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   

Real wages, monetary policy and innovation

In my drive into Oxford I pass a petrol station that offers a car wash service. Ten or twenty years ago you would have expected this to involve a large degree of automation. However in this particular case it involves a few workers with hoses, mops and buckets. Now anyone who has seen my own car will realise that I know very little about car cleaning technology. But with this caveat, it seems to me this garage offers a nice illustration of how labour productivity is a function of relative prices. If labour becomes expensive relative to capital, it is worth the garage investing in a car washing machine, but if the opposite happens, once the machine reaches the end of its life it goes back to the old labour based technology.

In technical terms what I describe above is just an example of factor substitution. This is one explanation of the UK’s productivity puzzle, investigated at the aggregate level by Joao Paulo Pessoa and John Van Reenen. They “argue that ‘capital shallowing’ (i.e. the fall in the capital-labour ratio) could be the main reason for [the productivity puzzle]”. Although initially the US did not see productivity fall, there are indications a milder form of this may be happening there too.

So why does this not happen in every recession? One answer, provided by Pessoa and Van Reenen, is that the behaviour of real wages in this recession has been very different. Real wages have been much more responsive to unemployment in this recession compared to the recessions of the 1980s or 1990s. Pessoa and Van Reenen suggest this could be the result of a combination of weaker union power and welfare reforms that keep effective labour supply high even when demand is low. You could also add greater availability of cheap labour from members of the EU where unemployment is high.

A counter argument might be that earlier recessions have been caused by tighter monetary policy, pushing up the cost of capital, whereas in the Great Recession interest rates have been at the zero lower bound. However there is evidence that the Great Recession has increased the cost of capital for large firms in the UK, and the impact on small firms will have been even greater. In addition a recession that involves a financial crisis is likely to leave firms feeling particularly reluctant to invest, because any borrowing will involve a long term financial commitment that leaves them more vulnerable. In the past they could have relied on their bank to see them over any temporary cash-flow problems, but now they are less sure. In these circumstances, labour intensive rather than capital intensive forms of production seem much less risky.

Indeed in a world of certainty the capital intensive form of production might actually be more efficient. In economic jargon, switching to people with buckets and hoses has actually reduced total factor productivity. But in a world where financial risk has increased, the firm may still choose the labour intensive form of production.

This process of factor substitution will also lead to a steady decline in survey measures of excess capacity. As the recession hits, the car wash business with a large machine will report excess capacity as people economise on car cleaning. However when the machine reaches the end of its useful life, it is replaced by people with buckets and hoses, and the firm reports no spare capacity.

What happens when demand begins to rise? Initially not much - the firm just hires more labour. Productivity does not increase. The situation becomes more interesting if labour becomes scarce. Does the firm start paying higher wages to attract more workers, or push up prices to choke off additional demand? Or does the firm now think that maybe it is time to invest in a car washing machine, which would in a more certain future allow the firm to reduce costs and prices (and lead to a reversal in the fall in productivity)?

Perhaps all of the above. But suppose that at the moment real wages or inflation begin to rise, the central bank tightens monetary policy. This would raise the cost of capital, and could be interpreted as an attempt to prevent real wages rising. In other words, a strong signal to the firm to stick with its labour intensive production methods. We enter a kind of low productivity, low wage trap. Monetary policy, which in theory is just keeping inflation under control, is in fact keeping real wages and productivity low.

Monetary policy makers would describe this as unfair and even outlandish. A gradual rise in interest rates, begun before inflation exceeds its target, is designed to maintain a stable environment. As the owners of the garage begin to appreciate this, they will eventually decide to invest in that car washing machine. On the other hand, if they sense that inflation might rise above target, they will not invest, however strong short term growth might be.

I’m not sure I believe this. As Chris Dillow argues here, investment may be particularly prone to confidence or animal spirits. Would these animal spirits be stimulated more by strong demand growth, even if it was accompanied by forecasts of 3% or 4% inflation, or by monetary tightening to prevent this inflation ever happening?  

I also have another concern about a monetary policy which tightens as soon as real wages start increasing. What little I know about economic history suggests an additional dynamic. As long as the firm is employing labour rather than buying a machine, there is no incentive for anyone to improve the productivity of machines. The economy where real wages and labour productivity stay low may also be an economy where innovation slows down. The low productivity economy becomes the low productivity growth economy.

