The 2008 crisis has resulted in significant downward revisions of potential growth for most advanced economies. As output collapsed we revised down our expectations of what is feasible in the long-term. This has resulted in estimates of potential output that are much lower than the ones we had before the crisis. There are several interpretations of these revisions, some of which can be very depressing.
One interpretation is that we just realized that demographics and technology would not be as favorable as we thought going forward. The crisis might have raised awareness that demographic trends (aging) combined with weaker productivity growth will be unable to deliver the same growth rates as before. This is bad news but if this is what is going on, then we need to accept it or find ways to reverse those trends (increasing retirement age, finding levers for faster innovation,...).
But this cannot be the main story behind the revisions of potential output given that most of the revisions are about the level of GDP, not so much about the growth rate going forward. As an illustration, I am plotting below the output gap for Italy as estimated by the IMF World Economic Outlook back in April 2009 and in its latest issue (April 2014). The output gap is the difference between actual GDP and potential GDP.
Since the crisis started not only we have changed our views about the future but we have also changed our views of the past. If you look at the blue line you can see that in 2009 we thought that the Italian economy had been growing at a rate similar to potential output for the previous 19 years (and remember that growth rates in Italy were already low during most of these years). But today we believe that Italy was producing "too much" during all those 19 years (with the exception of 1993). Every single year Italy was somehow employing too many workers or those workers where being too productive. Why that change? Because of the interpretation that some (most?) of the GDP fall during the crisis will be permanent and to make this consistent with what happened before the crisis we need to lower out estimates of potential output in those years as well. Let me me be clear, we have no theory and no direct evidence that potential output during those years was lower than what we thought before, we are simply finding a way to validate the current level of output that seems to be going nowhere. And because it GDP refuses to grow it must be permanent and structural.
The alternative (and much more depressing) interpretation is that a crisis, which is clearly global in its nature, this is not an Italian crisis, has resulted in a a very long period of low growth. This low growth has had an effect on potential output because long-term growth rates cannot be completely separated from cyclical conditions. Labor market conditions have an effect on long-term unemployment, discouraged workers and participation rates (what Blanchard and Summers called backed in 1986 hysteresis in labor markets). But even more fundamentally, investment rates, technology adoption are slowed down by cyclical conditions and these are the forces that drive potential growth rates. So the longer is the recession, the bigger the impact on potential output (I was very interested in these dynamics back in the late 90s and wrote a couple of papers with supporting empirical evidence: here and here).
From a policy point of view the two interpretation lead to completely different recommendations. Under the first interpretation we have been living in a fictitious world for the last 20 years thinking that we were more productive. Finally we understand that we are not so it is the time to adjust and live within our means. As this working paper from Bundesbank puts it
Consequently, earlier growth paths are probably no longer achievable, particularly for some European countries. Substantial macroeconomic imbalances built up... and painful adjustment processes are now underway. Attempts to explain this merely through a major shortfall in aggregate demand are far from convincing.
Under the alternative scenario we are now learning that the costs of crises are a lot larger than what we thought. We are not just talking about transitory output losses but events that leave permanent scars on the level of GDP. So it is time to react and generate enough growth not just to go back to potential but to restore the mechanisms that drive its long-term growth.
Antonio Fatás
One interpretation is that we just realized that demographics and technology would not be as favorable as we thought going forward. The crisis might have raised awareness that demographic trends (aging) combined with weaker productivity growth will be unable to deliver the same growth rates as before. This is bad news but if this is what is going on, then we need to accept it or find ways to reverse those trends (increasing retirement age, finding levers for faster innovation,...).
But this cannot be the main story behind the revisions of potential output given that most of the revisions are about the level of GDP, not so much about the growth rate going forward. As an illustration, I am plotting below the output gap for Italy as estimated by the IMF World Economic Outlook back in April 2009 and in its latest issue (April 2014). The output gap is the difference between actual GDP and potential GDP.
Since the crisis started not only we have changed our views about the future but we have also changed our views of the past. If you look at the blue line you can see that in 2009 we thought that the Italian economy had been growing at a rate similar to potential output for the previous 19 years (and remember that growth rates in Italy were already low during most of these years). But today we believe that Italy was producing "too much" during all those 19 years (with the exception of 1993). Every single year Italy was somehow employing too many workers or those workers where being too productive. Why that change? Because of the interpretation that some (most?) of the GDP fall during the crisis will be permanent and to make this consistent with what happened before the crisis we need to lower out estimates of potential output in those years as well. Let me me be clear, we have no theory and no direct evidence that potential output during those years was lower than what we thought before, we are simply finding a way to validate the current level of output that seems to be going nowhere. And because it GDP refuses to grow it must be permanent and structural.
The alternative (and much more depressing) interpretation is that a crisis, which is clearly global in its nature, this is not an Italian crisis, has resulted in a a very long period of low growth. This low growth has had an effect on potential output because long-term growth rates cannot be completely separated from cyclical conditions. Labor market conditions have an effect on long-term unemployment, discouraged workers and participation rates (what Blanchard and Summers called backed in 1986 hysteresis in labor markets). But even more fundamentally, investment rates, technology adoption are slowed down by cyclical conditions and these are the forces that drive potential growth rates. So the longer is the recession, the bigger the impact on potential output (I was very interested in these dynamics back in the late 90s and wrote a couple of papers with supporting empirical evidence: here and here).
From a policy point of view the two interpretation lead to completely different recommendations. Under the first interpretation we have been living in a fictitious world for the last 20 years thinking that we were more productive. Finally we understand that we are not so it is the time to adjust and live within our means. As this working paper from Bundesbank puts it
Consequently, earlier growth paths are probably no longer achievable, particularly for some European countries. Substantial macroeconomic imbalances built up... and painful adjustment processes are now underway. Attempts to explain this merely through a major shortfall in aggregate demand are far from convincing.
Under the alternative scenario we are now learning that the costs of crises are a lot larger than what we thought. We are not just talking about transitory output losses but events that leave permanent scars on the level of GDP. So it is time to react and generate enough growth not just to go back to potential but to restore the mechanisms that drive its long-term growth.
Antonio Fatás
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