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   

The UK recovery and the pessimists’ refrain

In two recent posts I plotted UK GDP per person since 1950. What is remarkable to me about that time series is how well a simple trend tracks the data – until the current recession. In reality trend growth rates have probably moved around a bit, but the important point is that past recessions have essentially turned out to be temporary deviations from trend growth, rather than signaling fundamental shifts. In particular, following both the major recessions of the early 1980s and 1990s, we achieved recoveries that brought us back to something close to the level of output we could have achieved if there had been no recession.

There are two arguments that this time will be different: what I will call the pessimists’ refrain. The first is that we were fooling ourselves before the recession, because in reality we were ‘living beyond our means’. This argument suggests that output in 2007 was unsustainably high, so our trend line should be lower and flatter. The second is that since 2008/9 productivity has stalled because the financial system in the UK has been broken. I call these ‘refrains’, because they usually come with a repeated message: we should stop stimulating the economy, because if we try to get back the ground we lost, we will fail and instead generate inflation. (A third argument focuses on hysteresis effects of high unemployment, but this is more important for the US than the UK.)

Larry Summers has recently reminded us that there was something odd about the pre-recession period in a number of countries including the US and UK. Although inflation was reasonably stable, we had the kind of housing bubbles that we normally associate with booms. Now Summers argued that this indicated an underlying demand weakness: we could only get people to buy all the stuff we could produce by encouraging them to take out an unusual amount of debt. There is an alternative explanation, which is that - despite appearances - there was a boom before the recession. We were, in 2007, living beyond our means. 

This idea is not the view of a small minority. Organisations like the OECD and IMF now calculate that in 2007 output gaps were large and positive. The latest OECD Economic Outlook gives 3.3% for the OECD area as a whole, 3.5% for the Euro area, 2.9% for the US and 4.4% for the UK. That is not what these organisations were saying at the time. In the June 2008 Economic Outlook, the equivalent numbers were 0.4%, 0.0%, 0.4% and 0.2%. At the time it looked like output in 2007 was close to the natural rate in many countries, including the UK. [1]

This change of view on output gaps, where 2007 goes from balance to a significant boom, is largely inevitable given the way the OECD and IMF calculate these numbers. Since the recession productivity in many countries has been much lower than we might have expected (in the UK it’s the ‘productivity puzzle’), which seems to indicate a fall in how much technical progress has been embodied in production. Traditionally we have thought of technical progress changing gradually, and as being largely unrelated to the economic cycle. If productivity is low today and technical progress only changes gradually, then it follows that some of this slackening in the pace of technical progress must have started before the recession. So in 2007 the economy was not capable of producing as much as we thought at the time.

What hard evidence do we have for all this? The living beyond our means case really comes down to the idea that both the housing bubble and the build up of personal debt must imply there was a boom. Yet this is really one piece of evidence rather than two. As Ben Broadbent shows, the build-up of debt was matched by an increase in assets: the value of houses. (The same appears to be true in the US.) This increase in personal sector indebtedness might have been foolish given what happened to house prices, but the underlying problem was the housing bubble.

Was the housing bubble an indication of a ‘hidden boom’ in 2007? There is a quite plausible alternative explanation, which is that you can get housing booms when real interest rates are low. Many economists, including Ben Bernanke, pointed out before the recession the unusually low returns on long term assets like government debt, an idea that became known as the ‘savings glut’. The return on assets was being driven down because consumers in China and its neighbours were saving extraordinary amounts, leading to large current account surpluses there. When returns on safe assets like government debt are low, people look elsewhere for higher returns, and this includes the housing market. This is probably why we are seeing rapid increases in house prices today in a number of major cities (e.g. London, Paris, Germany).

Not only is there this alternative explanation for the housing bubble, but the living beyond our means case cannot satisfactorily account for why - if we had a huge boom - inflation remained so subdued. What upward movement there was could easily be explained by large increases in oil and commodity prices. It is sometimes argued that inflation targeting, or cheap goods from China, kept a lid on consumer price inflation, but there was no indication of any overheating in the labour market either.

The second refrain, much more specific to the UK, focuses on the banking sector. The argument is not that the financial sector grew too rapidly before the recession, and must inevitably shrink back to a more normal size. That is almost certainly true, but the numbers just do not seem large enough. As Martin Wolf points out, the financial sector went from 6% of GDP in 1998 to 9% in 2008. Even if it returns to 6%, for the economy as a whole much of that should be recoverable, because most of those who have lost their jobs in the financial sector are highly skilled and so can be redeployed in other high productivity activities.

The argument is instead that, for the supply side of the economy to grow, more productive firms need to replace inefficient competitors, and new innovative start-ups should challenge existing firms. Both processes almost certainly require borrowing, and in the UK in particular that borrowing usually comes from a few large banks. If these banks stop lending, productivity growth will fall away. This argument is plausible, and can help explain two puzzles about the current recession. The first is why, when UK firms are asked how much spare capacity they have, they respond that they have very little. This is not consistent with the recession being only about lack of demand. The second is that inflation has not been falling more rapidly. If firms cannot get the finance to grow, there is little point in trying to expand your market by cutting prices.

What is frustrating about this idea is that there is little hard evidence either way. Bank lending to firms has certainly fallen, but how much of this is down to banks, and how much is simply that firms think it is too risky to borrow? (This study suggests at least some of the former.) There is a great deal of anecdotal evidence that some banks have in the last few years might have been hindering rather than helping small businesses, but translating this into actual numbers for productivity lost is almost impossible. The most compelling argument that something like this has been going on is that other explanations for the UK’s productivity puzzle are either implausible or inadequate in terms of scale.

