Explaining The Concluding X Years

The Great Recession was larger than whatsoever previous postal service WWII recession. But that is non what it volition live mainly remembered for. Unlike previous recessions, it appears to receive got led to, or coincided with, a permanent reduction inwards the productive potential [1] of the economic scheme relative to previous trends. As unemployment today inwards the States together with Great Britain is non rattling different from pre-recession levels, together with so some other way of maxim the same affair is that growth inwards labour productivity together with existent payoff over the concluding 7 years has been much lower than pre-recession trends. (As work has non nonetheless recovered inwards Europe, I volition focus on the States together with Great Britain here.)

I receive got posted charts showing this for the Great Britain many times, so hither is something similar for the US. It plots the log of existent gross domestic product (green) against the CBO’s (Congressional Budget Office) justice of potential output (yellow). Unlike the UK, potential growth inwards the States does non appear constant from 1955, but the CBO has potential output growth betwixt 3 to 3.5% inwards most years betwixt 1970 together with the early on 2000s. The intermission created yesteryear the Great Recession is clear: potential growth cruel to equally depression equally 1% at i time after the recession, is currently running at 1.5%, together with the CBO hopes it volition recover to 2% yesteryear 2020.

States Actual (green) together with Potential (yellow, origin CBO) Output, logged. Source: FRED.

There seem to live 2 ways of thinking near this spend upwards inwards potential output growth. One is that the slowdown inwards productivity growth was happening anyway, together with has nil to create amongst the global financial crisis together with recession. This seems unlikely to live the major story. For the Great Britain nosotros receive got to rewrite the immediate pre-recession years equally blast periods (a large positive output gap), fifty-fifty though most indicators suggests they were not. Influenza A virus subtype H5N1 global synchronised slowdown inwards productivity growth seems improbable, equally some countries are at the technological frontier together with others are catching up. As Ball notes, “in the countries hitting hardest yesteryear the recession, the growth charge per unit of measurement of potential output is much lower today than it was before 2008.” However the coincidence story is the i that both the OECD together with International Monetary Fund assume when they calculate output gaps or cyclically adjusted budget deficits. The CBO numbers for the States shown to a higher house adopt the coincidence theory to some extent, reducing potential growth from 3.5% inwards 2002 to 2.0% yesteryear the cease of 2007.

If nosotros stick to the to a greater extent than plausible thought that this is all somehow the termination of the financial crisis together with recession, nosotros tin i time again dissever explanations into 2 types: those that focus on the financial crisis together with debate that crises of this type (rather than other types of recession) touching on potential output, together with those that expect at the touching of the recession itself. The distinction is of import inwards agreement the touching of austerity. If the length together with depth of the recession has permanently hitting potential output, equally Fatas together with Summers suggest, together with so the cost of austerity is much greater than nosotros could receive got imagined.

Looking at previous financial crises inwards private countries, equally Nick Oulton has before that this termination leans heavily on sense inwards Latin American countries, together with Sweden’s recovery from its 1990 crisis suggests a to a greater extent than optimistic story. Estimates based on OECD countries lone suggest to a greater extent than pocket-size impacts on potential output, of unopen to solely 2%.

What near the touching of the recession itself? Here it is helpful to travel through the textbook story of how a large negative demand daze should touching the global economy. Lower demand lowers output together with employment. Workers cutting wages, together with firms follow amongst toll cuts. The autumn inwards inflation leads the fundamental banking concern to cutting existent involvement rates, which restores demand, work together with output to its pre-recession trend.

We know why this fourth dimension was different: monetary policy hitting the null lower outpouring (ZLB) together with financial policy inwards 2010 went inwards the incorrect direction. Yet work has recovered to a considerable extent (although less so inwards the States than the UK). Influenza A virus subtype H5N1 recovery inwards work but non output (relative to pre-recession trends) way yesteryear Definition a spend upwards inwards labour productivity growth. How could this happen?

