Saturday, 29 November 2014

Structural destruction

Researchers at the Federal Reserve recently produced a fascinating article in which they argued that severe recessions such as that in 2008-9 leave permanent economic scars.This set of charts shows the effect of the 2008-9 recession on real GDP trend growth for four economic areas - the US, the UK, the Euro area and Canada:

This reminds me of the four-image game on the UK's satirical current affairs show "Have I Got News For You". Spot the odd one out, and explain why.....and no, it isn't the one you think it is.

Actually each chart has a claim to be the odd one out, which just goes to show how the economic effects of the financial crisis varied by country. Or perhaps more accurately, how the response to the crisis by monetary and fiscal authorities varied. These charts show a significant drop in trend RGDP for all four economic areas: Canada, which had neither a property market crash nor a banking crisis, shows the smallest fall. Interestingly - and contrary to popular belief in the States - both the UK and the Euro area appear to have suffered a worse fall in trend RGDP directly attributable to the crisis than the USA did. 

But it is the behaviour of the red lines on these charts that really interests me, since they represent the actual path of RGDP post-crisis. As can be seen, Canada - which did not do QE but maintained fiscal spending (though it recommended austerity for everyone else) - has recovered better than the other three. But even though it didn't get such a kicking as the others, its RGDP is still below the previous trend. The Fed researchers show that even for mild recessions, output remains below previous trend seven years afterwards:

So despite Canada's milder recession, it is still suffering from a hangover. 

But Canada's headache is nothing like as bad as that suffered by the other three. The US, UK and Euro area have not only failed to recover previous trend growth, they have actually slowed down again since the crisis. The US's recovery slowed from 2011 onwards despite continual QE. It is hard to establish any cause for this other than misguided fiscal policy: the shenanigans over the fiscal cliff and the ridiculous sequester have taken their toll. It's an entirely self-inflicted wound and now, thankfully, over. As Matthew Klein puts it, the US has now at last stopped holding back its recovery

The UK's recovery stalled in 2010, prior to the Euro crisis. It is unclear exactly what the cause of this was: Simon Nixon at the WSJ suggested that it was due to misguided monetary tightening by the Bank of England, and I have argued that it was due to failure by both the fiscal and monetary authorities to offset an oil price shock. However, the fact that the UK elected an austerity-minded government in May 2010 whose first action was to raise VAT might also have something to do with it. When the economy is recovering from a severe demand shock, raising consumption taxes is just about the worst thing you can do. After all, if you need people to spend, taxing their spending is completely counterproductive. (Japan has just expensively discovered this.) Anyway, whatever the cause, the UK clearly experienced another shock which knocked it onto an even lower trend path for RGDP.

But the really shocking chart is that for the Euro area. The terrible consequences of the Euro crisis are all too clear. Like the UK, the Euro area suffered a second demand shock. But the response was very different. I criticise the UK government for inappropriate fiscal tightening, but at least it offset it with monetary easing, and latterly added fiscal easing too in the form of tax cuts and support for the housing market. It is these, in my view, that have generated the current recovery. In contrast, the response from EU fiscal and monetary authorities has been woefully inadequate. Such monetary easing as the ECB has done has failed to offset the severity of the demand shock, while procyclical fiscal tightening has actually amplified the shock. Euro area RGDP is on the floor and showing little sign of recovery. Adult unemployment is currently 11.5% across the whole Euro area, and much higher in some periphery countries: youth unemployment is double that of adults. Contrast this with the US, which has done far more to promote job creation than the Euro area despite unemployment only touching 10% at the height of the 2008-9 recession. If the US had unemployment at Euro area levels, it would be doing fiscal and monetary stimulus on an unprecedented scale. I am frankly astounded at the tolerance of the young people, in particular, whose futures are being systematically wrecked. They will bear the scars for life. Why they are not rioting in the streets is a mystery.

As yet, it is unclear what the new trend path for Euro area RGDP will be: the crisis is by no means over. But one thing is clear. The policies of Euro area fiscal and monetary authorities are doing serious damage to the economy. This is not "structural reform" - it is wholesale destruction of the productive capability of the economy. It's an unmitigated disaster. 

But the really worrying part of the Fed research is this chart:


This chart shows how growth expectations were gradually revised downwards over the years after the initial shock. This chart applies to the US, obviously, but the researchers found a pattern of downward revisions to growth estimates in 62 recessions from 1989 to 2009 in 23 advanced economies. Underestimating the severity of a shock appears to be an industrial bias among economists. Indeed, in my review of FOMC minutes earlier this year, I noted that FOMC members expected growth to return "any day now", even when indicators were negative, while expecting inflation to disappoint on the upside, even when indicators showed expectations were well-anchored. The combination of these two beliefs would lead monetary authorities to underestimate both the depth and length of demand shocks and therefore respond with inadequate monetary stimulus. 

This is bad enough. But these forecasts also affect the decisions of fiscal policy makers. And it is very clear, to me at any rate, that fiscal policy in the US, UK and Euro area was tightened too soon after the shock and by far too much. The driver for these decisions appears to be over-optimistic growth forecasts coupled with worries about high government deficits. There is also a pernicious belief that monetary easing offsets fiscal tightening even in the aftermath of a severe demand shock. It is now abundantly clear that it does not. Fiscal tightening is always contractionary, and particularly so after a demand shock. That is why the Euro area economy is in such a mess. It is being driven into the ground by inappropriate and in some cases frankly vicious fiscal policy. 

