Is a lost decade ahead?

It is quite obvious that the current economic situation in both Europe and the United States is not healthy. It has been argued that in both cases policy uncertainty or the inability of authorities to take decisions are detrimental to economic activity, and private investment in particular. It is not difficult to rationalize this with simple theory. The question is whether this could have some longer term consequences.

Kenza Benhima and Baptiste Massenot find that yes, we could be ahead of a lost decade like the one that Japan experienced in the 1990's. They take a simple real business cycle model, a model that is the least likely to produce very persistent deviations from trend or permanent departures from the growth path. They only amend the model in two ways: investors have a decreasing relative risk aversion, instead of constant, and they can choose between two technologies, a risky one with higher returns and a safe one with low returns. The model then exhibits two equilibria: the standard RBC one, and a second, self-fulfilling one, a trap where capital is mis-allocated into overly safe assets, there is little growth if any, and interest rates keep getting lower thereby reinforcing the trap.

These results are consistent with Japan during its lost decade. Total factor productivity decreases, essentially because of a mis-allocation of resources. Assets are mostly safe ones in the trap, compared to risky ones before. And the interest rate keeps declining. Interestingly, the resulting economy in the bad equilibrium looks like it had a bad technology shock, even though technology is just fine. This makes it consistent with the Hayashi-Prescott claim that Japan's lost decade was due to bad total factor productivity draws. The same applies to the Caballero-Hoshi-Kashyap claim that banks in Japan kept lending to unproductive firms, preventing better ones to enter and raise total factor productivity. Even Krugman's liquidity trap fits in the story because interest rates are very low in the trap as well.

And recent data in Europe and the US seems to be consistent with this trap as well. The only way out is a coordinated action of all market participants. The only ones that could make this happen are the authorities. Unfortunately, they seem to be quite far from that.