The tabular array below shows the charge per unit of measurement of growth of existent together with nominal payoff inwards the Great Britain together with States inwards pre together with postal service recession periods.

US	2002-7	2008-15
Annual wage growth (1)	3.8%	2.1%
Annual toll growth (2)	2.5%	1.5%
Difference	1.3%	0.6%
UK
Annual wage growth	4.5%	1.7%
Annual toll growth	2.8%	2.1%
Difference	1.7%	-0.4%

1. Compensation per employee, origin OECD Economic Outlook
2. GDP deflator, origin OECD Economic Outlook

Nominal wage growth followed the textbook story. But toll inflation did non autumn to match, implying steadily falling existent wages, specially inwards the UK. This could only reflect the spend upwards inwards productivity, which occurred either coincidentally or equally a termination of the financial crisis together with recession.

The financial crisis could receive got reduced productivity growth if a ‘broken’ financial sector had stopped financing high productivity investment projects, or kept inefficient firms going through ‘pretend together with extend’ lending. The recession could receive got reduced productivity growth yesteryear reducing investment, together with thus embodied [2] technical progress. Perhaps this loss of embodied technical progress occurs inwards all recessions, but nosotros create non unwrap it because recoveries are quick together with complete.

However the causality could live the other way around. Falling existent payoff led firms to switch production techniques such that they employed to a greater extent than labour per unit of measurement of capital. Workers priced themselves into jobs. The large inquiry together with so becomes why did firms allow this happen? Why did firms non accept reward of lower wage increases to cut back their ain prices, together with select instead to heighten their turn a profit margins?

One story involves a secular increment inwards firms’ turn a profit margins (Paul Krugman’s robber barons idea), either because of a reduction inwards goods marketplace position contest (profit margins are sometimes called the grade of monopoly), or a rising inwards rent seeking equally Bob Solow suggests (HT DeLong). [3] However it is non obvious why this should live connected to the recession. If it is not, it is similar the coincident together with exogenous productivity decline. We volition non larn dorsum to the before productivity growth path without reversing whatever caused this secular rising inwards turn a profit margins.

Another, inwards some ways to a greater extent than optimistic, story involves different degrees of nominal rigidity: nominal payoff are less glutinous than nominal prices. As a termination nominal payoff led prices inwards reacting to the recession, but at nowadays prices are ‘catching up’ together with turn a profit margins volition autumn back. That would fit nicely amongst inflation continuing below target for some time, together with existent payoff together with productivity recovering. It is an optimistic story, because an additional demand stimulus would increment wage but non toll inflation, together with nosotros would come across rapid growth inwards labour productivity equally firms reversed their before labour for uppercase substitution.

Unfortunately recent information suggests this is non happening. Instead gist inflation is at nowadays to a higher house target inwards the States together with rising to target inwards the UK.    

So is at that topographic point some other way that a large recession inwards itself tin displace a large reduction inwards potential output? Macroeconomists grouping such explanations nether a full general heading called ‘hysteresis mechanisms’: mechanisms whereby recent history tin receive got permanent effects. Ball summarises the iii primary types of mechanism that economists receive got identified: “it appears that recessions sharply cut back uppercase accumulation, receive got long-term effects on work (largely through lower labour forcefulness participation), together with may deadening the growth of full element productivity.” If technical progress is embodied, nosotros tin link the start together with last. That volition live the dependent champaign of a afterward post.  

[1] For those non familiar amongst the term, a traditional way of thinking near potential output is that it is what output together with incomes could receive got been if nosotros had avoided booms together with recessions, or equivalently if nosotros had avoided domestically induced variations inwards inflation. Potential output tin increment either because the labour forcefulness increases, or because labour productivity increases due to either technical progress together with investment.

[2] Embodied technical progress is greater labour productivity brought near through novel mechanism i.e. it needs investment for it to happen.

[3] Postscript (just): Here is Martin Sandbu on the same number