October 28, 2013
With the specter of Alan Greenspan again haunting the world, it’s a good time to tabulate the damage that he and his fellow central bankers inflicted. The International Monetary Fund (IMF) gives a simple way to construct a scorecard. The IMF routinely estimates potential GDP for most of its members. The estimates of potential are supposed to reflect the economy’s level of output if it was at full employment.
The IMF also makes projections of levels of GDP for the mid-term future, typically a five-year time-frame. These projections are in effect projections of potential GDP since they do not assume that countries will enter recessions in this five year period or alternatively, if they are currently in a recession that they will have recovered.
If we compare the IMF’s current estimates of potential GDP for 2013 with the projections for 2013 GDP made in the spring of 2008, before the collapse of housing bubbles had begun to push most economies into recession, we can get an idea of the enduring impact of the downturn. The former shows what the level of output the IMF thinks economies can sustain given the capital and labor they have now. The latter shows the levels of output the IMF expected these economies would be capable of sustaining in 2013, in the period just before the downturn.
The figure below shows the 2008 projections for 2013 GDP relative to the 2007 actual GDP compared to the most recent estimate of 2013 potential GDP compared to 2007 actual GDP.
In every case shown, the current estimate of potential GDP is below the 2008 projection. In most cases it is far below the 2008 projection. In some cases the new estimate of potential GDP for 2013 is below the actual GDP for 2007. This is the case for several of the euro crisis countries. For example, the IMF estimate of potential GDP in 2013 for Spain is 1.8 percent actual GDP in 2007. In Italy, the estimate of potential is 3.9 percent lower than 2007 GDP, and in Ireland it’s 5.0 percent lower. Not surprisingly Greece is hardest hit, with an estimate of potential GDP in 2013 that is 14.3 percent lower than its actual GDP in 2007.
Even the non-crisis countries don’t fare especially well in this story. The IMF’s latest estimates put the potential GDP of France and the Netherlands 3.2 percent higher than its 2007 actual. It puts the U.K.’s potential GDP for 2013 just 1.1 percent above its actual for 2007, implying growth of less than 0.2 percent annually.
There are three ways to view this set of comparisons. First it is possible that the both these countries were operating far above their levels of potential GDP in 2007 and the IMF’s economists failed to recognize this fact. (The latter assumption is necessary to explain projections that assumed continued growth from 2007 levels.)
This seems more than a bit far-fetched. It is certainly plausible that countries will operate some amount above potential GDP for short periods of time, but can it really make sense to claim that all the advanced economies were operating far above their potential for long periods of time? Furthermore, there is a serious credibility issue here for the IMF. If their economists failed to see such a massive divergence from potential GDP in 2008, is there any reason to take seriously their current assessments of economies? In other words, when did the IMF economists stop being wrong on the economy?
If we assume that the 2007 GDP numbers were not generally hugely above potential GDP then we have two possible explanations for the low estimates of potential GDP given in the most recent IMF data. The first is that the IMF is simply way off the mark. They derive estimates of potential from calculations on the rate of price change. If a country is way below its potential, the IMF’s model should show sharply falling prices. However if wages tend to be very sticky around zero (in other words, workers don’t take pay cuts), then this method can lead to a huge understatement of potential GDP, since wages and prices will not be falling even if the economy is far below its potential.
The third possibility is that these economies really have suffered enormous and lasting damage as result of a deep and prolonged downturn. This would take the form of workers losing skills and becoming far more difficult to reemploy after prolonged periods of unemployment. A period of weaker investment, as firms curtail plans due to the slowdown in growth, would also lead to less capital and less innovation. Both of these channels could explain lasting losses from the length and duration of the downturn.
These losses are large. If we take the case of the U.S., which has come out relatively well, the 2013 estimate of potential GDP is almost 5 percent below the projection from 2008. If we carry this out over the course of a decade and assume that GDP will be 5 percent lower on average as a result of the hangover from the downturn, we would be looking at a cumulative loss over the next decade of close to $8 trillion, or roughly $25,000 per person, or $100,000 for a family of four. That is real money.
