Winner of the New Statesman SPERI Prize in Political Economy 2016

Thursday 21 April 2016

Explaining the last ten years

The Great Recession was larger than any previous post WWII recession. But that is not what it will be mainly remembered for. Unlike previous recessions, it appears to have led to, or coincided with, a permanent reduction in the productive potential [1] of the economy relative to previous trends. As unemployment today in the US and UK is not very different from pre-recession levels, then another way of saying the same thing is that growth in labour productivity and real wages over the last seven years has been much lower than pre-recession trends. (As employment has not yet recovered in Europe, I will focus on the US and UK here.)

I have posted charts showing this for the UK many times, so here is something similar for the US. It plots the log of real GDP (green) against the CBO’s (Congressional Budget Office) estimate of potential output (yellow). Unlike the UK, potential growth in the US does not appear constant from 1955, but the CBO has potential output growth between 3 to 3.5% in most years between 1970 and the early 2000s. The break created by the Great Recession is clear: potential growth fell to as low as 1% immediately after the recession, is currently running at 1.5%, and the CBO hopes it will recover to 2% by 2020.

US Actual (green) and Potential (yellow, source CBO) Output, logged. Source: FRED.

There seem to be two ways of thinking about this decline in potential output growth. One is that the slowdown in productivity growth was happening anyway, and has nothing to do with the global financial crisis and recession. This seems unlikely to be the major story. For the UK we have to rewrite the immediate pre-recession years as boom periods (a large positive output gap), even though most indicators suggests they were not. A global synchronised slowdown in productivity growth seems improbable, as some countries are at the technological frontier and others are catching up. As Ball notes, “in the countries hit hardest by the recession, the growth rate of potential output is much lower today than it was before 2008.” However the coincidence story is the one that both the OECD and IMF assume when they calculate output gaps or cyclically adjusted budget deficits. The CBO numbers for the US shown above adopt the coincidence theory to some extent, reducing potential growth from 3.5% in 2002 to 2.0% by the end of 2007.

If we stick to the more plausible idea that this is all somehow the result of the financial crisis and recession, we can again split explanations into two types: those that focus on the financial crisis and argue that crises of this type (rather than other types of recession) impact on potential output, and those that look at the impact of the recession itself. The distinction is important in understanding the impact of austerity. If the length and depth of the recession has permanently hit potential output, as Fatas and Summers suggest, then the cost of austerity is much greater than we could have imagined.

Looking at previous financial crises in individual countries, as Nick Oulton has done for example, does suggest a permanent hit to potential, but I have noted before that this result leans heavily on experience in Latin American countries, and Sweden’s recovery from its 1990 crisis suggests a more optimistic story. Estimates based on OECD countries alone suggest more modest impacts on potential output, of around only 2%.

What about the impact of the recession itself? Here it is helpful to go through the textbook story of how a large negative demand shock should impact the global economy. Lower demand lowers output and employment. Workers cut wages, and firms follow with price cuts. The fall in inflation leads the central bank to cut real interest rates, which restores demand, employment and output to its pre-recession trend.

We know why this time was different: monetary policy hit the zero lower bound (ZLB) and fiscal policy in 2010 went in the wrong direction. Yet employment has recovered to a considerable extent (although less so in the US than the UK). A recovery in employment but not output (relative to pre-recession trends) means by definition a decline in labour productivity growth. How could this happen?

The table below shows the rate of growth of real and nominal wages in the UK and US in pre and post recession periods.

Annual wage growth (1)
Annual price growth (2)

Annual wage growth
Annual price growth
  1. Compensation per employee, source OECD Economic Outlook
  2. GDP deflator, source OECD Economic Outlook

Nominal wage growth followed the textbook story. But price inflation did not fall to match, implying steadily falling real wages, particularly in the UK. This could just reflect the decline in productivity, which occurred either coincidentally or as a result of the financial crisis and recession.

