Eight years have passed since the financial crisis of 2008 and many European countries, including the Netherlands, have only just surpassed their pre-crisis GDP level. The image of a waving line representing an economy going down and back up again in cycles is one of the most elementary concepts of economics; yet recent recovery has shown nothing of the like. Growth over the past years has been slow and fragile, not just in the Netherlands. We are used to seeing economies gain momentum and soar out of the depths of a depression: what has happened to the business cycle? This article is an extension on the original version published in the printed version of Rostra Economica. In this version I discuss in more detail several arguments, some of which are quite technical.
Over the last years, several theories have been put forward that try and explain the disappointing recovery. The one that has gained the most attention in economic debate is the so called “secular stagnation hypothesis”. This term originally dates back to the years following the Great Depression, but was revived by Larry Summers in 2014. Secular, or structural stagnation represents the idea that “sick recoveries die in their infancy and depressions feed on themselves.” Instead of focusing on short-run deviations from equilibrium like the majority of economic science, secular stagnation focuses on structural issues that hold back growth.
In general, secular stagnation focuses on two pillars: the potential growth rate and the output gap. The potential growth rate is the rate at which potential GDP grows: the theoretically maximum level of output that can be achieved using an economy’s production factors. The output gap is the gap that exists between the levels of actual and potential output. A negative output gap means actual output is below potential; a positive gap means the opposite. According to the secular stagnation hypothesis, the weak growth over last year’s comes from both a drop in the potential growth rate and a persistent negative output gap. The first holds back actual growth by not increasing its potential, the second by making actual growth consistently not live up to its potential.
Understanding the difference between the two is crucial, yet complicated. So by analogy, when comparing the economy to a car, potential growth would be the maximum speed achievable with your engine while the output gap would be factors constantly slowing down the car down. When your engine doesn’t get any faster and you are driving on bad tires, accelerating becomes really hard. As we see in the graph below, this describes quite accurately the Dutch economy over the last years.
The first pillar: a lower long run potential growth
The question is: why have both these pillars underperformed? This is where academic opinions start to diverge, as many (often country specific factors) are emphasized. Starting with potential growth, economic literature puts forward four “headwinds” as explanations: demographics, education, inequality and government debt. Out of these, demographics is the most significant to the Netherlands. When a country’s labour force grows the potential output it can produce grows as well. Simply put, output in an economy equals what is produced in an hour (labour productivity) times the hours worked (labour supply). When both stop growing, so does output. Looking at the Netherlands, labour force participation has been stable for 15 years, meaning the economy has not really made more hours since. Meanwhile, productivity growth has fluctuated around zero since the crisis. The combined effect of these trends looks like this:
It becomes clear that demographics have done nothing to drive potential economic growth in the Netherlands. The effects of education, inequality and government debt on potential growth are less pronounced, yet are far from negligible.
Firstly, education can boost economic growth by increasing a worker’s productivity as well as his income. In the past century we have seen landmark educational gains with strong effects on the economy’s potential growth. Arguments have been made that these gains have finished and that it seems unlikely will see experience something similar in the future. When looking at education in the Netherlands, we indeed find that enrolment rates in primary and especially secondary education steadily increased over the past century, but have stabilized since 1990. The so called “education revolution” appears to be finished, but does this mean we can no longer expect education to be driver of economic growth? If we look closer at trends in education we find something else with which we are all familiar: in around a 100 years the number of university students has grown by a factor 86, while the population has grown by a factor of 3. University, or tertiary, education has increased exponentially which in turn has made our labour force very highly educated: in 2015 around 34% of the Dutch labour force had received tertiary education (OECD). Though we cannot directly assume this will benefit economic growth in the same way the education revolution has, it seems reasonable to more tertiary education is not reducing potential growth. As such, education does not appear to be a strong force of secular stagnation in the Netherlands.
Secondly, inequality can suppress long run potential growth when income gains mainly benefit the few. When income becomes concentrated with a few, economic theory suggests the propensity to spend will decrease and effective demand will fall. Though both income and capital inequality in the Netherlands are present (the latter more so then the first, see for example Van Bavel, 2014), both do not appear to be strong enough to significantly limit long run potential growth. Though the trend over the past years shows a worsening, which eventually could limit potential GDP growth.
A third additional reason for lower long run potential growth relates to public debt. As public debt is reaching historical highs, the government’s ability to support the economy could in the future become limited. Restricted by the rules set by the Maastricht treaty (3% deficit/GDP and 60% public debt/GDP) room for fiscal expansion through debt issuance is limited at high levels of debt/GDP. In the long run this could deepen future recessions and structurally worsen consumer expectations as they become aware of their government’s limit ability to counter and intervene economic recessions.
The graph below shows the development of the public debt to GDP ratio and its components over the past 20 years. First we see the debt over GDP ratio decreasing as a result of growing GDP and relatively stable public debt. But after 2008 we see the opposite, GDP growth stabilizes while public debt rises. In this period the ratio rose from roughly 43% to 70%.
How bad is this ratio? As with inequality, there is no optimal economic value for the debt/GDP ratio (though the benchmark proposed by the IMF is 60%). When comparing the Netherlands with other European countries the ratio looks less excessive compared to the EU average of 86%. As such the current public debt to GDP ratio seems not yet detrimental to long-run potential growth.
