The Recovery from the Global Financial Crisis of 2008: Missing in Action
The speed of the recovery from the 2008 global financial crisis has been unusually slow. The slow recovery is a symptom of the permanent decline in GDP following a financial crisis, since the economy never fully rebounds from the initial recession. We estimate long term output losses from the crisis ranging from almost none in Germany to almost 20% in Italy and Spain. This article highlights several factors behind the slow recovery and the large long term effects of the crisis:
- The financial crisis made the economy more vulnerable to other negative shocks.
- Trend growth may have been slowing down before the crisis.
- Financial crises lead to big drops in labour productivity that take a long time to reverse.
Figure 1: GDP Per Working Age Person in Advanced Economies since 2007
Source: Euromonitor Macro Model and International Statistics
Note: 2007 level normalised to 1 for all countries. Forecast starts in 2014.
Where is the recovery?
Economic growth has been disappointing in comparison to past recoveries. We estimate how much advanced economies have underperformed relative to trend since the start of the financial crisis in 2008 and suggest several factors behind the slow recovery. We will focus on comparing the US, Japan and the 5 largest EU economies.
One significant factor in the growth slowdown of recent years has been faster population aging. The decline in the growth rate of the working age population (ages 15-64) on its own can account for a decline in the annual GDP growth rate of advanced economies of 0.7 percentage points. To focus on the effects of the financial crisis we adjust for slower potential labour force growth by looking at GDP growth per working age person, using UN demographic projections. The remaining key issue is how to compute the trend. As a benchmark we use the historic average growth rate of GDP per working age person for advanced economies of 1.7%, as estimated in a recent ECB working paper (Nuno et al, 2012). The implicit assumption is that over very long periods of time developed economies should have similar growth rates, after adjusting for demographics and absent major shocks such as financial crises. The deviation from trend is defined as the difference between the actual increase in GDP per working age person and the increase assuming a constant growth rate of 1.7% after 2007, relative to the increase assuming a constant growth rate. Our focus is on a horizon of up to ten years after the start of the global financial crisis in 2008.
Figure 2: Deviation from Trend of GDP Per Working Age Person since 2007
Source: Euromonitor Macro Model and International Statistics
Note: The deviation from trend is reported as a percentage of GDP per working age person trend. Trend growth rate is 1.7%. Forecast starts in 2014.
The figures above confirm the common perception that Germany and Japan have been hurt less severely by the financial crisis. Both of these countries are expected to almost fully recover the output losses relative to trend by 2018. In contrast economic activity in Italy and Spain is forecast to be almost 20% below trend, making their post 2007 performance comparable to an economic depression. The outcomes in France, the US and the UK are somewhere in the middle. Our estimates suggest that by 2013 the US economy barely recovered from the peak output loss of 8.3%, though we expect it to eliminate 42% of the output losses by 2018. The UK has turned a corner and started to bounce back in 2014. Nevertheless it still has a long way to go, with an output loss relative to trend of 13% in 2013.
As a cross check we compare our estimates to those based on OECD forecasts of potential output. A recent study by Lawrence Ball from the University of Maryland (Ball, 2014) extrapolates OECD estimates of potential output from 2007 using the average growth rate over 2000-2009 to measure trend output growth. Most of his estimates are surprisingly similar to ours despite the different methodology. There is some latitude in the exact definition of trend or expected growth, so that the growth gap relative to trend is subject to significant measurement error. But the finding of large and persistent output losses more than 5 years after the start of the financial crisis seems robust.
Table 1: Deviations in GDP Per Working Age Population after 2007 from Trend in Advanced Economies
Source: Euromonitor Macro Model and International Statistics
Note: Based on 1.7% historical long-term growth in GDP per working age person. 2018 is forecast.
Why is the recovery so slow?
One immediate answer is that financial crises in general usually cause large permanent damage to economic activity levels. In a classic empirical study, Cerra and Saxena (2008) look at the effects of financial crises over a 10 year horizon using a panel of 190 countries from 1960 to 2001. The peak estimated output loss from a financial crisis in their sample is almost 8%, with output losses of around 7% at a 10 year horizon. Cerra and Saxena‘s results have been criticised for some of their statistical assumptions, in particular not taking into account differences in the length of crises across countries. More robust methods still find a significant long run impact of financial crises, with 10 year output losses ranging from 5 to 10% (Mueller, 2012). Why do financial crises lead to slow recoveries? A general answer to this question goes way beyond the scope of this article. Instead, we will analyse some of the key factors behind the slow recoveries after the 2008 crisis.
