With long-term output estimates significantly lower, are we awakening from a fictitious world of excess or is this recognition that scars from the financial crisis may be permanent?
The 2008 crisis has resulted in significant downward revisions of potential growth for most advanced economies. As output collapsed, estimates of potential long-term output were revised and are now 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 attributes this downward revision to the realisation that demographics and technology will not be as favorable as we thought going forward. The crisis might have raised awareness that a generally aging population combined with weaker productivity growth will be unable to deliver the same growth rates as before. If this is what is going on, then we need to accept it or find ways to reverse the trends, such as increasing the retirement age or finding levers for faster innovation.
However I doubt this is the main story given that most of the revisions are about the level of GDP, not so much about the growth rate going forward.
Were Italian Workers Too Productive?
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 have we 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 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 either Italy was somehow employing too many workers or those workers were being too productive.
Why the change?
This could be explained in the interpretation that some (most?) of the decline in GDP during the crisis will be permanent. 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 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 the GDP refuses to grow it must be permanent and structural.
The alternative (and much more depressing) interpretation is that the crisis, which is clearly global in its nature, has resulted in 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.
Labour market conditions have an effect on long-term unemployment; discouraged workers; and participation rates (what Blanchard and Summers called back in 1986, the hysteresis in labour markets). But even more fundamentally, investment rates and technology adoption are slowed down by cyclical conditions and these are the forces that drive potential growth. So the longer the recession, the bigger the impact on potential output (I was very interested in these dynamics back in the late 1990s and wrote a couple of papers with supporting empirical evidence: here and here).
Where to go from here?
From a policy point of view the two interpretations 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:
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 previously thought. We are not just talking about transitory output losses but events that leave permanent scars on the level of GDP. It is time to react and generate enough growth not just to return to potential but to restore the mechanisms that drive it long-term.