The past two weeks have been turbulent for the world's markets. But they have been buoyant for proponents of the theory that the global economy is stuck in a semi-permanent rut.
The so-called "secular stagnation" hypothesis was first advanced by economist Alvin Hansen in the late 1930s, and revived by former US treasury secretary Larry Summers in a different form two years ago.
Mr Summers argued that growth potential in advanced nations has been sliding for decades. Ageing populations, globalisation and automation have come together to depress wages, especially for the less skilled. Demand for new investment is therefore deficient when compared with societies' desire for savings. As a result, the "natural" rate of interest these economies can bear has been declining and might even have turned negative.
If the theory is correct, private borrowers will not have many profitable projects at rates of interest that allow savers to expand their nest eggs. Without more public investment, the world faces a drawn-out slump punctuated by unsustainable speculative bubbles.
Critics dismiss secular stagnation as an attempt to justify ultra-low global interest rates since the 2008 crisis. They say private investment is weak not because demand is inadequate, but because near-zero borrowing costs are leading to misallocation of capital.
A test for the debate came on Aug 11, when the People's Bank of China unexpectedly devalued the yuan. It was a tiny change - the Chinese currency is now 3 per cent weaker against the US dollar. But the shift triggered a spike in what are still very low real interest rates in the United States.
How big was the jump? Yields on 20-year inflation-protected securities issued by the US government - a proxy for the long-term natural real interest rate - climbed to 1 per cent, from just 0.85 per cent. That was enough to spark a broad sell-off in stock and commodity markets. The MSCI World Index fell 10 per cent in two weeks, before recovering some of the losses.
That such a minor move should prompt investors to knock billions off their estimates of what equities are worth is worrying. Before the financial crisis, long-term real interest rates of 2 per cent were the norm. Now investors seem unable to stomach borrowing costs half as high. If the natural rate of interest has indeed fallen, Mr Summers says, it would be a "dangerous mistake" for central banks to hike policy rates now.
Hedge fund manager Ray Dalio of Bridgewater predicts that attempts to normalise US monetary policy will be a repeat of 1936-1937, when the Federal Reserve raised interest rates by just half a percentage point before lowering them again. This time, the reversal might be followed by more money-printing, he says.
These are still minority views. Maybe the market turmoil last month was pure panic. There is considerable uncertainty about when the tightening cycle will start and how high US rates will go.
Besides, equity valuations were stretched, making them vulnerable to small changes in the future cost of money. The dollar's surge has caused capital to flee emerging economies. Beijing's surprise move may have provided the excuse for an overdue correction.
If secular stagnation is unproven in practice, it also remains a contested idea. Dr Hansen's analysis was influenced by the pessimism of the Great Depression - and turned out to be completely wrong. Critics warn that falling into a similar trap would add to the fragility of a financial system already weakened by years of near-zero interest rates.
More money-printing would spawn asset bubbles, but not sustainable gross domestic product growth or healthy inflation. A good example is Japan: Decked up in cheap cash, but not going anywhere.
But the secular stagnation debate will not be settled by Japan. The proof will come from China.
If concerns about a wrenching growth slowdown in China are overdone, capital outflows will ebb. The pressure on the yuan to depreciate will ease. Commodity prices will strengthen and fears of global deflation will recede. The Fed will normalise interest rates, and the idea of long-term decline will look silly.
However, if China's woes deepen, advocates of secular stagnation would gain more clout. After all, China has absorbed plenty of the world's excess savings in creating new industrial capacity. If that is now over, the global economy has a problem. At the minimum, it would be time to admit the possibility that secular stagnation is more than an empty phrase.
The writer, a former Straits Times journalist, is a columnist with Reuters Breakingviews.
This article was first published on Sept 2, 2015.
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