The financial crisis could have reduced productivity growth if a ‘broken’ financial sector had stopped financing high productivity investment projects, or kept inefficient firms going through ‘pretend and extend’ lending. The recession could have reduced productivity growth by reducing investment, and therefore embodied [2] technical progress. Perhaps this loss of embodied technical progress occurs in all recessions, but we do not notice it because recoveries are quick and complete.

However the causality could be the other way around. Falling real wages led firms to switch production techniques such that they employed more labour per unit of capital. Workers priced themselves into jobs. The big question then becomes why did firms let this happen? Why did firms not take advantage of lower wage increases to reduce their own prices, and choose instead to raise their profit margins?

One story involves a secular increase in firms’ profit margins (Paul Krugman’s robber barons idea), either because of a reduction in goods market competition (profit margins are sometimes called the degree of monopoly), or a rise in rent seeking as Bob Solow suggests (HT DeLong). [3] However it is not obvious why this should be connected to the recession. If it is not, it is like the coincident and exogenous productivity decline. We will not get back to the earlier productivity growth path without reversing whatever caused this secular rise in profit margins.

Another, in some ways more optimistic, story involves different degrees of nominal rigidity: nominal wages are less sticky than nominal prices. As a result nominal wages led prices in reacting to the recession, but now prices are ‘catching up’ and profit margins will fall back. That would fit nicely with inflation continuing below target for some time, and real wages and productivity recovering. It is an optimistic story, because an additional demand stimulus would increase wage but not price inflation, and we would see rapid growth in labour productivity as firms reversed their earlier labour for capital substitution.

Unfortunately recent data suggests this is not happening. Instead core inflation is now above target in the US and rising to target in the UK.    

So is there some other way that a large recession in itself can cause a large reduction in potential output? Macroeconomists group such explanations under a general heading called ‘hysteresis mechanisms’: mechanisms whereby recent history can have permanent effects. Ball summarises the three main types of mechanism that economists have identified: “it appears that recessions sharply reduce capital accumulation, have long-term effects on employment (largely through lower labour force participation), and may slow the growth of total factor productivity.” If technical progress is embodied, we can link the first and last. That will be the subject of a later post.  

[1] For those not familiar with the term, a traditional way of thinking about potential output is that it is what output and incomes could have been if we had avoided booms and recessions, or equivalently if we had avoided domestically induced variations in inflation. Potential output can increase either because the labour force increases, or because labour productivity increases due to either technical progress and investment.

[2] Embodied technical progress is greater labour productivity brought about through new machinery i.e. it needs investment for it to happen.

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


  1. Small thought, since we are no longer a manufacturing nation, but a service nation, in % terms it's difficult to get productivity growth in manufacturing to appear in the statistics since it forms a supposedly small % of economic activity. It's easy to put 5p on a latte and keep the illusion of wages and growth continuing , but in reality there is little manufacturing or construction growth going on. So one has to ask where is the 2 and a bit % growth coming from. That's what baffles me with the current situation and why no huge rise in unemployment. Is it all down to the politico's now being so skilled at "losing" inconvenient unemployed workers and why are we (UK) so much better at this growth illusion than most other nations at the moment, when we have little manufacturing growth.

  2. Oh, my...
    while reading and seeing the charts i wanted to joke about it by; you should introduce "sticky prices" instead of sticky wages as the solution to model problems. And then you did introduce "sticky price change". LOL.

    Potential output is taken as ex-post fact, longer the lower output goes it will have more impact on "potential output"
    Potential output should be measured as multiple of present productivity and total employable people, not as historic awerage as is the case now. Then you could infer the right conclusions. This way is just trying to proove the existing model which is just wrong model.

    If you want to return to precrisis growth then it would be easy just to provide economy with official interest rate level (not just states and banks) and grow minimum wage with historic real value. That is it. Booom is there again and potential growth would be higher then now.

    Economy does not enjoy official interest rate. Which is why monetary policy doesn't work. Provide people and firms with loans at official interest rate and boooom will be happening.
    To raise productivity - raise minimum wage.

