Matt O'Brien has a nice piece presenting charts from Larry Summers (yes, the rest of us had made this point long ago) showing that estimates of potential GDP have dropped as the economy has remained weak since 2007. The point is that a temporary downturn can have lasting economic consequences. Unemployed workers lose skills and can become permanently unemployed. And, by having a long period of weak investment, the economy's capacity will be expanding less rapidly than would otherwise be the case. As the piece notes, this means that current obsession with deficits is not just lowering output and raising unemployment in the present, it is likely to have a lasting impact on the economy.

It is great to see people like Larry Summers openly pushing the idea that the economy can face serious demand problems. This view was routinely ridiculed by mainstream economists all through the 1990s and the last decade, so it is nice to see them change their minds. Summers has even gone the extra mile of noting that lack of demand is not just a problem in the current downturn but one that has been present since the 1990s. This shows the potential for learning among mainstream economists.

However there is still one additional step that they must take to get the full picture. As every intro textbook tells us, Y = C+I+G+(X-M). That means the level of demand in the economy is equal to the sum of consumption, investment, government spending, and net exports. This is an accounting identity -- it is true by definition. It cannot be wrong, if you don't like it then it's your problem.

The significance of this simple identity is that net exports have been a large negative since the late 1990s. Back in the early post-war years we typically had trade surpluses. We began to run modest trade deficits in the 1970s due to the OPEC price increases. The trade deficit rose sharply in the 1980s following a run-up in the dollar, but then fell back to around 1.0 percent of GDP following the Plaza Accord, which brought down the value of the dollar against the currencies of our major trading partners.

The deficit stayed close to 1.0 percent of GDP until 1997. That was when the East Asian financial crisis hit. The harsh terms imposed on the countries of the region by the United States and the I.M.F. required them to massively increase their exports. This led them to sharply reduce the value of their currency against the dollar. Furthermore, to avoid ever being in the same situation as the East Asian countries, most countries in the developing world followed the same course. They lowered the value of their currency so that they could increase their exports and accumulate massive amounts of dollars to hold as reserves.


The resulting rise in the dollar led to an explosion of the U.S. trade deficit. It eventually peaked at almost 6.0 percent of GDP in 2005. Since then a decline in the dollar and the weakness of the U.S. economy has brought it down to around 3.0 percent of GDP (@$500 billion a year).

This matters hugely for the secular stagnation story because this 3.0 percent of GDP is demand that must be made up by the other components of GDP. We must either have more consumption, more investment, or more government spending, or some combination, than would normally be the case because we have a trade deficit of 3.0 percent of GDP. Again, this is accounting identity stuff, it has to be true. If you disagree, read this as many times as necessary until you understand.

We don't have any good ways of substantially boosting investment. We have politicians who yap about taxes and regulations, but we have tried that path (been there, done that, in technical terms). It doesn't work.

We can't boost consumption too much without asset bubbles. The problem is that people insist on trying to save for retirement. Those of us with access to government data know that consumption is actually relatively high right now, not low as you often hear in the media.

This leaves government spending. Unfortunately, our politicians are religiously opposed to budget deficits in the same way that many question evolution. That means we have no good way of offsetting the demand lost due to the trade deficit, end of story, game, set, and match.

It might seem a hopeless battle to think that manistream economists will ever accept the national income accounting that appears in the first chapter of their textbooks, but there is some basis for hope. After all, a decade ago the possibility that they would accept secular stagnation seemed pretty hopeless as well.

One final point, if we can't get to full employment on the demand side, we can go the supply side route. Work sharing, paid family leave, sick days, and vacations are all great ways to spread around the available work. Again, it will take our economists some time to appreciate the merits of this route as an alternative to high unemployment (this is Germany's secret), but there is evidence they can learn.