Great Recession may cost US economy $5,900 billions
by Gavyn Davies
October 23, 2011 4:11 pm
It has become commonplace for economists to attempt to “nowcast” the growth rate of real GDP from the dozens of sources of activity data which appear during the quarter.
Lately, most of these estimates have suggested that US real GDP has risen at a fairly healthy rate during Q3. For example, Dave Altig at the Atlanta Fed “nowcasts” that the growth rate may be as high as 3.2 per cent when the official estimate appears next Thursday.
This compares to an average growth rate of only 0.8 per cent in the first half of the year. Although much or all of the rebound has probably been due to temporary factors (notably the improvement in Japanese component supply after the earthquake damage in Q2), it will support the Fed’s expectation that growth will recover somewhat from now on.
However, we need to view this small improvement in the context of the much less satisfactory picture which emerges from a longer term perspective. The Wall Street Journal points out that the level of US GDP remains 6.7 per cent below the CBO’s estimate of potential GDP, which means that the economy could be producing $900 billion more per annum without risking higher core inflation rates. Furthermore, Dave Altig reckons that, at the current pace of job creation, the unemployment rate will remain in a 9-10 per cent range until at least 2017.
The truth is that the US economy seems, at best, to be stuck on a long term path which is very similar to the one which has been followed by previous economies which have suffered deep recessions, along with severely damaged financial sectors. Goldman Sachs recently published the following graph, which tells the story:
The peak-to-trough drop in US GDP relative to trend (ie the change in the output gap) was around 7 per cent in the recent recession, which is slightly larger than the average of 24 recessions associated with housing and financial busts in developed economies since 1970, but is slightly less than the five worst examples. The sluggish and bumpy recovery which the economy now appears to be experiencing is also broadly similar to these previous examples.
If the US is following these past templates, what can we expect to see happening next? One attempt to answer this question was given in a paper from economists at the University of Houston, presented last week at the Boston Fed conference on the long term effects of the Great Recession. This paper contains a statistical analysis of slumps in developed economies, and asks how long it typically takes for these slumps to end. (The end of a slump is defined as occurring when the underlying growth rate of the economy has returned to normal, and the level of output has returned to trend.) The Houston conclusion from previous comparable cases is that, on average, it takes about nine years for this type of slump to end. If that offers any guidance to the current US case, the future for real GDP (expressed in natural logs) might look something like this:
The good news contained in this graph is that the implied rate of real GDP growth is fairly high, at around 3.8 per cent per annum for the next 5 years. This simply follows from the fact that growth needs to be consistently higher than normal if GDP is to return to trend by 2016, given that the GDP trend is assumed to grow continuously at 2.3% per annum. Encouragingly, this is the path which other economies have managed to achieve in similar circumstances, even though they have been suffering from severely damaged financial sectors, and even though their household sectors have been consistently deleveraging throughout these periods.
So it can be done. And if this growth path is followed, the outcome for equity markets might be a lot better than many pessimists currently believe is possible.
But the graph also contains another message which is far more sobering. Even if the US follows the recovery path shown, GDP will remain far below potential for several more years, and the unemployment rate will remain considerably above the structural unemployment rate. Put simply, there will be a massive further wastage of economic resources. A rough calculation suggests that the cumulative loss of GDP from the Great Recession of 2007-16 will amount to $5,900 billion, of which about $2,200 billion is still to come in the next five years. (These figures are at 2010 prices.)
That implies that the total loss of output from the Great Recession will be equivalent to 41 per cent of the current annual level of GDP. Of this, 26 per cent is now water under the bridge, but another 15 per cent of annual GDP is likely to be lost before the recession is over. These are truly extraordinary losses, which make the GDP losses from virtually any other cause appear almost trivial by comparison.
Another way of doing the calculation is via the amount of excess unemployment relative to its normal or structural rate. This amounts to the equivalent of forcing 23 per cent of the labour force to take a whole year off work, which translates into 35 million wasted years of employment potential.
And remember that all this makes the relatively rosy assumption that the US economy can grow at 3.8 per cent per annum in the next five years, a rate which most forecasters think is far too high. If, instead, the current US episode proves to be more serious than the average of previous slumps – as in the case of Japan in the 1990s, for example – then the eventual costs in lost output and wasted employment could prove even higher.
Macro-economists used to say that there were only two macro questions really worth studying: what determines the long term trend growth rate of GDP, and what caused the huge deviation below trend in the depression of the 1930s? Everything else was comparatively inconsequential in terms of human welfare. But now we have a third great question: how do we bring the Great Recession to the soonest possible end? Nothing in economics matters anything like as much.
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Gavyn Davies is a macroeconomist who is now chairman of Fulcrum Asset Management and co-founder of Prisma Capital Partners. He was the head of the global economics department at Goldman Sachs from 1987-2001, and was chairman of the BBC from 2001-2004.
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