According to macroeconomics textbooks, a fall in aggregate demand causes a recession in which output drops below potential output – the normal level of production given the economy’s resources and technology. This effect is temporary, however. A recession is followed by a recovery period in which output returns to potential, and potential itself is not affected significantly by the recession.
A growing literature has called this textbook theory into question. Authors such as Cerra and Saxena (2008) and Reinhart and Rogoff (2009) find that deep recessions have highly persistent effects on output. Haltmaier (2012) and Reifschneider et al. (2013) argue that these effects occur because a recession damages an economy’s labour force and productivity, thereby reducing its potential output. Some economists use the term ‘hysteresis’ for these scarring effects of recessions (Blanchard and Summers 1986).
Experience since the financial crisis and Great Recession of 2008–2009 has strengthened the evidence for long-term effects of recessions. It has become increasingly clear that the recession has done lasting harm – that countries around the world face a new normal with lower levels of output than anyone expected in 2007. In a recent paper (Ball 2014), I seek to quantify the damage suffered by 23 OECD countries.
Measuring the damage
For each country, I measure potential output with estimates from the OECD, which are based on a production function and trends in labour, capital, and total factor productivity. I estimate the effects of the Great Recession by comparing two paths for potential: the path that potential has followed according to current OECD data, and a hypothetical path that it would have followed if the recession had not occurred.
The current data for potential come from the OECD’s Economic Outlook for May 2014, and include forecasts through 2015. To construct my counterfactual series for potential, I examine the Economic Outlook for December 2007, on the eve of the financial crisis. This issue of the Outlook reports estimates of potential through 2009. I extend these pre-crisis estimates through 2015 by log-linear extrapolation – for the period after 2009, I assume that the annual change in log potential equals the average change from 2000 to 2009.
Figures 1 and 2 illustrate my procedure for the US and Spain. In these graphs, y is the log of actual output, y* is the log of potential output according to current OECD estimates, and y** is the no-recession counterfactual based on the 2007 data. For both countries in the figures – and for most others in my study – the path of y** over 2000–2009 is close to a straight line. In extrapolating y** beyond 2009, I essentially extend the straight line.
Figure 1. The effect of the Great Recession on potential output in the US
Figure 2. The effect of the Great Recession on potential output in Spain
I measure the long-term damage from the Great Recession by the percentage deviation of potential from its no-recession path. In 2013, this loss of potential is 4.7% in the US and 18.2% in Spain. According to current OECD forecasts, the loss will grow to 5.3% in the US and 22.3% in Spain in 2015.
Results for 23 countries
I estimate the damage from the Great Recession in 23 countries for which the OECD published series for potential output in both 2007 and 2014. The loss in potential varies greatly across countries, but is large in most cases. For 2015, the loss ranges from almost nothing in Switzerland and Australia to over 30% in Greece, Hungary, and Ireland. The average loss for the 23 countries in the sample, weighted by the sizes of their economies, is 8.4%.
My analysis yields two related results, which are also illustrated by the Figures (most clearly in the case of Spain).
- First, in most countries the loss of potential output from the Great Recession has been almost as large as the loss of actual output.
That is, the dashed line for y* falls almost as far below the pre-crisis trend as the solid line for y. This finding implies that hysteresis effects have been remarkably strong in recent years.
- Second, in the countries hit hardest by the recession, the growth rate of potential output is much lower today than it was before 2008.
In Spain, the OECD currently predicts that potential will grow at an average rate of only 0.8% over 2014–2015, compared to a 3.5% growth rate in the pre-crisis data for 2001–2009. In Greece (not pictured here), the predicted growth rate is 0.2% for 2014–2015, compared to 4.0% in the pre-crisis data. In countries like Spain and Greece, if potential growth rates remain at current depressed levels, then the losses of potential output relative to pre-crisis trends will grow rapidly over time.
Through what mechanisms do recessions reduce potential output? This question is addressed in a number of recent papers (see Ball 2014). While the results vary, it appears that recessions sharply reduce capital accumulation, have long-term effects on employment (largely through lower labour force participation), and may slow the growth of total factor productivity. This last effect is poorly understood – one possible factor is a decrease in the formation of businesses with new technologies. A better understanding of hysteresis mechanisms is a high priority for research.
Can policymakers repair the damage from the Great Recession? Once again, the answer is not clear, but I believe that hysteresis effects can work in reverse if macroeconomic policy creates a strong economic expansion. Procyclical investment would increase the capital stock, plentiful job opportunities would increase workers’ attachment to the labour force, and so on. My past research finds that expansionary policy can reduce the natural rate of unemployment (Ball 2009). Today, a strong expansion might push potential output back toward its pre-crisis path. Failing that, the expansion might at least reverse declines in the growth rate of potential, so the damage from the Great Recession does not continue to grow.
Ball, Laurence (2009), “Hysteresis: Old and New Evidence”, in Jeff Fuhrer, Yolanda K Kodrzycki, Jane Sneddon Little, and Giovanni P Olivei (eds.), Understanding Inflation and the Implications for Monetary Policy: A Phillips Curve Retrospective, Federal Reserve Bank of Boston.
Ball, Laurence (2014), “Long-Term Damage from the Great Recession in OECD Countries”, NBER Working Paper 20185, May.
Blanchard, Olivier J and Lawrence H Summers (1986), “Hysteresis and the European Unemployment Problem”, NBER Macroeconomics Annual 1986.
Cerra, Valerie and Sweta Chaman Saxena (2008), “Growth Dynamics: The Myth of Economic Recovery”, The American Economic Review, 98(1): 439–457.
Haltmaier, Jane (2012), “Do Recessions Affect Potential Output?”, International Finance Discussion Paper 1066, Federal Reserve Board, December.
Reifschneider, Dave, William L Wascher, and David Wilcox (2013), “Aggregate Supply in the United States: Recent Developments and Implications for the Conduct of Monetary Policy”, 14th Jacques Polak Annual Research Conference, November.
Reinhart, Carmen M and Kenneth S Rogoff (2009), “The Aftermath of Financial Crises”, The American Economic Review, 99(2): 466–472.