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Monday 21 Aug 2017 | 16:36 | SYDNEY
Monday 21 Aug 2017 | 16:36 | SYDNEY

The long term damage of the global financial crisis



24 July 2014 09:29

One of the messages of John Edwards' Beyond the Boom is that Australia sailed through the 2008 crisis unscathed. As a result, Australia's GDP in 2013 was 16% higher than in 2007, while many of the G7 countries had barely regained their pre-crisis GDP level: the strongest rebound, in Canada, was only 8% above its 2007 GDP. These are feeble recoveries. The damage of the 2008 crisis is, however, even more serious and lasting than these figures suggest.

Economic recoveries usually involve a strong 'catch-up' component, when income grows much faster than its underlying trend rate. Workers and enterprises, unemployed during the downturn, are brought back into full production. Business cycles are often described as 'V' shaped. The implication is that that economies get back to their pre-downturn trend line.

There is growing evidence that this catch-up has not occurred during the present global recovery. The recovery is not a 'V'; it is a reversed 'J', never getting back to the old trend line.

One compelling study of the issue is provided by Johns Hopkins economist Larry Ball. Ball took the potential growth rate estimates made by the IMF and OECD in 2007 showing how each of the OECD economies could grow if running at full productive capacity. He then compared these 2007 potential growth trends with the similar potential growth trends shown in the latest OECD and IMF forecasts. The latest estimate is well below the 2007 estimate. He attributes the difference to the damaging effect of the 2008 global financial crisis. Here's how he summarises his results:

I find that the loss in potential output from the Great Recession varies greatly across countries, but is large in most cases. Based on current forecasts for 2015, the loss ranges from almost nothing in Switzerland and Australia to over 30% of potential output in Greece, Hungary, and Ireland. The average loss for the 23 countries, weighted by the sizes of their economies, is 8.4%.

This graph of the US (above), from the Congressional Budget Office (CBO), illustrates the point. The sharp downward break in actual GDP growth (the solid line) in 2008 has not been reversed. Eye-balling this as far forward as the actual data take us, it doesn't look like the US is getting back to its old trend line (the darker blue dash line) any time soon, or ever. The lighter blue dashed line shows the best current guess of where the potential growth trend lies.

Nor are most of the other 22 OECD countries Ball examined doing any better. The current potential growth paths (as calculated by the IMF and the OECD) have fallen about as much as the actual fall in GDP during the recession. These countries are now on a permanently lower growth trajectory. Countries which suffered the biggest recessions (notably, the eurozone peripheral countries like Greece and Spain, but also eastern Europe) have lost the most in terms of potential growth.

Less marked examples of this phenomenon have occurred in the past, where a recession discourages investment and leaves a permanently smaller capital stock. Technological progress and innovation are less dynamic in downturns. Most notably, workers who lose their jobs adapt to worklessness and remain jobless either because they stop looking for work or take early retirement. Sometimes their sojourn in unemployment has diminished their skills. Those in education stay there longer, with little accumulation of work-relevant skills.

Iin the jargon, it's known as 'hysteresis', and as a result output never gets back to the original potential growth path. In the US, the participation rate — the proportion of working-age population either working or looking for work — has fallen from nearly 66% in 2007 to less than 63% now. 

The powerful lesson here is: 'don't have a recession and, if you have one, recover quickly'. If you want to see what lasting damage a serious recession does to potential output, look at Larry Ball's graphs for Ireland, Spain or Greece.

But the CBO graph shows that something else is happening: the new potential output trend is not only lower, it is also flatter than before. This takes us to a broader debate about 'secular stagnation'. For example, the US used to have a potential annual growth rate of around 3%. The CBO now thinks it is just over 2% and some estimates are lower still. Demographics are reducing the relative size of the workforce. Various other factors are adding to the fall in participation in the workforce. Productivity seems to be slower in many countries.

There are plenty of esoteric arguments among the cognoscenti about all of this, and plenty of room for differences of opinion. A sensible concept of GDP is hard enough to measure and predict, and productivity is harder still. Many of the huge benefits we receive from technology (not just new products, but quality improvements in old ones) come to us at little or no extra cost, and probably don't get fully measured in the national accounts. Perhaps some of those who have dropped out of the work force are enjoying their new-found leisure, which is not counted at all in GDP.

There is, however, no doubt that the 2008 crisis was hugely damaging, and the inability of most of the OECD countries to achieve a normal rapid recovery has left a deep and permanent scar on living standards. In Australia we missed this bullet, through a combination of competent policy and good luck. The Hanrahans, with their relentless gloom, should be reminded of this.

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