How long-run economic prospects fell sharply after the great recession

Lehman failed ten years and two weeks ago; this coming Wednesday will be the 10th anniversary of the enactment of the Troubled Asset Relief Program, aka the bailout. In honour of the anniversary, there have been approximately 1,000,000,000 pieces reflecting on the 2008 financial crisis and its effects. Many have suggested, rightly, that the political fallout continues to shape our world today. But as far as I can tell, surprisingly few have focused on the long-run economic effects.

What’s odd about this relative neglect is that even a cursory look at the data suggests that these effects were huge. It’s true that U.S. unemployment is back below it was before the crisis; although it’s not widely realized, euro area unemployment is also way down, not quite to eve-of-crisis levels but well below its pre-crisis average. But in both case,s we’ve returned to sort-of full employment at a much lower level of real GDP than informed people projected we’d reach before the crisis struck.

I am, of course, not the first or only person to make this observation. Antonio Fatás and Larry Summers have been banging on this drum for years, as has Larry Ball. But it seems worth pointing out to a (slightly, maybe) larger audience the sheer extent to which the future is not what it used to be, speculating a bit about why and how that may have happened, and talking about its implications for future policy.

From the Great Recession to the Great Shortfall

Economists use the term “potential output” to refer to the maximum amount an economy can produce without inflationary overheating. This concept plays a central role in monetary policy, and some role in fiscal policy too. As I’ll explain in a bit, the theoretical underpinnings of the concept look weaker now, in the light of post-crisis experience, than they used to. But for now, let’s just note that a number of agencies, from the U.S. Congressional Budget Office to the International Monetary Fund, routinely produce estimates of current potential output and projections of future potential output.

To be clear, these are model-based estimates, not actual data. And one possible story is that the models are all wrong, that we’re looking at a construct that has nothing to do with reality. But as I said, these models matter for policy. So what do we find if we compare pre-crisis projections of potential output over the decade ahead to current estimates? The answer is, a huge downgrading of estimates of economic capacity on both sides of the Atlantic.

Figure 1 compares CBO’s 10-year projection of potential U.S. real GDP as of January 2008 with what it now thinks happened. The downgrading of the estimate is huge – more than 11 percent as of 2018. One way to say this is that the U.S. economy is as far below pre-crisis expectations now as it was in the depths of the Great Recession, even though we have supposedly recovered from the crisis.

Three stories about the shortfall: happenstance, hypochondria, and hysteresis

One possible story about the way the Great Shortfall followed the Great Recession is that post hoc wasn’t propter hoc: the economy’s potential is far less than people expected it to be a decade ago, but the reasons for the downward bend in the long-run growth curve have little to do with the financial crisis – they just happened to kick in roughly at the same time. That is, the roots of the growth slowdown lie in things like technological disappointment (there’s a new iPhone; who cares?) and social change leading to a lower share of the population participating in labor markets (opioids or video games, take your pick) that would have happened even if there had been no Great Recession.

This story is in effect, though not explicitly, the narrative underlying actual economic policy: the Fed and other central banks, which are the real actors in macroeconomic policy under current conditions, don’t act as if they’re very worried that a future recession might depress the economy not just in the short run but permanently. Fiscal authorities, to the extent that they think coherently about these issues at all – i.e., outside the current U.S. administration – also take the path of future economic potential mostly as a given.

To be fair, CBO’s projections try to take the incentive effects of tax policy and the effects of deficits on investment into account, but these are small change compared with what you would need to link the Great Recession to the massive downgrading of long-run growth projections.

What’s the evidence against this view? The most compelling evidence, cited by both Fatás/Summers and Ball, is that the size of the Great Shortfall varies a lot between countries – and the countries whose estimated economic potential has taken the biggest hit are precisely the countries that had the biggest slumps in the economic crisis. Indeed, the relationship between output decline in the crisis and the fall in long-run potential GDP is pretty much one-for-one.

Figure 3 shows the most extreme case, Greece, comparing actual and potential GDP as estimated by the IMF. As everyone knows, Greece has suffered a huge, Depression-level slump. According to the IMF, however, around half that slump is a decline in capacity rather than reduced utilization of capacity.

And even this understates the change in projections, because it’s not just the future that isn’t what it used to be, but the past. In Figure 3, Greece is shown as having had a drastically overheated economy, operating far above sustainable levels, in 2007 and 2008. But few people said that at the time. In fact, the IMF’s own estimate as of early 2008 was that in 2007 Greece was operating only 2.5 percent above potential, compared with its current estimate of 10.7 percent for the same year.

What’s going on? The IMF’s method for calculating potential GDP basically reads any sustained slump as a decline in potential output relative to previous expectations, and this interpretation of decline affects both its projections of the future and its interpretation of the past: if it concludes that potential output in 2010 was really low, the IMF marks down its estimates of potential in previous years too.

Which brings me to a second possible explanation of the Great Shortfall: maybe it exists only in the minds and models of policymakers (or, actually, their technical experts), and isn’t a real thing at all. That is, the belief that our economic potential has fallen far below previous expectations doesn’t represent an actual economic ailment, but instead reflects policymakers’ hypochondria.