The financial crisis made the economy more vulnerable to other negative shocks
For example, the costs of bailing out banks and the decline in tax revenues due to lower economic activity or fiscal stimulus attempts worsen government finances. In the case of Southern European countries, such as Italy and Spain, the initial crisis led to growing concerns about the sustainability of public finances. The result was a sovereign debt crisis on top of the original recession. The increase in sovereign debt risk premia then fed back into further increases in private sector costs of financing and more economic uncertainty. Fiscal cutbacks attempting to stabilise sovereign debt risk premia caused even bigger contractions in economic activity in the short run. The compound effect of two financial crises with a few years delay has contributed to output losses in Southern Europe of a magnitude matching the great depression of the 1930‘s.
Trend growth may have been slowing down before the crisis
This expalantion is particularly relevant for the Eurozone, where productivity growth slowed down significantly starting in 1995. According to European Comission estimates productivity growth in the Eurozone had already dropped below 1% in the early 2000‘s. But even if we assumed a trend growth of 1% instead of 1.7% in the Eurozone our estimate of the peak output loss since 2007 is still 14.2% in Spain (compared to an initial estimate of 18.7%) and 14.8% in Italy (compared to the initial estimate of 20%). Pre-crisis declines in potential growth rates matter, but they cannot explain most of the deviation of output from trend after 2007.
The crisis led to large and persistent declines in the capital stock and total factor productivity relative to trend
Investment plunged in 2009, with only a very partial recovery. In 2013, the investment to GDP ratio was still almost 3-4 percentage points below its pre-crisis level in the US, France, Germany and the UK. In Italy the investment to GDP ratio is still 5 percentage points below its 2007 level, while in Spain it has declined by almost 13 percentage points. The Spanish case is extreme and mostly represents lower residential investment. But there is little doubt that business investment has also suffered tremendously. The cumulation of many years of low investment is a lower capital stock available for workers in the economy, making them less productive. Reversing the loss of capital would require several years of an investment boom, but such a boom is highly unlikely according to current forecasts.
Figure 3: Investment to GDP Ratios
Source: IMF World Economic Outlook, April 2014
Note: Forecast starts in 2014
Even if the capital stock recovers, labour productivity can stay depressed if the financial crisis reduces the overall efficiency with which the economy uses both capital and workers- that is if the crisis lowers the Total Factor Productivity (TFP) of the economy below trend.
Using European Comission estimates (McMorrow and Roger, 2013, lower labour productivity accounted for 57% of the decline in potential output growth over 2008-2013 relative to average growth in 1998-2007, with a roughly equal decomposition between lower capital accumulation and lower TFP. A Stanford University study (Hall, 2014) provides a detailed decomposition of the slow recovery in the US. He finds that below trend labour productivity growth is responsible for 62% of the output losses in the US in 2007-2013. Of this proportion, the decline in capital is responsible for 33% of the output loss while below trend TFP growth accounts for 29% of the output loss.
There are several factors underlying the decline in capital and TFP:
- First, the crisis seems to have led to a long-term reduction in the supply of credit in developed economies, due to a combination of stricter financial regulation and an increase in the risk aversion of financial institutions. While interest rates have declined, this compensates only partially for the tightening in collateral requirements and other lending standards. Looking at the Federal Reserve‘s bank lending conditions survey, credit standards have tightened during the initial phase of the crisis, and have yet to recover to pre crisis levels. In the Eurozone, the ECB‘s bank lending conditions survey indicates that credit standards on business loans tightened each quarter since mid-2007, and have only started easing in the second quarter of 2014. Again, there is a large dispersion in performance across different Eurozone members, with Italian and Spanish firms much more financially constrained than German firms. Continued restrictions on access to external financing discourage capital investment, research and development and other productivity enhancing expenditures. Therefore, labour productivity is likely to underperform as long as the credit crunch continues.
Figure 4: Net Percentage of Domestic Banks Tightening Standards on Commercial and Industrial Loans in the US
Source: Federal Reserve Economic Data
- Recent research suggests that even if lending standards recovered completely, negative effects on capital investment and TFP would continue for many years through several channels. For example, reductions in research and development spending and new business entry during the financial crisis reduce the growth rate of innovation over several years, cumulating into permanent declines in the efficiency of the economy. In the US for example, the number of business startups (firms less than one year old) declined by more than 25% in 2007-2010, leading to a “missing generation“ of new firms (Siemer, 2014). A recent Federal reserve study (Queralto, 2014) tries to quantify the effect of lower innovation due to a financial crisis in a macroeconomic model with bank capital constraints and new business entry. The study finds that for plausible model parameter values, even if the initial financial shock dissipates after a few years the reduction in business entry and innovation can generate permanent declines in labour productivity exceeding 6%, leading to permanent declines in GDP of more than 10%.