And the consequences are terrible. The OECD's latest forecast of the "non-inflation accelerating rate of unemployment" (NAIRU) for Greece was 17.275%: for Spain, it was 18.9%*. This means that the supply-side of the economy now cannot create enough jobs for the adult population without inflationary consequences. For Spain, nearly a fifth of the workforce must remain unemployed, apparently. If ever there were evidence of the damage done to the supply side of Euro area periphery economies by the combination of severe shocks and misguided policies, this is it. To add insult to injury, having failed to prevent or repair this damage, EU authorities now present the people of these countries with a choice: leave your home and migrate to a foreign land where you do not speak the language (and where you are becoming increasingly unwelcome), or be thrown on the scrap heap. 

The EU authorities continue to talk about the need to do something about unemployment, and in particular youth unemployment. Now and then they even come up with initiatives, usually involving spending very little money relative to the scale of the problem. But while fiscal harshness and lack of monetary support remain the order of the day, there can be no real improvement. 

Eventually, I suppose, the Euro area will recover, because economies always do. But by then an entire generation of Europeans will have been sacrificed to appease the gods of ordoliberalism and hard money. The Euro area depression will be officially the longest and deepest in recorded history. And the rest of the world will be stagnating due to the deflationary impact of the European disaster. 

The "Great Recession" is no longer an adequate name for the time we are living through. As Brad DeLong said, it should now be known as the Greater Depression.

Related reading;

* Earlier version of this post had OECD forecasts from November 2013. Now updated.


  1. "This set of charts shows the effect of the 2008-9 recession on real GDP trend growth for four economic areas - the US, the UK, the Euro area and Canada:"

    Are you assuming real AD is unlimited?

    1. No. I should perhaps have added a link to my latest post at Pieria, which discusses the global demand shortfall and the paucity of measures to address it. The 2008-9 crisis was a negative global demand shock which has had serious supply-side consequences in advanced economies. That's what the charts show.

    2. Let me try it this way.

      Can real AS go above real AD without there being a demand shortfall or a negative demand shock?

  2. An additional and important reason for poor EZ performance is that it is trying to deal with disparities in competitiveness as between Germany and the periphery by imposing deflation on the periphery. Thus the problem in the EZ is to a significant extent one that is inherent to common currencies. At least they’re trying to impose a common currency on countries which are very different in nature: e.g. Greece just isn't the same thing as Germany.

    1. Newcastle just isn't the same thing as London. Should the currency union they're in be dissolved?

  3. There's a methodological problem with these dotted line "trend growth" estimate. In boom periods the trend includes an ever increasing contribution from negative net value activities that get booked to GDP but are not sustainable. One of the function of recessions is to clean out those (and arguably some other things, it's not perfect). So is the assumption that trend growth is this dotted line valid?

    Why are the unemployed youth not rioting? Maybe they're too busy working? Official numbers show the number who get unemployment benefit. This is not the same as people who don't work. Southern Europe has a thriving informal sector, which, while obviously not perfect (lots of badly paid precarious jobs, inefficiencies of scale, low unionisation) does make the situation not as bad as the same numbers would be in Northern Europe.

    Moreover some of the "rioting" went through the ballot box in voting as seen in the performance of UKIP sister parties and other fringes. Arguably burning a few cars may have been a better idea.

    There's also the student issue: some commentators have suggested (some of) the Spanish youth responds to such crisis by studying longer thus making the unemployed look bigger (as the total active population in that age class is smaller than it would otherwise be). One could wonder if the UK has not seen the reverse effect: highly employable youth joining the jobs market earlier due to being explicitly charged for higher education thus making the structurally unemployed look smaller. Longer term effects of more education in Spain and less in the UK (if the hypothesis is correct) may not be so nice. BTW Frances, it may make a good subject to cover: has the UK university funding revolution caused fewer (indigenous) people to study, or study less? I don't know what the answer is, though basic theory says when the cost of something is high OR more explicit, demand goes down.

    I'd be curious to know how the OECD is coming up with those estimates NAIRU (a notoriously unobservable number). If someone wants to take the other side of a derivative that pays off (to me) if the OECD is wrong -- hitting those numbers doesn't cause material inflation -- I'd be interested.

  4. You mention both monetary and fiscal policy. They certainly work together.

    I have been working on a monetary model that I call the Fiat Decay Model. I think it provides an improved visibility of fiscal action. A graph comparing transactions calculated by the Fiat Decay Model and standard velocity of money can be found at

    Please scroll down past the math [that explains how the exponent (the number of transactions) is found] and look at the graph. The graph shows periods of above average numbers of transactions (and velocity) which seem to me to coincide with better economic activity. The graph also clearly shows that both annual transactions and velocity of money have been falling for a long time. I believe the above average transactions are the result of above average private activity influenced by fiscal polity.

    The FD Model shows the effects of fiscal policy by emphasizing transactions of money as money passes through a tax exposure.

  5. London is always bashing the EU. In my opinion, what they're really saying is, don't burst our debt bubble. If the EU goes forward with GOMO, London will be a shit heap!