After all, how is potential output calculated? The details are complex, but basically such calculations rely on one or both of two theories: that slumps and booms are always short-lived, and/or that inflation is an “accelerationist” process.

Suppose, first, that you start from the assumption that deviations of actual GDP from potential GDP tend to be eliminated over the course of a few years at most, with the economy surging after slumps and stagnating or shrinking after booms. In that case, you believe that the average difference between actual and potential GDP will be roughly zero over any extended period, which means that you can get an estimate of potential GDP by taking actual GDP and applying some kind of statistical method that smooths out the fluctuations.

Suppose, alternatively, that you believe – as most mainstream economists did not long ago – in some version of Milton Friedman’s “natural rate” hypothesis. According to this hypothesis, an economy running above potential output will experience not just inflation but accelerating inflation, while an economy with persistent slack will experience ongoing disinflation, with the inflation rate falling continuously and eventually turning into accelerating deflation. If this hypothesis is true, you can in effect infer where we are relative to potential by asking what’s happening to inflation: if it’s stable, the economy is producing roughly at potential.

In the light of post-2008 experience, however, it’s clear that both of these theories are wrong. When interest rates hit zero, it’s far from clear why or how the economy will quickly recover, since the usual way we bounce back from a slump – the central bank cuts interest rates, boosting spending – can’t happen. Meanwhile, thanks in part to the reluctance of employers to cut wages even in the face of high unemployment, even obviously depressed economies seem at worst to experience low inflation, not an ongoing slide into accelerating deflation.

Given these realities, consider how estimates of potential output will respond if an economy suffers a big decline in overall demand that persists for a number of years. Because the economy remains depressed for a long time, statistical methods that don’t allow for this possibility will falsely interpret a sustained slump as a fall in potential GDP. Because inflation, while it may decline a bit at first in a slump, typically remains stable thereafter, models that try to infer potential output from changes in inflation will also conclude wrongly that the economy is operating near potential.

So is the Great Shortfall something that exists only in policymakers’ minds, when the real story is that there’s still a huge amount of excess capacity? It’s certainly a possibility worth considering. And I’m reasonably sure that when it comes to Greece in particular, the huge decline in estimated potential output is exaggerated. I simply don’t believe that after a 25 percent decline in real GDP, almost none of it made up by recent growth, and with 20 percent unemployment even now, Greece is only 2 percent below potential – which is the IMF’s estimate.

But this is a harder story to tell for the U.S. or the euro area as a whole. The simple version of the hypochondria hypothesis would be that officials misinterpret high unemployment as a structural problem when it’s actually a demand problem. But at this point neither the U.S. nor the euro area has high unemployment by historical standards. Everyone knows the U.S. story; Figure 4 shows the euro area unemployment rate, which while higher than the U.S. rate is also now low compared with pre-crisis norms.

It’s true that many people argue that the unemployment rate has become a misleading measure of labor market slack, that the job market isn’t as good as the standard measure indicates. But as Figure 5 shows, even broader measures like labor-force participation of prime-age adults aren’t down all that much, and they were on a declining trend even before the crisis. So even a “hidden unemployment” story won’t explain the hugeness of the Great Shortfall – that is, it’s not enough to make what we see consistent with a story that claims that it’s all, still, about massively inadequate demand.

Which brings us to the third story, which is that the Great Recession itself damaged potential output, largely by reducing productivity.

Why the Great Shortfall matters

Nobody wants to go through a repeat of the Great Recession, which is a reason to pursue policies that both reduce the likelihood of another financial crisis and increase our ability to respond if one happens. Hence financial regulation, expanded ability to seize troubled financial institutions (so as to be able prop them up without bailing out stockholders and executives), and so on. Some of us have also argued for a higher inflation target, which would leave more room to cut real interest rates when the next slump comes.

If the Great Recession really did cause the Great Shortfall, the urgency of such measures is much greater. Using conventional measures, the Great Recession and the depressed economy that lingered for years thereafter cost the U.S. something like 15 percent of a year’s GDP. If the decline in long-term economic prospects was also caused by the slump, this cost rises to something much bigger – possibly more than 70 percent of a year’s GDP so far, and much more to come.

Beyond that, as Fatás and others have argued, a link between short-run economic weakness and long-run prospects makes a huge difference to our assessment of policies in response to crisis. If monetary policy has run out of room, the case for fiscal stimulus becomes much stronger. And the argument against the austerity policies that many countries adopted instead when interest rates were still near zero and unemployment very high becomes overwhelming.

In fact, as Fatás says, an austerity mindset risks creating a “doom loop,” in which fiscal contraction leads to a decline in economic prospects, worsening the budget outlook, leading to even more contraction. Greece has slashed spending, at huge social cost, but been rewarded – at least according to the official estimates – with a drastic decline in future prospects, so that its debt outlook looks barely better than it did before the cuts.

So the Great Shortfall – the long-term shadow on the economy apparently cast by the Great Recession – is a huge issue. It deserves more attention, with maybe less focus on the few months of credit crunch after Lehman fell.