Unemployment, the output gap and wage flexibility

This post is about the impact of nominal and real wage flexibility on unemployment and the output gap. It starts in an academic, abstract sort of way, but the policy implications do follow. I try and make the analysis as accessible as I can to non-economists.

Start with an economy with a zero output gap (defined below) and no involuntary unemployment. Everything in the economy is just fine, which is a non-technical way of saying it is efficient. Then a ‘crisis’ happens that leads consumers to consume less and save more, so aggregate demand falls. Normally in these situations the central bank cuts nominal and real interest rates sufficiently to restore aggregate demand. Once this has happened, call everything in this economy ‘natural’, so the real interest rate that restores demand is the natural rate of interest. The natural level of output may not be the same as the pre-crisis level, because for example the new natural rate of interest can have knock on effects on how much people want to work. [1] However the natural level is the level of output that policymakers should aim for. [2]

In the Great Recession this mechanism did not work because nominal interest rates hit zero, and maybe also because monetary policy put a cap on inflation expectations. As a result, actual real interest rates are above the natural level. In addition, fiscal policy is in the hands of people who know nothing about macroeconomics, so there is no help from there. However monetary policymakers still think they could do something ‘unconventional’, so they want to know what to aim for. The answer is that, as long as what they do does not seriously distort the economy, they should try to get to the natural level of output, because that produces an efficient economy.

The difference between the actual level of output and the hypothetical natural level is called the output gap. The traditional way of defining the output gap was the difference between actual output and ‘productive potential’, which was the amount that could be produced if all factors of production were fully utilised. That is still how the gap is often measured in practice, although the measurement problems can still be huge, as Paul Krugman notes here. The problem at a conceptual level is that this approach downplays considerations of optimality, so nowadays theoretical macroeconomics uses the natural level of output to define the output gap. This has the advantage that we know what policy should be aiming to do: achieving the natural level of output.

Now imagine three almost identical economies where an output gap exists because nominal interest rates have hit zero. The level of real interest rates that would eliminate the output gap is the same in all three economies (i.e. they have the same natural levels of output). In the first economy, workers resist nominal wage cuts, so this puts a floor on how much unemployment reduces real wages. (Equally firms may be reluctant to impose wage cuts, as this research suggests - HT Kevin O’Rourke.) If nominal wages stop falling, at some point firms will stop cutting prices to protect their profits. We settle down to a new lower level of demand deficient output, high unemployment, but stable wages and prices. There is plenty for unconventional monetary policy to do, even though inflation is not falling.

In the two other economies nominal wages carry on falling. In the second economy prices get cut pari passu, so real wages remain unchanged, while in the third they do not, so real wages fall. So in the second economy inflation is lower than in the first, but real wages are the same. Does this lower rate of inflation increase or decrease the output gap? That depends only on whether actual output falls or increases because of lower inflation: the natural level of output involves a hypothetical economy which is unaffected by whether nominal wages fall or not in the actual economy [3]. Actual output may fall if negative inflation makes debtors spend a lot less but creditors not much more - this and other mechanisms are discussed in Mark Thoma’s post here. However, if monetary policymakers have been inhibited from doing much because inflation was not falling (which would be one interpretation of UK policy, for example), then as David Beckworth says, lower inflation may raise actual output by encouraging expansionary unconventional monetary policy.

How about the third economy, where real wages have fallen? Suppose firms respond to lower real wages by substituting labour for capital, and this process continues until all those who want to work can find a job. So in the third economy involuntary unemployment goes away. But is the output gap any lower? Once again, the natural level of output has not changed. (It was set in our hypothetical economy where real interest rates fell to their natural level.) So the key question becomes whether lower real wages and lower unemployment reduces or increases aggregate demand, and therefore actual output. It could go either way. So it is perfectly possible that both actual output and therefore the output gap is exactly the same in all three economies, even though unemployment has returned to its natural rate in one, and the other two have very different inflation rates. 

This comparison suggests that those who say unemployment in the first two economies is caused by wage inflexibility kind of miss the point. The basic problem is lack of aggregate demand. You could argue (I would) that the third economy is better off than the other two, because the pain of deficient demand is evenly spread (everyone has lower real wages), rather than being concentrated among the unemployed. But the first best solution is to raise aggregate demand, because that gets rid of the pain.

