Should-Read: Valerie Cerra and Sweta C. Saxena: The Economic Scars of Crises and Recessions

Should-Read: “Hysteresis” in response to 2007-2009 is, I have to admit, much less than I feared it would be six years ago. But it is also much much bigger than zero. The points about the calculation and measurement of potential output are especially important: Valerie Cerra and Sweta C. Saxena: The Economic Scars of Crises and Recessions: “According to the traditional business cycle view… our new study casts doubt on this traditional view and shows that all types of recessions…

…including those arising from external shocks and small domestic macroeconomic policy mistakes—lead to permanent losses in output and welfare…. Some researchers have explained the sluggish post-crisis growth as driven by demographic trends or other factors specific to the United States. But such explanation ignores the fact that output dynamics after the crisis followed a similar pattern seen in other countries…. Using updated data from 1974 to 2012, we confirm our earlier findings that the irreparable damage to output is not limited to financial and political crises. All types of recessions, on average, lead to permanent output losses. Contrary to conventional wisdom, we also show that countries do not typically have growth booms before crises and recessions….

What does this… mean for economic policy?… The concept and measurement of the output gap may need to be revisited…. Estimating potential output by smoothing the path of actual output creates false cycles and constant revisions in potential output estimates. For instance, there has been a constant downward revision in the estimated path of potential output for the United States and a closing of the output gap in recent years. But potential GDP estimates were revised down to actual GDP, not the other way around. Such revisions and closures of output gaps are partly just a result of measurement issues. When including years of lower output after the crisis, potential GDP (the measured trend) is mechanically reduced, with a corresponding dramatic change in our view of history. We now measure a very positive output gap (when actual output is above potential) for most advanced countries on the brink of the crisis in 2007, even though there were no signs of overheating at the time…