    Marginal tax rate to grow to 90% would help too. Just as it was when those record growths were created.

    1. Present productivity understimates potential output: it's not just a question of how many are employed but how effective and efficient they are at work. When a demand shock (initially from financial contraction then sustained by austerity) hits a labour market with inelastic supply, then much of the impact of that shock is felt on real wages. This makes it profitable to substitute labour for capital (hand car washes) or to use over-qualified staff (post-grad waiters). High demand would force out poor uses of labour through higher wages while creating higher productivity alternative employment.

  3. Don't forget about historical data revisions. They can be killer when made 20 years later. Take out the bubble nod your head, we have been slowing down since 67.

  4. The entrance of 3-400 million new Chinese workers making EVERYTHING in Walmart must have had some influence.

  5. Capital accumulation is the sum of new capital and wasting of old capital. The truly striking effect beginning in 08 was the stupendous rate at which US capital was shut down and then abandoned. With customers still hurt by loss of real estate equity and PV lifetime income insufficient to fund necessary purchases such as housing, college and retirement, marginal ROI for new capital is too low for additions.

    To avoid this, we needed national economic management focused on the maintenance of cash flows to capital assets. What we got instead was the full expenditure of political capital to fund guarantees against financial assets. What a mess. We could have achieved this maintenance of real capital by fiscal policy that went directly to the customers in a trickle up fashion.

    Oh, and CBO seems to be doing something like a moving average to determine potential, plus an assumption that full capacity will be reached (but how?) over a set period of time, which seems weak.

  6. It seems to me that the issue is:

    When a person moves from unemployment to employment, then unemployment fells by one but the increase in employment depends on the ft/pt status of the newly employed worker. The ONS, I think, count the new worker as one when it could be 0.5 or other. Given this difference it is possible that the part time workers, counted as full time, will produce less than full time workers. The result is that productivity falls as the authorities are not using the correct denominator as they assume all workers are full time. Or am I wrong please?

    Thanks for a wonderful blog

  7. "The recession could have reduced productivity growth by reducing investment, . . . "

    Productivity should be increasing?

    It appears that investment {productive?} has been the driver of 'growth'?

    “The depth of the crisis was reached in the spring and summer of 2009, and we now have the initial estimates for the economy for the same period in 2015. GDP as a whole increased by £100bn over the period, after allowing for inflation, a rise of nearly 13 per cent. Companies spent an additional £32bn on new investment in 2015 compared to the same period six years ago. In percentage terms, this was by far the fastest growing sector of the economy, up by 26 per cent. By contrast, consumer spending grew by only 10 per cent, less than the economy as a whole. It has been an investment-led recovery, with the role of public spending negligible. “

    Or, maybe, it is public investment that drives productivity?

    Infrastructure investment spending of the government will increase both the marginal product of labour and capital [New Keynesianism and Aggregate Economic Activity by Assar Lindbeck – Economic Journal, 108, 1998 pp167-80]

  8. "The output of the financial services sector is notoriously difficult to estimate. Last autumn, an excellent article in the Bank of England Quarterly Bulletin noted drily that we “should not have unreasonably high expectations of some of the proxy measures that have to be used to estimate output in the sector.”

    In other words, even the Bank has not got much of a clue as to what has been happening to output in financial services. "

  9. I am perplexed by the way you consider everything to be tickety-boo in the pre-2008 economy. If everything was fine in the years running up to 2008 and GDP was a valid measure of the value of activity in the economy, then the Great Recession would not have happened. So in order to judge the post-crash years, you need to adjust for how much of your baseline was just an over-leveraged finance bubble supporting combined with the shift of manufacturing to China.

    I would suggest that the 10 years previous to 2008 have more relevance to the current state of the UK economy than relatively small changes to public spending in the years since.

  10. what about financial sector regulation? surely, if the accelerator-mechanism itself is changed by post-crisis policies ...


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