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Wednesday, November 12, 2014

'Potential Output and Recessions'

The profession appears to be changing it's mind about the permanence of large shocks to aggregate demand:

Potential Output and Recessions: Are We Fooling Ourselves?, by Robert F. Martin, Teyanna Munyan, and Beth Anne Wilson, Federal Reserve: The economic collapse in the wake of the global financial crises (GFC) and the weaker-than-expected recovery in many countries have led to questions about the impact of severe downturns on economic potential. Indeed, for several major economies, the level of output is nowhere near returning to pre-crisis trend (figure 1). Such developments have resulted in repeated downward revisions to estimates of potential output by private- and public-sector forecasters. In addition, this disappointment in post-recession growth has contributed to concerns that the U.S. economy, among others, is entering an era of secular stagnation. However, the historical experience of advanced economies around recessions indicates that the current experience is less unusual than one might think. First, output typically does not return to pre-crisis trend following recessions, especially deep ones. Second, in response, forecasters repeatedly revise down measures of trend.

Figure 1

... Economic models usually assume that recession-induced gaps will close over time, typically via a period of above trend growth. In our results, growth is not faster after the recession than before, implying that the recession-induced gap is closed primarily by revising estimates of trend output growth lower. Interestingly, much of the downward revision to estimates of trend output happens well into the recovery. In particular, as economies recover and the lower level of actual output persists, potential output is gradually revised down toward actual GDP. ...
Although these calculations are simple, they raise deeper questions about the impact of recessions on trend output. The finding that recessions tend to depress the long-run level of output may imply that demand shocks have permanent effects. The sustained deviation of the level of output from pre-crisis trend points to flaws in the way the economics profession models the recovery of output to economic shocks and raises further doubts about the reliance on measures of output gaps to determine economic slack. For policymakers, the results also point to the cost of recessions, especially deep and long ones, and provide a rationale for strong and rapid policy responses to economic downturns. ...
Disclaimer: IFDP Notes are articles in which Board economists offer their own views and present analysis on a range of topics in economics and finance. These articles are shorter and less technically oriented than IFDP Working Papers.

[There is quite a bit more detail -- tables, graphs, etc. -- in the full article describing how they arrive at this conclusion.]

One note: I want to emphasize that "the results also point to the cost of recessions, especially deep and long ones, and provide a rationale for strong and rapid policy responses to economic downturns." An important question is how much of the permanent effect can be avoided with a correct and timely policy response -- something we surely did not get with fiscal policy in the most recent episode.

    Posted by on Wednesday, November 12, 2014 at 09:34 AM in Economics | Permalink  Comments (34)


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