The Great Recession may have crushed America’s economic potential

November 5, 2013

Source: Dave Reifschneider, William Wascher and David Wilcox, Federal Reserve Board

The title of a new paper from three economists at the Federal Reserve is bloodless: "Aggregate Supply in the United States: Recent Developments and Implications for the Conduct of Monetary Policy"

But its conclusions are chilling.

The paper offers a depressing portrait of where the economy stands nearly six years after the onset of recession, and amounts to a damning indictment of U.S. policymakers. Their upshot: The United States's long-term economic potential has been diminished by the fact that policymakers have not done more to put people back to work quickly. Our national economic potential is now a whopping 7 percent below where it was heading at the pre-2007 trajectory, the authors find.

As Dave Reifschneider, William Wascher  and David Wilcox sum up in their abstract, “The recent financial crisis and ensuing recession appear to have put the productive capacity of the economy on a lower and shallower trajectory than the one that seemed to be in place prior to 2007.”

What seems to be happening, they argue, is that people who lost their jobs in the recession have now been out of work for years, leading their skills to atrophy and them to become less attached to the workforce. As those workers’ productive capacity diminishes, so does the total potential of the U.S. economy.

The authors argue that while the “natural” rate of unemployment — the proportion of joblessness in a fully healthy economy — has likely risen due to the recession, that effect should be dissipating. “We see the evidence of recent years as suggesting that the natural rate of unemployment may have moved up between ½ and 1½ percentage points since the onset of the recent recession,” they write.  “However, the evidence also suggests that the factors leading to this increase have begun to reverse and that further increases in aggregate demand might therefore bring about further healing in the labor market.”

But beyond analyzing the economic situation in which the United States finds itself, the Fed staffers make an important argument worth considering for policymakers here and around the world.

There is a tendency to think of a nation’s “aggregate supply,” or potential output, as something that exists outside the realm of influence by short-term economic policy. The economic potential, after all, comes from the education of its people, the richness of its land, the quality of its machines — all things that a central banker can’t do much of anything to influence.

In other words, supply is “exogenous” to a policymaker’s economic model. But that may turn on its head in circumstances like the present. They write:

The implications for monetary policy may differ sharply from what is commonly presumed because much of the supply-side damage could be an endogenous response to weak aggregate demand. If so, then an activist monetary policy may be able to limit the amount of supply-side damage that occurs initially, and potentially may also help to reverse at a later stage such damage as does occur. By themselves, such considerations militate toward a more aggressive stance of policy and help to buttress the case for a highly aggressive policy response to a financial crisis and associated recession.

In other words, when there is weak demand and people remain out of work, the cyclical downturn can become a structural downturn. That means that policymakers should move particularly aggressively to keep that from happening.

It’s not a new argument; the activist wing within the Federal Reserve has been making this argument for years now, pulling their hair out trying to urge their own colleagues and fiscal policymakers in Congress to do more to try to avert a loss of America’s long-term economic potential. But expect this new paper to help their case.

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