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Did the financial crisis make us permanently poorer?

(Photo by Doug Pensinger/Getty Images)

Five years later, the effects of the financial crisis are still with us. The question is whether they always will be.

It's called hysteresis, and it's a simple, if terrifying, idea: A deep recession can cause irreparable damage to the economy. That's because an anemic labor market can turn into a persistently smaller one. The long-term unemployed might become unemployable, and people who want full-time jobs could think things are so bad that they might not even look for work at all. Not only that, but too little investment today might make us less productive tomorrow. Add it all up — fewer and less efficient workers — and a weak recovery can beget weaker growth, forever.

There's already concern that the Great Recession and the not-so-great recovery have permanently made us poorer. As you can see below, the Organization for Economic Cooperation and Development's (OECD) latest outlook estimates that the crisis has already cost advanced economies an average of 3.25 percent of potential output.

Potential Output Quartiles2.jpg.jpg

But this is almost certainly too pessimistic. For one, the OECD assumes that, if not for the Great Recession, countries would have had the same labor force participation today that they did in 2007. So it interprets slower growth that's partly due to an aging population — like in the United States -- as entirely due to the crisis.

The OECD also argues that depression-level unemployment doesn't come from depressions, but rather from inflexible labor markets. You can see that in its country-by-country projections below: The OECD says Greece and Spain can't grow as much anymore because their 25 percent-plus unemployment is their new normal. 

In other words, the OECD thinks that all is for the worst -- that lower participation rates are mostly cyclical, not structural, and higher unemployment rates are mostly structural, not cyclical. But these are contradictory.

Potential Output Countries.jpg.jpg

This has profound consequences. If you think the economy can't grow as much as it used to, then you don't think it needs as much stimulus to get back to full strength. But that's only because you've defined full strength down to the point that the recovery we have is the best recovery we can get. It's a kind of policy fatalism — and it's unwarranted.

The problem, as economist Paul Krugman points out, is that this line of thinking mistakes a protracted slump for a near-permament fall in potential GDP. See, most models assume that the economy will quickly bounce back from any shock, no matter how big. But suppose there's a shock so big that even what seems like a lot of stimulus isn't enough to bring back growth? Then these models will confuse a depression for a fall in growth potential. In other words, they see a recovery that remains weak because of inadequate stimulus as a reason not to try any more stimulus.

But hysteresis is a reason to do more stimulus, not less. It could happen, but it probably hasn't yet. That's why, as the International Monetary Fund points out, policymakers should err on the side of doing too much rather than too little. The good news is that the Fed is still focused on the long-term unemployed and on part-time workers who want full-time jobs — on the people who could disappear from the labor market if we give up on them.

The crisis doesn't have to make us permanently poorer. But thinking can make it so.

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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