The second pillar: a structurally negative output gap
The second pillar of secular stagnation relates to the output gap. Here we look at forces that consistently ensure actual GDP growth is below potential GDP growth. In the literature, four main issues are found to be relevant to this pillar: long-term unemployment, income growth, balance sheet recession effects and the real natural interest rate gap. Especially balance sheet recession effects appear to be relevant for the Netherlands. Proposed by Richard Koo, this argument states that following the burst of a debt-financed bubble we see a tendency towards private debt minimization. In the wake of a recession, asset prices collapse while debt remains, causing individual “balance-sheets” to run into a deficit. As a result, companies and households prioritize paying off existing debts before taking on new loans or making investments. They become more austere: paying down debt (or saving more) while spending less. Though reasonable on the individual level, this decreases an economy’s aggregate demand, and in the long run can have very powerful and lasting consequences, as for example Japan’s lost decade. In the Netherlands, the main type of household debt is the mortgage on a house. The graph below shows the long run development of household mortgages, GDP and housing prices.
We clearly see the rapid expansion of households mortgages from 54% of GDP in 1995 to close to 100% in 2008. Following the crisis, housing prices fell into a slump and mortgages went underwater; basically bankrupting the household balance sheet. The situation in the Netherlands prior and following 2008 is quite favourable for balance sheet recession effects to take hold and strengthen the negative output gap. CBS data on Dutch household saving and consumption post 2008 confirm this, as the first saw a strong increase while the second fell sharply. Dutch companies are left out of this analysis for they are generally not exceptionally leveraged, making it harder to distinguish balance-sheet recession effects.
Three other arguments are put forward in the literature as explanation of a structural negative output gap: long-term unemployment, income growth and the real natural interest rate gap. Starting with the first, high unemployment can keep output from reaching its potential when unemployment fails to improve in the wake of a recession and it becomes a long-term drag on economic growth. In the Netherlands long-term unemployment has gone from 1.4% to 3.1% since 2008. Though we have seen high long-term unemployment before 2008 as well, the current share of short-term unemployment (4.4% out of 7.4%) is exceptionally low. The total unemployment rate has stabilized around 7% for the last two years; a level not seen since 1996 when it stood at 7.7%. When looking within the EU the Netherlands end up in the middle with overall EU unemployment standing at 10%. However, opposed to the Netherlands, most EU members have seen their unemployment rate decrease over the last two years. Long-term unemployment is a problem of the Dutch economy.
This argument is further supported when looking at data on the Dutch NAIRU, the non-accelerating inflation rate of unemployment. The NAIRU can be thought of as the equilibrium rate of unemployment: below this level inflation expectations will rise, above this level they will fall and cause disinflation. Looking at the graph below we see that the structural output gap of the past years largely corresponds to a period of above NAIRU unemployment rates. This suggests unemployment as a reason for economic underperformance as well as the observed falling level of inflation. In short, unemployment can be assumed a main cause for the output gap.
A second reason for sustained negative output gaps is income growth. Output gaps can be the result of weak income growth when economic growth is not translated into real income growth. Evidence from the Netherlands shows that household mean income has barely grown since 2008, just 0.6% on average. As such, income growth in the Netherlands has been weak and has done little to support economic recovery.
The final argument I will consider here relates to the so-called real natural interest rate gap. The real natural interest rate is a theoretical concept introduced by Wicksell (as the neutral interest rate) and most commonly defined as ‘’ the real short-term interest rate consistent with output at its potential level and a stable rate of inflation’’. This definition immediately shows its relevance to the topic of this article: if the real interest rate structurally deviates from the real natural interest rate, this could keep output from reaching potential. The real natural interest rate gap has been put forward as the main reason for structural stagnation by Larry Summers in his ‘’new secular stagnation hypothesis’’. He suggests that if the natural real interest rate has fallen significantly below zero, it might be the case that with nominal interest rates fixed at the zero lower bound (ZLB) and ample inflation, the real interest rate is unable to reach its natural level.
What evidence of Summers’s ‘’new secular stagnation hypothesis’’ do we find in the Netherlands? First we need to estimate the path of the natural real interest rate in the Netherlands. Secondly, we need to compare this estimate to the real interest rate to see whether a gap between the two has existed that prevented output from reaching potential. Since the natural real interest rate is a theoretical concept, numerical estimates are complicated to obtain and often the result of complex statistical. A more intuitive understanding of the natural interest rate and its trend is found by looking at its underlying determinants, mainly productivity and population growth. As stated earlier in this article, both productivity and population growth in the Netherlands have stagnated in a way similar to those seen across the EU. Labour productivity growth has steadily declined while population growth has stagnated: both putting a downward pressure on the real natural interest rate. From the similarity in trends between the Netherlands and Europe in general, we can reasonable assume the natural real interest rate in the Netherlands has followed a similar downward path as Europe. The current real interest rate in the Netherlands is approximated to be below zero. The nominal rate (using the annualized short-term interest rate as a proxy) has been near zero for four consecutive years, while inflation (using the basic CPI as a proxy) has steadily declined and has averaged 0.3% in 2015. Though the real interest rate is perceived to be negative, it is likely the real natural interest rate has seen a significantly steeper decline and lies even lower; an indication of a structural real interest rate gap. We can assume the Netherlands, like the rest of Europe, is suffering from structural real interest rate gap which prevents output from reaching its potential.
Secular stagnation is a cause for concern in the Dutch economy. Both a decline in the potential growth rate and a persistent negative output gap have weakened economic growth over the past years. The first, mostly as a result of a stagnant labour force and weak productivity growth. The latter mainly due to balance sheet recession effects: households become more austere after the crisis as a result of excessive leverage and falling housing prices. These problems are not easily solved. Secular stagnation has deep roots and will require firm policy changes if it’s effects are to be resolved. What makes this even more challenging is that modern economic theory is largely structured around short-term business cycle deviations. The revived importance of structural factors on the economy will pose many new challenges in the near future. Without an adequate revision of both policy and academics aimed at solving the structural issues raised by secular stagnation, economic growth in the Netherlands and many other countries is likely to remain disappointing in the years to come.