I started writing this post because of a recent study by Pessoa and van Reenan, who argue that the mysterious decline in UK labour productivity that I have talked about before can in large part be explained by unusually slow growth in UK real wages. The mechanism they have in mind is entirely traditional: if real wages are low firms substitute labour for capital. This in turn may explain (see Neil Irwin here for example) why UK unemployment originally rose by less than in the US (see first chart), even though the UK’s output performance was worse. On this issue looking at consumer price based measures of real wages will be misleading, so below is a very simple measure of real product wage growth in the two countries: compensation per employee less the GDP deflator. Real wage growth in the UK has noticeably fallen since the recession, whereas the fall has at least been less abrupt in the US (2013 is a forecast).

Unemployment in the US and UK: Source ONS and BLS

Growth in compensation per employee less GDP deflator: OECD Economic Outlook

In terms of just the UK economy, whether Pessoa and van Reenan are right is debatable. When I discussed this in an earlier post I referenced a Bank of England paper by MPC member Ben Broadbent, which argued that for the factor substitution story to explain most of what we have seen in the UK, investment should have completely collapsed, which it has not. This difference in view reflects a number of nitty gritty issues, like how you measure the capital stock, and whether the substitution elasticity is one (as implied by the Cobb Douglas production function), or nearer one half.

However most seem to agree that some of this factor substitution is going on in the UK. So my hypothetical discussion above suggests that, by spreading the pain of deficient aggregate demand further, this ‘real wage flexibility’ in the UK has been a good thing, but it does not mean the aggregate demand problem has decreased. If anything, it suggests that looking at unemployment underestimates the size of the output gap. Monetary policy makers please note.

[1] New Keynesian economists sometimes call the natural economy the outcome when all prices are completely flexible. That is OK, as long as we note that flexible prices here has to include the possibility that nominal interest rate can go negative, which in the real world it cannot.

[2] Opinions may differ on whether the crisis itself is a necessary correction for past errors, or whether it is itself a distortion. For example, was risk undervalued before the crisis, or is it overvalued now. In other words, was the pre-crisis economy efficient, or would there be a distortion in the post-crisis economy even without an aggregate demand problem? These are important complications compared to the story I tell here, but they will have to wait for another post.

[3] The idea is that the economies are identical except for the extent of nominal inertia in goods and labour markets. In economy 1 wages are sticky, in economy 3 prices are sticky but wages are flexible, and in economy 2 the degree of wage and price stickiness is such that real wages do not change. 

Labour productivity in the recession: why are the UK and US so different?

I’m afraid this post is going to seem like an episode of House, except without finding out what the patient had at the end. Indeed it is not even clear which patient, the UK or the US, has the unusual symptoms.

Here are two charts, taken from a new study by the Institute for Fiscal Studies.[1] The first compares UK labour productivity in this recession and two earlier large UK recessions.

The second chart compares labour productivity growth in this recession across selected countries. 

These are startling differences, so what can explain them? The IFS study, which builds on earlier analysis by the Bank, MPC member Ben Broadbent, and others [2], has some ideas about some things that may be going on and some things that are not, but I think its fair to say that we are still in the conjecture phase on this. So this post is mostly conjecture.

Let us start with the first chart. There are two classes of explanation for such a dramatic change. One is that the structure of the UK economy has radically changed. The other type of explanation is that the nature of the recession is different, and so the outcomes are also different. This recession has been generated by a financial crisis rather than by tight monetary policy. However, the fall in productivity growth in the UK is pretty widely spread across industries, so it is not a composition effect caused by a decline in the financial services sector. We need more clues.

One clue may be the unusual behaviour of UK real wages, which have fallen in this recession to a much greater extent than they did in earlier downturns. Unfortunately there is a chicken and egg problem here: does real wage growth reflect productivity growth (as it generally does in the long run), or does it have a causal role? It helps here to look at investment. Investment always falls in a recession, but UK investment has fallen by more in this compared to earlier recessions.

This leads to one possible story: factor substitution. Firms are replacing machines by workers, because real wages are low. Real wages are low because the UK labour market has become more flexible, and workers are cutting wages in response to unemployment by more than they used to. So this is a structural change story. If true, this could be good news. If the economy recovers and unemployment falls soon enough to avoid significant hysteresis effects, real wages will increase again, factor substitution will go into reverse, and labour productivity will make up lost ground.

