By David Papell and Ruxandra Prodan
The United States is well into the fourth year of what Carmen Reinhart and Ken Rogoff call the Second Great Contraction and Bob Hall calls the Great Slump, exceeded only by the Great Depression of the 1930s in its length and severity. While the Great Recession of December 2007-June 2009 ended over two years ago, the recovery has been characterized by very slow growth and persistently high unemployment. When will the Great Slump end?
We recently presented a paper, “The Statistical Behavior of GDP after Financial Crises and Severe Recessions,” at the Federal Reserve Bank of Boston Conference on the “Long-Term Effects of the Great Recession.” We ask two questions. Do severe recessions associated with financial crises cause permanent reductions in potential GDP, or does the economy return to its trend? If the economy eventually returns to its trend, does the return take longer than the return following recessions not associated with financial crises?
The paper develops a statistical methodology that is appropriate for identifying and analyzing slumps, episodes that combine a contraction and an expansion, and end when the economy returns to its trend growth rate. We consider (log) aggregate real GDP, so that the first-difference is the economy’s growth rate. Since long-term growth is generally positive, the data will be trending. We search for a pair of structural changes in real GDP. The first break is characterized by a negative change in the intercept and a change in the slope, while the second is characterized by a change in the slope. We estimate three types of models. The less restricted model constrains the slope following the second break to equal the slope preceding the first break, so that long-term growth is unchanged. The more restricted model also constrains the level of GDP following the second break to equal the level that would have been attained if the first break had not occurred, so that the slump does not affect potential GDP. In a few cases where neither type of model appears to be appropriate, we estimate an unrestricted model where long-term growth can change.
Real GDP for the U.S. fell by 5.3 percent from the peak of December 2007 to the trough of June 2009, and the Great Slump shows no sign of abating. In order to identify comparable historical experiences, we analyze the Great Depression of the 1930s for the U.S., severe and milder financial crises for advanced economics, severe financial crises for emerging markets, and postwar recessions for the U.S. and other advanced economies. Five slumps following financial crises are of sufficient magnitude and duration to qualify as comparable: the slumps lasting 7-1/4 years for Denmark (1989), 7-3/4 years for Australia (1990), 8-1/2 years for Finland (1990), 9-1/2 years for Sweden (1990), and 12 years for the U.S. (1929), with the first year of the slump in parentheses. Four of the five slumps, including the Great Depression for the U.S., did not affect potential GDP as the more restricted model cannot be rejected in favor of the less restricted model. The exception is Finland, where long-run growth was unaffected but potential GDP was permanently lower. Figures 1 and 2 depict the results for Sweden and Finland, where potential GDP is affected for the latter but not the former.
Figure 1: Sweden
Figure 2: Finland
The “lost decade” for Japan starting in 1992 is often used as an example of the severe effects of a major financial crisis. While Japan’s slump lasted for 10 ¾ years and it experienced severe effects following the crisis, they are not the same effects that the U.S. is experiencing during the Second Great Contraction. Real GDP fell from peak to trough by only 0.23 percent, an order of magnitude smaller than for the U.S. during the Great Recession. Moreover, long-term growth in Japan decreased after the crisis, as both the more restricted and the less restricted models are rejected in favor of the unrestricted model. It is the decline in long-term growth that caused the “lost decade,” not the aftermath of a severe recession caused by a financial crisis. Figure 3 depicts the results for Japan. While the downturn is barely visible, the long-term growth effects are clear.
Figure 3: Japan
The other historical episodes that we study do not provide comparable historical experiences. The magnitude of slumps following postwar recessions for the U.S. and other advanced countries is too small, and the duration is too short, to provide insight regarding the duration of the Great Slump. While the magnitude of slumps following severe financial crises in emerging economies is large, their duration is no longer than the duration of slumps following U.S. recessions.
We now become more speculative. If the path of real GDP for the U.S. following the Great Recession is typical of the historical experiences described above, the Great Slump will last 9 years but will not affect potential GDP. Assuming that the Great Slump started in 2007:4, it will not end until 2016:4.
Is this scenario plausible? We start with results presented by Menzie Chinn in his September 7, 2011, Econbrowser post. Figure 4 depicts (log) real GDP through 2011:2, potential GDP through 2012:4 from the Congressional Budget Office, and survey mean forecasts of real GDP through 2012:4 from the Wall Street Journal. If growth increases starting in 2013, it would require a 4.16 percent annual growth rate over the following 4 years for real GDP to equal potential GDP in 2016:4. This is also depicted in Figure 4. The postulated 4.16 percent annual growth rate is lower than the average annual growth rate in the last four years of the slumps for Denmark, Australia, Finland, Sweden, and the U.S., 4.40 percent, although higher than the average excluding the U.S. during the Great Depression, 3.77 percent. It is also consistent with recent CBO projections.
Figure 4: Implied GDP growth for the United States
History does not always repeat itself, and we do not know the ultimate shape and duration of the Second Great Contraction. The overarching message of Reinhart and Rogoff (2009), however, is that the “this time is different” syndrome leads people to mistakenly believe that the current financial crisis will be different from past financial crises. Taking comparable historical experience as a guide, the Great Recession will not ultimately affect potential GDP, but the Great Slump is not yet half over.
This post written by David Papell and Ruxandra Prodan