- Financial shocks cause long lasting distortions in the allocation of capital, a key source of loan collateral, across firms. The misallocation of capital across firms hurts in particular small and medium entreprises with high return investment opportunities and high dependence on external financing, constraining their ability to get loans and to expand. This again leads to persistent declines in investment and productivity. In a model calibrated to the US great recession, Khan and Thomas (2013) find that this effect can significantly slow down the recovery.
The crisis has had a persistent negative effect on employment rates
In the US the employment to population ratio has gone down from 63.3% in the beginning of 2007 to 59% in July 2014. The European experience varies significantly across countries. The employment rate of the 20-64 population in 2013 was less than 0.5 percentage points below that in 2007 in France and the UK. The German employment rate actually increased in the same period by more than 4 percentage points. But in Italy, there was a similar decline in the employment rate as in the US, and in Spain the employment rate declined by more than 10 percentage points over 2007-2013. Usually, employment can respond more quickly to economic conditions than capital or TFP, so a faster recovery is more likely. But there are several factors that could slow down this process or even lead to a long-term decline in employment:
- Part of the reduction in employment rates is due to accelerating population aging. 55-64 year olds are less likely to participate in labour markets, though recent years have seen significant increases in labour force participation rates of this age group.
- Lower labour productivity reduces the profitability of hiring. As a result, demand for labour declines. The decline in labour productivity below trend is likely to be quasi-permanent, due to the factors discussed above. As a result, this mechanism should depress employment for many years after the crisis.
- The recession has created a large number of long term unemployed (without a job for more than half a year). Job finding rates for these long term unemployed are typically lower for reasons ranging from stigma (spending a longer time in unemployment sends a bad signal that the job seeker may be a lower quality employee) to faster depreciation of job skills. The good news in the US is that since 2010 the number of long term unemployed has dropped by more than 50%, though much of this decline is due to lower labour force participation.
Economic growth coming out of the 2008 financial crisis has been disappointing in comparison to recoveries from previous recessions. Even if we are likely to return to more normal growth rates after 2015, this hides the weakness of rebound effects and the long term damage done to the level of economic activity by the crisis.
Laurence Ball, Long Term Damage from the Great Recession in OECD Countries, working paper, 2014, http://www.econ2.jhu.edu/People/Ball/long%20term%20damage.pdf
Valerie Cerra and Sweta Chaman Saxena, Growth Dynamics: The Myth of Economic Recovery, American Economic Review, 2008`
Robert Hall, Quantifying the Lasting Harm to the US Economy from the Financial Crisis, working paper, 2014, http://web.stanford.edu/~rehall/MA140405.pdf
Aubik Khan and Julia K. Thomas, Credit Shocks and Aggregate Fluctuations in an Economy with Production Heterogeneity, Journal of Political Economy, 2013, http://www.juliathomas.net/KhanThomasDCTsept2013.pdf
Hannes Mueller, Growth Dynamics: The Myth of Economic Recovery – Comment, working paper, 2012, http://www.politik-salon.de/files/Comment04012012.pdf
Kieran McMorrow and Werner Roeger, The Euro Area‘s Growth Prospects over the Coming Decade, Quarterly Report on the Euro Area, 2013, http://ec.europa.eu/economy_finance/publications/qr_euro_area/2013/pdf/qrea4_section_1_en.pdf
Galo Nuno, Cristina Pulido and Ruben Segura-Cayuela, Long Run Growth and Demographic Prospects in Advanced Economies, working paper, 2012, http://www.bde.es/f/webbde/SES/Secciones/Publicaciones/PublicacionesSeriadas/DocumentosOcasionales/12/Fich/do1206e.pdf
Albert Queralto, A Model of Slow Recoveries from Financial Crises, working paper, 2013, http://www.federalreserve.gov/pubs/ifdp/2013/1097/ifdp1097.pdf
Michael Siemer, Firm Entry and Employment Dynamics in the Great Recession, working paper, 2014, http://www.federalreserve.gov/pubs/feds/2014/201456/201456pap.pdf