Perhaps the key question, though, is how permanent this all is? If bank lending starts to recover, can we get back the productivity we have lost? We can look at past financial crises in other countries, as Nick Oulton has done. (His paper also provides useful detail on why other explanations for the productivity puzzle do not seem to work. The section on fiscal policy, however, departs from his usual high standards, as this article in Pieria suggests.) His analysis indicates some permanent hit to GDP from a financial crisis, but the larger numbers come from Latin America. The example of Sweden in the early 1990s is much more optimistic. A priori we might expect a good deal of the innovation to have been ‘put on hold’ because of lack of finance, and this could be activated once banks’ balance sheets are repaired. But perhaps some opportunities may have been lost forever.

Given these uncertainties, two implications for policy seem clear. First, we should stimulate demand until there are clear signs of overheating in both the goods and labour markets. We should only do otherwise if the pessimistic case is compelling, and it is not.

Second, to the extent that we do not recover the ground that we lost in the recession, the costs of the financial crisis are even larger than we thought. This suggests we must do something to make the economy less dependent on the behaviour of a small number of large UK banks. What is interesting about at least some of those who sing the pessimists’ refrain is that they seem to treat this implied loss of UK capacity like an act of God: not only is it something we can do nothing to reverse, but there is little point in investigating it further. That is a strange attitude to take, particularly given that there has been no equivalent productivity puzzle in the country where the banking crisis really started. (This may be another reason to praise small US banks: see Felix Salmon here.) Some who are pessimistic preach the usual neoliberal message for enhancing growth, including lower taxes on high incomes, but seem strangely uninterested in what has caused this alleged huge reduction in supply. Perhaps they fear the answers to the UK’s productivity puzzle will not be to their liking.

[1] For the CBO’s assessment of US potential, see Menzie Chinn.           

The strange case of the disappearing productive capacity

                Have a very quick look at the chart below.

It looks like recent developments in actual output relative to potential. But it is not. It is various assessments of UK potential output against the pre-recession trend.

                It comes from the post-budget forecast produced by the Office for Budget Responsibility (OBR), the independent body that the UK government has contracted out the job of producing the official budget forecast to. It shows that the OBR, and other international forecasters, think that the recession will in a few years time have led to a permanent loss of UK output of over 10%. That is an extraordinarily large number. It makes the recent US debate on the subject look positively tame by comparison.

                The OBR estimates mainly come from survey evidence. The following chart is from a recent OBR working paper which describes their methodology.

We can see the problem by comparing 1981 with 2009. Between 1979 and 1981 UK GDP fell by about 3.5%, whereas between 2007 and 2009 it fell by 5.5%. Yet movements in the output gap look quite similar. More significantly, from 2009 to 2011 UK GDP grew at an average annual rate of just less than 1.5%, yet this survey evidence suggests the output gap was almost halved as a result!

                The OBR estimate that the current output gap is about 2.5%. Of this about 0.5% represents below trend levels of output per worker, with about 2% reflecting the gap between actual and potential employment. Unemployment is now around 8.5%, compared to about 5% before the recession.

                Other institutions use a production function approach to estimating productive capacity. The extent to which this is an alternative methodology depends in large part on how underlying total factor productivity (TFP) is estimated. (We can estimate the potential labour force from employment and unemployment, and the capital stock from investment data, but there is no data on changes in how efficiently those factors could be used.) If TFP is imputed from survey evidence on the output gap, we are going to get similar results.

                So if these numbers are correct, how can they be explained? The major explanation has to come from a slowdown in underlying productivity. Actual labour productivity has indeed fallen in most sectors: the chart below comes from the Bank of England’s Feb 2012 Inflation Report.

Now falls in labour productivity are what might be expected in a demand led recession, because it takes time for firms to adjust employment. However after a while one of two things should happen. The first possibility is that employment adjustment does occur as firms reconcile themselves to lower output, so productivity should rebound. It has not, particularly in services. The second is that firms are hoarding labour because they think output will recover to something like pre-recession trends. But in that case they should be reporting substantial spare capacity, which we have seen they are not. This behaviour in productivity appears to be the main difference between the UK and US estimates of potential output.

                It is still possible that the survey data is just wrong. This is a view taken by Bill Martin (see both his FT article and the more detailed analysis behind it). However the survey evidence does receive some support from inflation. Although I noted that wage inflation had been very subdued following the recession, and that the recent peak in consumer price inflation was largely caused by commodity prices and tax changes, it remains the case that movements in domestic profit margins appear to be reasonably consistent with the survey evidence on the output gap. Firms are not cutting prices in an effort to utilise substantial spare capacity. However this is fairly weak evidence: there may be other reasons why firms are not cutting prices.

If the survey evidence is correct, then we have a major supply side puzzle. Is it the case that innovation has really come to a halt following the recession, perhaps because of financial constraints? Or are there more subtle supply side factors at work? (Subtle is code here for ideas that maybe interesting, or maybe silly.) A further possibility is that hysteresis effects may have operated more quickly than anyone thought, which really would be an indictment of austerity. A crucial question either way, posed by Mark Thoma, is whether these changes are temporary or permanent.

In the UK, this is not just an academic puzzle. With inflation still above target, the size of the perceived output gap remains important for (unconventional) monetary policy. Furthermore, and unlike the US, the government’s main fiscal target relates to the cyclically adjusted budget deficit. As I noted here, downward revisions made to potential output by the OBR in November led to a tightening of the government’s austerity plans. This was admittedly put off for a few years, but expectations matter. It is important to get this right, because with hysteresis effects (see DeLong and Summers) there is a danger that pessimism about productive capacity and productivity, even if it is misplaced, may become self-fulfilling.