Winner of the New Statesman SPERI Prize in Political Economy 2016

Wednesday 12 July 2017

Why recessions followed by austerity can have a persistent impact

Economics students are taught from an early age that in the short run aggregate demand matters, but in the long run output is determined from the supply side. A better way of putting it is that supply adjusts to demand in the short run, but demand adjusts to supply in the long run. A key part of that conceptualisation is that long run supply is independent of short run movements in demand (booms or recessions). It is a simple conceptualisation that has been extremely useful in the past. Just look at the UK data shown in this post: despite oil crises, monetarism and the ERM recessions, UK output per capita appeared to come back to an underlying 2.25% trend after WWII.

Except not any more: we are currently more than 15% below that trend and since Brexit that gap is growing larger every quarter. Across most advanced countries, it appears that the global financial crisis (GFC) has changed the trend in underlying growth. You will find plenty of stories and papers that try to explain this as a downturn in the growth of supply caused by slower technical progress that both predated the GFC and that is independent of the recession caused by it.

In a previous post I looked at recent empirical evidence that told a different story: that the recession that followed the GFC appears to be having a permanent impact on output. You can tell this story in two ways. The first is that, on this occasion for some reason, supply had adjusted to lower demand. The second is that we are still in a situation where demand is below supply.

The theoretical reasons why supply might adjust to demand are not difficult to find. (They are often described by economists under the jargon word 'hysteresis'.) Supply (in terms of output per capita) depends on labour force participation, the amount of productive capital in the economy, and finally technical progress, which is really just a catch all for how aggregate labour and capital combine to produce output. A long period of deficient demand can discourage workers. It can also hold back investment: a new project may be profitable but if there is no demand it will not get financed.

However the most obvious route to link a recession to longer term supply is through technical progress, which connects to the vast literature under the umbrella of ‘endogenous growth theory’. This can be done through a simple AK model (as Antonio Fatas does here), or using a more elaborate model of technical progress, as Gianluca Benigno and Luca Fornaro do in their paper entitled ‘Stagnation traps’. The basic idea is that in a recession innovation is less profitable, so firms do less of it, which leads to less growth in productivity and hence supply. Narayana Kocherlakota has promoted this idea: see here for example.

The second type of explanation is attractive, in part because the mechanism that is meant to get demand towards supply - monetary policy - has been ‘out of action’ for so long because of the Zero Lower Bound (ZLB). (The ZLB also plays an important role in the Benigno & Fornaro model.) However for some this type of explanation currently seems ruled out by the fact that unemployment is close to pre-crisis levels in the UK and US at least.

There are three quite different problems I have with the view that we no longer have a problem of deficient demand because unemployment is low. The first, and most obvious, is that the natural rate of unemployment might be, for various reasons, considerably lower than it was before the GFC. The second is that workers may have priced themselves into jobs. In particular, low real wages may have encouraged firms to use more labour intensive techniques. If that has happened, it does not mean that the demand deficiency problem has gone away, but just that it is more hidden. (For anyone who has a conceptual problem with that, just think about the simplest New Keynesian model, which assumes a perfectly clearing labour market but still has demand deficiency.)

The third involves the nature of any productivity slowdown caused by lack of innovation. A key question, which the papers noted above do not directly address, is whether we are talking about frontier research, or more the implementation of innovation (for example, copying what frontier firms are doing). There is some empirical evidence to suggest that the productivity slowdown may reflect the absence of the latter. This is very important, because it implies the slowdown is reversible. I have argued that central banks should pay much more attention to what I call the innovation gap (the gap between best practice techniques, and those that firms actually employ) and its link to investment and aggregate demand.

All this shows that there is no absence of ideas about how a great recession and a slow recovery could have lasting effects. If there is a problem, it is more that the simple conceptualisation that I talked about at the beginning of this post has too great a grip on the way many people think. If any of the mechanisms I have talked about are important, then it means that the folly of austerity has had an impact that could last for at least a decade rather than just a few years.


