View: Free exchange: Humbler horizons | The Economist
Free exchange: Humbler horizons | The Economist
WHEN the American economy emerged from recession three years ago, forecasters fell into two broad camps. Optimists reckoned brisk growth would quickly return the economy to its long-term potential level of output, the maximum sustainable GDP that could be achieved with the capital and labour on hand. That would pull down unemployment and prop up inflation. Pessimists, however, predicted sluggish growth, persistently high unemployment and inflation that would slip ever lower as a result of unused capacity in the economy.
What has actually happened since then has been a mixture of the two. Unemployment and inflation have moved in the directions that optimists expected. Since peaking at 10% in late 2009, the jobless rate has now fallen by nearly two percentage points. Core inflation, which excludes food and energy, dipped below 1% in 2010 but is now above 2%. Yet economic growth has averaged 2.5%, a rate more typical of the economy at full employment rather than when recovering from a deep bust.
Economists advance several explanations for this dichotomy. The drop in unemployment may simply be mechanical, a snapback after employers fired workers too indiscriminately during the recession. Inflation has been underpinned by the indirect effects of higher commodity prices, rising rents and the influence of stable inflation expectations on prices and wages. Optimists say that GDP may be revised up later.
But there is another, more troubling possibility: the crisis may have permanently dented America’s productive capacity. If so, the “output gap” between the economy’s current level of production and its potential level is much smaller than expected. Unemployment has fallen because there are fewer people available to work. Inflation is stable because there is less idle capacity to restrain prices. This would be bad news all round. America would be permanently poorer than would otherwise have been the case. The Federal Reserve would have less room to ease policy before inflation revives. More of the budget deficit would be structural, rather than the temporary result of a depressed economy.
Policymakers do not embrace this scenario. Ben Bernanke, the Fed chairman, said last year that the crisis and recession had not left “major scars” on the economy’s potential. Other countries’ experience suggests he may be wrong. A 2009 paper* by the OECD, a think-tank, studied 30 developed countries and concluded that crises on average reduced the level of potential GDP by 1.5% to 2.4%. Severe crises—America’s easily qualifies—knocked it back by nearly 4%. The International Monetary Fund, studying a much broader sample of crises, found that seven years after the onset of a banking crisis, GDP was on average still 10% below where its pre-crisis path would have put it. This is much greater than the impact of a currency crisis (see left-hand chart).
What accounts for this stifling effect? Both the OECD and the IMF argue that crises stunt the three main ingredients of growth: capital, labour and innovation. First, by choking off the supply of credit and throttling sales, crises depress investment and thus productivity. Second, they leave prolonged high unemployment in their wake. Some workers lose their skills, which makes it hard for them to find jobs again. Others simply drop out of the workforce altogether, lowering labour-force participation rates. Third, and more controversially, the papers argue that crises undercut innovation, and the efficiency with which capital and labour are used, by interrupting the supply of capital to high-growth firms or by reducing spending on research and development.
The upshot is a permanent reduction in the path of potential GDP. This does not necessarily mean a permanently lower growth rate: an economy whose trend growth was 2.5% before a crisis should return to that rate, but from a lower starting-point.
Official forecasters are coming round to this way of thinking. The Congressional Budget Office has repeatedly revised down its estimates of America’s output potential since 2007 (see right-hand chart). It reckons the output gap this year will be 5% of GDP; it would have been 10% had potential remained on its 2007 trajectory. A major factor in the revisions is the failure of labour-force participation to rebound since the recession ended. Back in 2007 the agency thought that the potential labour force would be 160m in 2012. The actual labour force in April was just 154m. Temporary factors explain some of this shortfall: discouraged workers have given up hunting for work because no jobs are available, and the young are staying in education longer. But much of the gap represents permanent departures from the labour force because of early retirement or workers going on disability benefit.
Earlier this year, staff at the Federal Reserve also marked down their estimate of the country’s potential GDP and the output gap in response to the surprisingly steep drop in unemployment. Details of the shift are not public, but a 2011 staff study sheds some light. The authors, Charles Fleischman and John Roberts, tease out the economy’s potential by analysing how inflation, unemployment and other variables have behaved. They conclude that America’s potential growth rate averaged just 1.8% from 2008 to 2010, far below the 2.5% that Fed policymakers generally cite as the long-term trend.
Potential is an inherently slippery concept. Who is to say whether a former worker or a vacant factory will ever produce again? Nor is it written in a country’s stars. How much potential is damaged will depend, in part, on how well policymakers prop up demand. The IMF notes that countries that responded to past crises with aggressive monetary and fiscal stimulus, structural reforms and rapid repair of their financial systems limited the loss of potential. American policymakers have tried to apply those lessons but not, apparently, hard enough.
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