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.

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

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   

Costing Incomplete Fiscal Plans: Ryan and the CBO

Some of the regular blogs I read are currently preoccupied (understandably) with the US Presidential election. This is not my territory, but the role of fiscal councils – in this case the CBO – in costing budget proposals is, and the two connect with the analysis of the Ryan budget plan. The Ryan ‘plan’ involves cutting the US budget deficit, but contains hardly any specifics about how that will be done.

There is nothing unique to the US here. In the 2010 UK elections, both main parties acknowledged the need for substantial reductions in the budget deficit over time, but neither party fully specified how these would be achieved. Now as the appropriate speed of deficit reduction was a key election issue, this might seem surprising. In particular, why did one party not fully specify its deficit reduction programme, and then gain votes by suggesting the other was not serious about the issue?

The answer has to be that any gains in making the plans credible would be outweighed by the political costs of upsetting all those who would lose out on specific measures. People can sign up to lower deficits, as long as achieving them does not involve increasing their taxes or reducing their benefits. However, I think it’s more than this. If people were fully aware of the implications of what deficit reduction plans might entail, you would guess that lack of information might be even more damaging than full information. As people tend to be risk averse, the (more widespread) fear that their benefits might be cut could be more costly in electoral terms than a smaller number knowing the truth.

The fact that this logic does not operate suggests to me that (at least among swing voters) there is a bigger disconnect in people’s minds between aggregate deficit plans and specific measures. Saying you will be tough on the deficit does not panic swing voters, but adds to your credibility in being serious about the deficit ‘problem’. Indeed, from my memory of the UK election, claims by one side about secret plans of the other were effectively neutralised as scaremongering.

This can be seen as the reverse side of a familiar cause of deficit bias. A political party can gain votes by promising things to specific sections of the electorate, but does not lose as many votes because of worries about how this will be paid for. The media can correct this bias by insisting on asking where the money will come from (or in the reverse case, where the cuts will come from), but they may have limited ability to check or interrogate the answer. This is where a fiscal council, which has authority as a result of being set by government but also independent of government, can be useful.

For some time the Netherlands Bureau for Economic Policy Analysis (often called the CPB) has offered to cost political parties fiscal proposals before elections. The interesting result is that all the major parties take up this offer. Not having your fiscal plans independently assessed appears to be a net political cost.

What the fiscal council is doing in this case is conferring an element of legitimacy on aggregate fiscal plans, a legitimacy that is more valuable than uncosted fiscal sweeteners. Which brings me to the question of what a fiscal council should do if these plans are clearly incomplete? In particular, suppose plans include some specific proposals that are deficit increasing or neutral, but unspecified plans to raise taxes or cut spending which lead to the deficit being reduced. By ‘should do’ here I do not mean what it is legally obliged to do, but what would be the right thing to do.

It seems to me clear that the right thing to do is not to cost the overall budget. What, after all, is being achieved by doing so? Many people or organisations can put a set of numbers for aggregate spending and taxes into a spreadsheet and calculate implied deficits, and the adding up can easily be checked. By getting the fiscal council to do this fairly trivial task serves no other purpose than to give the plan a legitimacy that it does not have.

In this situation, a fiscal council that does calculate deficit numbers for a plan that leaves out all the specifics is actually doing some harm. Instead of asking the difficult questions, it is giving others cover to avoid answering them. It is no excuse to say that what was done is clear in the text of the report. The fiscal council is there partly so people do not have to read the report. So I wonder if the CBO had any discretion in this respect. If Ryan was playing the system, perhaps the system needs changing to give the CBO a little more independence.