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Economists expect extended period of slow growth
THE United States and the rest of the industrial world may have to resign themselves to an extended period of slow economic growth, subdued inflation and low interest rates. The trick lies in avoiding something even worse.
This is the sobering message from the American Economic Association's annual conference, which brought economists and policymakers from around the world to San Diego for a three-day meeting. The event ended on Sunday.
Despite the US and other major developed economies having recovered from the financial crisis of a decade ago and seeing their unemployment rates come down a lot, "we're still seeing no significant increases in estimates of productivity growth, in estimates of trend GDP growth or in R star", the long-run equilibrium rate of interest that neither spurs nor hinders economic activity, said New York Federal Reserve Bank president John Williams.
"We have come to the realisation that these factors are basically the hand we've been dealt for the next five to 10 years," he added.
If that's indeed the case, policymakers confront a risky world. With growth and inflation so low, it wouldn't take much to push industrial countries into the sort of deflationary malaise that afflicted Japan after its gigantic asset bubbles burst in the early 1990s.
Navigating the shoals ahead is going to be tricky and will require a rethink of the traditional playbook that countries have followed in fighting off recessions.
With interest rates so low, central banks can no longer be counted on to combat contractions on their own. Fiscal policymakers will have to play a much larger fire-fighting part than they have traditionally through tax cuts and government spending increases.
While "monetary policy has a meaningful role to play, it's unlikely to be sufficient in the years ahead", former Fed chair Janet Yellen said. It "should not be the only game in town".
Ms Yellen, now at the Brookings Institution in Washington, said she agreed with former Treasury secretary Lawrence Summers that the US was enmeshed in secular stagnation - a state where desired savings are bigger than investment and interest rates are depressed as a result.
The US nevertheless is better positioned than other major economies to handle the difficulties ahead. While US growth, inflation and interest rates are all lower than they have been historically, they're higher than in Europe or Japan.
The dangers are greater in the euro area, where the European Central Bank has been forced to restart quantitative easing to lift sagging inflation expectations and a slowing economy.
"I believe that for the euro area, there is some risk of Japanification, but it is by no means a foregone conclusion" if it acts comprehensively to avoid a deflationary future, former ECB president Mario Draghi said via a video link to the conference.
"The euro area still has space to do this, but time is not infinite," he added. ("Japanification" is a term economists use to describe the country's nearly 30-year battle against deflation and anaemic growth.)
Mr Draghi took euro area governments to task for working at cross purposes with the ECB's efforts to aid the economy in recent years by pursuing restrictive fiscal policies.
"This is why the ECB has been consistently calling for fiscal policy to play a stronger role and capitalise" on the low rates, he said.
He counselled policymakers in Europe against becoming resigned to slipping into deflation. "It is certainly not too late for the euro area to avoid this," he said, adding: "The euro area is not in a deflationary trap."
While Japan's post-bubble experience is a cautionary tale for policymakers elsewhere, its most recent performance suggests not all is lost. Through a combination of super-easy monetary and fiscal policies, Japan has managed to lift itself out of deflation, though its inflation rate is still well short of the Bank of Japan's 2 per cent target.
Peterson Institute for International Economics president Adam Posen said one lesson from Japan is the importance of fiscal and monetary policy coordination.
"The Bank of Japan has basically gotten it right" by anchoring long-term interest rates that the government pays on its debt through a strategy of yield curve control, he said.
Dr Summers, a Harvard University professor, played down fears that the huge government debt Japan has run up while breaking free of deflation will blow up the economy at some point in the future.
In the US, the low level of interest rates has sparked fears that will spawn such financial stability risks as asset price bubbles and excessive leverage.
If Japan is any indication though, that may not be such a big worry. Despite years of super low interest rates, "we don't see any sign of overheating asset prices", said Bank of Japan deputy governor Masazumi Wakatabe.
The same can be said for Europe, said ECB chief economist Philip Lane.
That, though, may be cold comfort to policymakers. He said the biggest ingredient for asset bubbles is excessive optimism. BLOOMBERG