumulated claims seem disinclined to dis-save. The state sector is in fact reducing borrowing at a time when income inequality requires that it increase. Pensioners are being systematically forced to defer dis-saving by poor pension income prospects and increases in longevity. The personal sector is constrained because the aggregate income accruing to this sector is a smaller part of GDP and it is being encouraged to save what little income is accruing. Only the private business sector, representing the owners of the means of production, has the capacity to expand spending via investment.

Deferring the great stagnation (and it is only a deferral) requires a meaningful increase in capital expenditure. It needs to be large enough to absorb surplus GDP and move the economic system to potential. Unfortunately, it will also expand this potential so it merely defers the current problem until a larger problem arises at a later date. Perhaps by this time the state can borrow once again and defer the new crises a little longer. Looked at from this angle one can see that secular stagnation is not an anomaly but a fundamental flaw in the market system. The roots of the problem are in the profit-motivated process which drives the system. It is a very productive system which can generate exceptional material growth for long periods. However, it also generates the very unequal distribution of income that ultimately will undermine the whole process. Eventually the system collapses under the weight of the very productivity that it produces. Unequal income distribution eventually means output cannot be realised (sold) and the secular stagnation sets in until something jolts it into action once again.

What can jolt it into action? Generally anything that allows production of goods that do not need to be sold or that can be sold without the above constraints. War serves this purpose very well. The state can commandeer goods and pay with questionable future promises. The goods produced need never be sold and, by and large, regularly need to be replaced. A less horrific alternative would be some limited form of deficit financing. The central bank prints cash that it gives to the state, no questions asked. The state uses this cash to buy up surplus output and employ surplus labour. So long as this does not interfere with the profit-motive too much it can ameliorate the situation sufficiently to keep the system stable, for a while. It must however be limited and calculated to only equal surplus output and employment. The goods so purchased can be distributed to the less well off. State employment provides people with cash to buy surplus GDP.

One problem with monetary financing is the inclination for states to abuse the facility. If the state systematically asks the CB to print more cash than the value of the surplus GDP, inflation will arise and a whole new set of problems. The are also many operational problems (calculating the value of surplus output). Most serious however is the moral hazard that a systematic deficit financing programme introduces. If owners of the means of production believe they can sell any quantity, then output will be inefficiently produced. The market discipline is lost and the whole point of a market system undermined. Deficit financing cannot provide a permanent solution to the problem of secular surplus output. Nor indeed can war. So what, if any, is the solution?

The answer lies in an optimal income distribution. Too much inequality leads to surplus output. Too little inequality, within a market system, may lead to inadequate growth of potential output (the conventional notion of secular stagnation). Logically there may exist some level of inequality that leads to just the right amount of growth of potential output without systematic surpluses arising. It need not be a unique degree of inequality and it may vary across time and culture. The implication however is that what is being classed as secular stagnation at the moment is secular surplus output and is being caused by excessive inequality and that action to reduce inequality is what is required. This cannot be achieved through existing channels of monetary policy which has by and large increased inequality by operating via a wealth effect (credit expansion being ineffective). It can only be achieved through fiscal policy and redistribution.

There is an evident trend in economic policy (certainly in the UK) towards redistributive measures. Wealth taxes are becoming more evident. The so-called Mansion Tax being proposed by the Labour and Liberal democrat parties in the UK is rather good example. House prices have boomed in part as a result of the monetary policy pursued since 2008. This has benefited asset holders which in the UK primarily means house owners. The nominal wealth of house owners has increased and exacerbated inequality. The Mansion Tax is not however a logical or ‘fair’ way to tax this wealth. Second homes are already subject to CGT and a differential CGT rate on second homes could be introduced. More important however main homes are exempt from CGT. It makes more sense to tax the sale of a property rather than, as the Mansion Tax will, simply ownership. The best taxes are self-financing. Income taxes take a part of income earned. No earnings equals no taxes. Wealth taxes are not self-financing. They impose a cash flow burden on owners that may be deriving no cash from the asset. A sales tax takes a part of the sale revenue and is thus self-financing. There is already a sales tax on the property purchaser in the form of stamp duty. Although levied on the purchaser the burden also falls on the seller in some adjustment to price. One could introduce a separate tax on the seller on adjust the stamp duty rather than introduce the Mansion Tax.

The counter argument is that such taxes can be avoided if you simply do not sell the property. If sales taxes become onerous people will either never move or adjust their living arrangements via letting and renting elsewhere. This may ultimately boost the rental sector. This will help boost income tax revenue as you pay tax on rent received but cannot offset tax on rent paid. The other counter argument is that the implicit rent on high value properties is also high and ownership is a very tax efficient way to live in such a property (see my blog Personal Finance 8: Residential Property, which is under the property tag). A Mansion Tax is one way of reducing this tax advantage. One should expect more and more redistributive measures and whilst they be frustrating, it should be remembered that excessive income inequality ultimately hurts everyone; rich and poor.