Analysis: Economists fear lasting recession damage

The Washington PostJune 12, 2014 

— The Great Recession was bad enough, but the not-so-great recovery might be even worse.

It’s been so weak that the long-term unemployed might become unemployable, that too little investment today might create bottlenecks tomorrow and that, taken together, we might never get back to growing like we did before the crisis.

In other words, we might be permanently poorer.

But just how much poorer? Economist Larry Ball has compared how much the Organization of Economic Cooperation and Development (OECD) thought that developed economies could grow in 2007 with how much they think those countries can grow today. The depressing answer is that, on an economy-weighted average, they think rich countries have lost 8.4 percent of their potential output.

“Potential output” is a commonly misunderstood idea. It doesn’t refer to how much the economy can produce without a bubble. It means how much the economy can produce without accelerating inflation, a sign of overcapacity. The OECD is worried that countries don’t have as much capacity as once thought, because the weak recovery might never undo all the harm from the recession.

And that damage hasn’t been evenly spread. The OECD thinks countries such as Switzerland and Australia – which, not coincidentally, have had some of the most aggressive monetary policy – have barely lost any potential, if at all. But it thinks the euro zone’s crisis countries have been maimed: Greece and Ireland, according to the OECD’s estimates, have lost almost 35 percent of their potential output.

Here’s the good and bad news. The countries that have had the biggest declines in actual output have also had the biggest declines in potential output. The pessimistic explanation is that hysteresis is real, and it’s spectacularly terrifying – that deeper recessions cause deeper long-term damage.

But there’s an optimistic explanation, which is that the way we calculate potential output interprets long slumps as never-ending ones – therefore, we’re overestimating the harm. As economist Paul Krugman points out, this method would have told us that the United States recovered from the Great Depression by 1935, when unemployment was still in the mid-double digits.

It comes down to what Krugman calls the “two zeros.” Normal recessions are normal, in part, because the central bank makes them so. It cuts interest rates when things look hairy to help the economy bounce back quicker.

But suppose a big shock, like a once-in-three-generations financial crisis, comes along, and even zero interest rates – our first ones – aren’t enough to bring back growth. The recovery will be nasty, brutish and long. And our models will think this slow growth is as fast as we can ever grow because they only extrapolate from the past few years of data.

Remember, potential output tells us the most we can make while keeping inflation low and stable. So, falling inflation should tell us when we’re falling below potential. The only problem is what economists call “nominal downward rigidity,” and what everyone else calls common sense: People don’t like taking pay cuts, so even in a depression, wages and prices don’t tend to fall outright. They stay flat, at – our second – zero. That means inflation stays low and stable in a slump, so our models don’t think we’re still in that slump. They think it’s a new normal.

We don’t know if it is, but we do know that it will become the new normal if we don’t start trying more. The worst that could happen is a little more inflation. That’s a price worth paying for a real recovery.

The State is pleased to provide this opportunity to share information, experiences and observations about what's in the news. Some of the comments may be reprinted elsewhere in the site or in the newspaper. We encourage lively, open debate on the issues of the day, and ask that you refrain from profanity, hate speech, personal comments and remarks that are off point. Thank you for taking the time to offer your thoughts.

Commenting FAQs | Terms of Service