How bad policy is making the Great Recession’s damage permanent


Carla Gottgens/Bloomberg

Don't blame the Great Recession for making us permanently poorer. Blame our policymakers for letting it.

This concept is called hysteresis, and it's the idea that a long enough slump can maim the economy's long-run potential. That's because 1) too little investment today can keep us from growing as much tomorrow, and 2) too few jobs can make the long-term unemployed give up hope of ever finding work again. In other words, it means that we might never undo all the damage the financial crisis has done.

And that would leave us with a lot of damage still. How much exactly? Well, Johns Hopkins professor Larry Ball has tried to answer that by comparing how much the OECD thought rich countries could grow in 2007 with how much it thinks they can grow now. The depressing result: aside from Australia and Switzerland, all of those country's prospects look much worse today. Specifically, the OECD thinks that the Great Recession has cost the advanced world 8.4 percent of its pre-crisis potential.

Now, the good news is that these economic scars don't have to be as permanent as they might seem. The way we try to calculate potential output can underestimate it by mistaking a long slump for a never-ending one. That's why, as Paul Krugman has noted, these economic models of potential output can be too conservative -- they would have told us that the U.S. had fully recovered from the Great Depression in 1935, double-digit unemployment notwithstanding.

But the bad news is that today, unlike the Great Depression, we aren't going to get the policies we need to get rid of these scars. Instead, we're going to get more of the same—less government spending and less inflation—that, at least in the aftermath of the crisis, have already hurt our productive capacity so much.

Budget cuts worsen our economic scars

As Krugman points out, there's a decent-sized correlation between the amount of austerity a country's instituted and the amount of potential output it's lost. You can see this in the chart below. It shows how much the IMF estimates each country's structural balance, which adjusts the budget for the business cycle, changed between 2009, when stimulus started, and 2013, when it was well over. Then it compares that with how much its potential has fallen from its pre-crisis trend.

It's not a perfect relationship, but, in general, for every 1 percent of GDP that a country has cut, its potential has fallen 1 percent, too.

Austerity Hysteresis

There's also a correlation between how much a country's inflation changed from before to after the recession, and how much its potential did. As you can see below, I took the IMF's numbers on average annual inflation for 2007 and 2013, and plotted the difference against the difference in pre-and-post-crisis potential. Roughly-speaking, the countries that were unable or unwilling to keep inflation from falling the most tended to be the ones where potential fell the most.

And this was a big effect: for every 1 percentage point that inflation declined, potential did by 3.3 percent.

Inflation Hysteresis

How bad policy hurts our economic potential

None of this should be true. The economy's potential shouldn't have a lot to do with how much the government decides to spend or how much inflation the central bank decides to allow. But both matter now. Both inflation and government spending were highly statistically significant when I regressed them together against lost potential, with an R-squared of 0.55. In other words, insufficient fiscal and monetary stimulus explain over half the fall of potential output.

But why? In the long run, shouldn't the economy recover on its own? Well, yes. But that long run can be too long if the private sector has too much debt to pay back before it can start spending and investing again—in which case, our economic potential will be dead due to hysteresis.

Now, if that's right, the countries that added the most private debt before the crisis should have been the most vulnerable to bad policy after it. And that seems to be the case. As you can see below, I took the OECD's numbers on each country's private sector debt to GDP from 2002 and 2007, and compared the change with the change in potential output. For every 10 percent of GDP that private debt increased, economic capacity decreased by 1.7 percent.

Private Debt Hysteresis

Next, I took the numbers for austerity, inflation, and private debt, and regressed them together against the decline in potential output. All of them were statistically significant, and the R-squared was 0.64. Taken all at once, it suggests that austerity of 1 percent of GDP reduces potential by 0.7 percent, inflation that's 1 percentage lower reduces it by 1.9 percent, and private debt that's 10 percent of GDP higher reduces it by 1 percent.

Willing to be 'wrong' in the right way

Suppose, in the worst case, that hysteresis really is irreversible. It would mean that bad fiscal and monetary policies haven't just hurt the recovery today. They've prevented a full recovery tomorrow. The question then is why policymakers haven't been more aggressive. And the answer is that they think they have been.

Just look at inflation. Central banks have, in stops and starts, actually experimented quite a bit with unconventional policies. It's been enough to keep inflation from falling below zero, but not enough to keep it from consistently falling below target—which, we know from our regressions, damages potential more than anything else.

Still, some countries have managed to avoid, or at least start to climb out of, this "lowflationary" trap. Australia, for example, defines "price stability" more liberally than other countries—2 to 3 percent averaged over the business cycle—and that's helped it keep rates and inflation from falling too far to begin with. And then there's Japan: after decades of deflation, it's finally raised its inflation target, started printing money again, and promised to permanently double its monetary base.

All of these, though, are further than most central banks are willing to go. That's because their unconventional policies are still circumscribed by conventional concerns. Or, to paraphrase Keynes, it's better for their reputations to fail with the "right" unconventional policies than to succeed with the "wrong" ones.

The problem is we live in an upside-down economic time. Prudent policies are dangerous, because they could turn temporary losses into permanent ones. And dangerous policies are prudent, because they could keep this from happening—keep the economy's growth trajectory from getting knocked down.

It's a radical time. Policymakers need to be too.

Matt O'Brien is a reporter for Wonkblog covering economic affairs. He was previously a senior associate editor at The Atlantic.
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