Jared Bernstein Thinks About Larry Ball on the Damage Done by Hysteresis: Monday Focus for July 7, 2014

Jared Bernstein: The Great Recession, Hysteresis, Tolstoy, and Unhappy Economies: “All happy macro-economies are alike…

…all unhappy macro-economies are unhappy in their own way. This post, based on… Larry Ball… present[s] a typology of those unhappy economies…. [F]irst… “hysteresis”… when a cyclical shortfall morphs into a structural one…. Key inputs like capital investment or the labor force fall in recession… [and] keep falling or fail to recovery much in the upturn… slow[s] the economy’s potential growth rate even when it’s fully back on its feet… a patient whose long illness has reduced their baseline health, even upon full recovery….

From the hysteresis perspective, the bounceback, or V-shaped recovery, is the most benign. It’s your grandfather’s recession…. By contrast, the last three recoveries have been more backward-leaning L’s than V’s… “jobless recoveries.” If you’re scratching your head asking how we can have a bona-fide recovery without much job growth, well… welcome to my world….

The recession led to large and persistent output gaps. Worse, in many counties, it also looks to have lowered the economy’s potential growth rate… not just that POST [recession trend] is below PRE [recession trend]… the slope of POST is below that of PRE…. The patient may be recovered, but she’s moving a lot slowly than before her illness….

Ireland[‘s]… growth rate of POST is far below PRE…. Greece… looks even worse…. Germany… unscathed…. Ball finds that over $4 trillion in potential output is lost… that’s an annual loss that just keeps on losing. Those are the economic magnitudes you should be thinking about when you hear certain economists complain about the policy mistakes we’ve made both in allowing bubbles to form and not aggressively mopping up the damage when they implode…. The longer we ignore hysteresis, the worse, as in more entrenched and thus harder to reverse, it becomes…

This is, I think–I hope–premature. We really do not know what the people who have dropped out of the labor force would do were we to return to an economy with a relatively high-pressure labor market. That forecasters believe that trend total factor productivity growth has slowed sharply’s starting in 2006 does not in fact make it so.

I do not see any changes in the fundamentals of technological progress and innovation that would suggest that the knowledge and organization components of long run economic growth has been significantly impaired in the years since 2006. I grant that the investment shortfall has had serious consequences. I grant that the decay of unemployed workers skills and social networks to find jobs has had serious consequences. But I am still optimistic that a great deal of the perceived slowdown in potential GDP growth since 2006 could be reversed where there could be a boom.

And I am certain that macroeconomic policy should not be made as if we know that potential GDP growth slowed markedly after 2006: we do not.

When inflation reaches 3% per year and not before is the time to conclude that we have re-attained potential output.