  1. If improved implementation of innovation is important to recovering from austerity, then how well equipped is the UK to handle post-austerity + Brexit?
    Historically, has the UK not struggled to convert primary, often government funded, scientific research into technological innovation, into successful business, into global corporations?
    What could/should a modern UK government do, possibly without the constraints of the EU rules, to build a thriving, growing, back on (global) trend, post-austerity, post-Brexit economy?

    1. What EU rules constrained the UK in terms of implementation of innovation? A couple of examples please...

  2. Daniele Girardi13 July 2017 at 06:45

    Thank you for a great post, I always learn a lot from your blog. I just have one question. If these mechanisms (endogenous capital accumulation and technological change adoption, flexibility of the participation rate) exist, then they must be at work (almost) all the time, not only during recessions and at the 'ZLB'. But then what is really conceptually obscure, to me, is how would 'hysteresis' apply only to negative demand shocks but not to positive ones, and how it would happen only at the ZBL or in recession. If demand fluctuations affect the capital stock and the innovation rate through investment and the size of the labor force through participation (and they do, obviously), then a positive demand shock in 'normal times' has a positive effect on potential output, and the NAIRU is endogenous (influenced by demand shocks) all the time. If supply adjusts to demand to some significant extent, and if the mechanisms are the ones you described, then it seems arbitrary to confine this to 'special times' and negative shocks.

  3. Interesting, but the one missing explanation (conspicuous by its absence) for the lack of recovery vitality is 'profits'. Return on capital. It arguably leads investment and worldwide, return on capital having risen for much of the eighties and nineties has been falling ever since.

  4. Professor I do not disagree that premature fiscal consolidation is bad both for the short and for the long term. However I am not quite sure that the lower growth rates in the UK and US as compared to previous trends can be solely attributed to misguided domestic fiscal policies. I believe that a big factor is exogenous to both countries and it is the dismal performance of their biggest trading partner: the Euroarea. If one looks at the figures, the Euroarea is way, way, out of trend. It has been by far the worst performing region of the world, since its birth and surely since 2008. This must have had repercussions on the rest of the world, in particular a world very closely connected to it, such as the UK.

  5. Could hysteresis not only apply to workers (redundant/ loss of skills etc) but also to employers adopting low technology management methods e.g. zero hour contracts quasi self employment outsourcing?

  6. It is very helpful to get these issues explained clearly and comprehensively, and concisely, provided with equally relevant links.

    Lots of food for thought. Four observations:

    1. The OBR advised in its March economic outlook that it was likely that the UK economy no longer had an output gap or spare capacity, notwithstanding SWL's point about the economy operating at 15% below its post-war trend. This would mean that even at full employment, the deficit is running at 2-3% of gdp, giving rise to the OBR's most recent warning that policymakers should, in effect, build in a margin of error within their efforts to eliminate that deficit, in order to mitigate the risk of future shocks/recessions impacting upon the long term sustainability of the public finances. Not much room in that analysis for fiscal stimulus to counteract the ZLB.

    2. SRL's comments on hysteresis (seems like a term out of freudian psychoanalysis), as constructed, appears to refer to shorter term rather than the long term lingering impacts of periods of deficient demand: the practical example that makes sense to me is that of the construction industry: busts reduce its future capacity to meet demand, by deskilling and entrenching its labour sub-contracting model reliant on migrant labour.

    3. With respect to the NAIRU now being lower than it was during the Great Moderation due to, perhaps, workers being disciplined by the experience of the GFC to 'price themselves into a job', allied to the development of a more flexible labour market marked by growing rates of self-, part- and zero hours contract employment, which has encouraged firms to 'make use of more labour intensive techniques', resulting in the problem of deficient demand becoming hidden rather than absent. This rather begs the question whether NAIRU has fallen as a product of greater labour market flexibility, or, rather, that flexibility is a cause of low productivity and below trend growth.

    4. Not sure what the CB acting within it current remit, in contrast to the Treasury and wider government, can do in terms of any innovation gap (tax breaks for R&D, training policy??)

    5. The arguments contained in the some of the links provided in the post suggest a positive relationship between fiscal stimulus and innovation, which brings us back to the essential conundrum in the UK context: how best to design and manage a fiscal stimulus targeted to secure a higher sustainable growth rate.


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