I’m sure there is some of this going on. But it does not account for why the same thing has not been happening in the US, the archetypal flexible labour market. In addition, Ben Broadbent argues that a much larger fall in investment would be required to explain observed productivity this way.[3] There are also many other reasons why investment in this recession might be relatively low. The size of the downturn is greater, as is probably its expected duration (or at least the uncertainty associated with it’s duration). In addition, firms may just not be able to invest because banks will not lend them the money.

Here is another interesting clue. Large firms appear not to suffer from this problem: they have plenty of cash. There is some evidence that small firms, who are both more reliant in the UK on bank finance and are a more risky proposition, may have been subject to credit constraints. However we should not forget a third category of firms: start-ups.

One final clue. As has been noted by the IFS study and others, company liquidations in this recession have been lower than in previous recessions. (Tim Harford looks at this from a European angle.) In a recession where banks, as well as some firms, were in difficulties, banks may be reluctant to acknowledge failed loans and so may increase forbearance. Equally banks that are particularly concerned about their loan book are unlikely to take on new risk, so it may be much more difficult for new companies to get finance. (There is some support for this idea from the fact that the variance of rates of return and productivity have increased during the recession, but I have not seen evidence on whether this is unusual for a typical recession.) This is a story told about Japan’s lost decade. [4]

So, to the extent that UK banks have become much more cautious, they have stopped providing finance for new (potentially innovative) firms, but are keeping low productivity firms in business. A similar process may be going on within larger companies, where getting finance is not a problem. Innovation often requires investment, and so a reduction in investment generated by uncertainty (and perhaps greater risk aversion) will slow down productivity growth. (The structural econometric model of the UK economy that I built twenty years ago, COMPACT, has a vintage production structure, so I have a fondness for this idea.)

This story puts the unusual nature of the recession - a financial crisis and an associated reduction in risk taking - at the centre of the explanation of the UK productivity puzzle. There is also a nice corollary, which I have not seen emphasised elsewhere. To the extent that new entry has become less likely because of a lack of finance, the extent of competition has decreased. (Markets have become less ‘contestable’.) This will allow existing firms to increase profit margins, which may also help explain why UK inflation has been surprisingly persistent in this recession. So the story helps explain two UK puzzles rather than just one.[5]

Yet this is a story that explains one of the charts - unusual behaviour in UK productivity - but not why none of this is visible in the US. Indeed, given that many European countries have similar profiles to the UK (except just not so bad), and given the econometric evidence noted below, the puzzle here may actually be the US. There are many people who know much more than me on these issues, but at the moment I cannot see any obvious reason why the US should be different.

The US banking industry appears much less concentrated than in the UK: there are many more US banks than UK banks even after allowing for the different size of each economy. I have seen it suggested that larger banks may find it more difficult to use local knowledge about particular markets or industries, local knowledge which could help offset the impact of higher risk aversion on innovation. Perhaps US start-ups have access to a greater range of sources of finance than those in the UK, but there seems to be the same concern in the US about small business lending as there is in the UK.

So I do not think we even have a potential answer to the puzzle posed by both charts, although I should also note an ever present danger in macro of trying to explain too much with too little data (to overfit). A recent very good study that tries to maximise the data by looking at financial crises the world over has just been published by Nicholas Oulton and María Sebastiá-Barriel. They find that financial crises not only tend to lower productivity by more than other types of recession in the short run, but also that there is a permanent productivity effect from financial crises. However they also find that this long run effect is not robust - it comes from the inclusion of developing countries in the data set, particularly Latin American countries. Which suggests that nothing is inevitable, and being fatalistic about potential output that we can never get back may be a big mistake.  

[1] The productivity puzzles, Richard Disney, Wenchao Jin and Helen Miller, IFS

[2] Bruegel has some useful links here. This includes some who still believe a lot of labour hoarding is going on, and I would not want to discount that possibility.

[3] In other words we are seeing very low UK TFP growth as well as low labour productivity growth

[4] For example Caballero, R. J., Hoshi T and Kashyap A. (2007) “Zombie Lending and Depressed Restructuring in Japan”, American Economic Review 98.

[5] In fact an increase in monopoly power in the UK following the recession would produce on its own higher inflation, lower real wages and lower labour productivity (via factor substitution). However it would also imply a falling labour share, which as Chris Dillow points out does not appear to have happened. So you need to add some additional productivity story as well.