Forecast errors compared

And a coda defends experts against Aditya Chakrabortty

A recent conversation got me thinking about different types of macroeconomic forecast error, and what implications they might have for macroeconomics. I’ll take three, from a UK perspective although the implications go well beyond. The errors are the financial crisis, the lack of a downturn immediately after Brexit, and flat UK productivity.

The immediate cause of the Global Financial Crisis (GFC) was the US housing market crash, but that alone should have caused some kind of downturn in the US, with limited implications for the rest of the world. What caused the GFC was the lack of resilience of banks around the world to a shock of this kind.

Were there any indications of this lack of resilience? Here is an OECD series for banking sector leverage in the UK: the ratio of bank assets to capital. The higher the number, the more fragile banks are becoming.

UK Banking sector leverage: Source OECD

The first and perhaps most important problem with forecasting the financial crisis was that macro forecasters were not looking at data like this. For most it was not on their radar, because banks, let alone bank leverage, played no role in their models. It was a sin of omission, a big gap in our macro understanding. (Whether, if forecasters had been having to forecast this data, they would have predicted a crisis is improbable, but some would have at least noted it as an issue.)

Moving on to the second mistake, it is often said (correctly) that forecasters are very bad at predicting turning points or dramatic changes. But many did predict such a change immediately following the Brexit vote: a sharp and immediate slowdown in demand caused by the uncertainty of Brexit. It didn’t happen. The main reason was consumption, which held up by more than people were expecting, given the fall in real incomes that was likely to come from the Brexit depreciation. There are two and a half obvious explanations for this. First, because of Leave propaganda half the population thought Brexit would make them at least no worse off. Second, those who did anticipate the rise in import prices may have taken the opportunity to buy consumer durables made overseas to beat the prospective price increase. The half is that the Bank cut interest rates a bit.

None of these effects are very new. They may not have been incorporated into the forecasters’ models, but they could in principle have been incorporated using the forecaster’s judgement, although getting the quantification right would have been very difficult. In the end we got the slowdown, but delayed until the first half of this year, as Leavers began to face reality and the higher import prices came through, so it was an error of timing more than anything else (although it was apparently enough to make MP Liz Truss change her mind and support Brexit!). You could describe it as an unchallenging error, because it could easily be explained using existing ideas. It is the kind of error that forecasters make all the time, and which makes forecasting so inaccurate.

The third error was UK productivity, which I talked about at length here. Until the GFC, macro forecasters in the UK had not had to think about technical progress and how it became embodied in improvements in labour productivity, because the trend seemed remarkably stable. So when UK productivity growth appeared to come to a halt after the GFC, forecasters were largely in the dark. What many like the OBR did, which is to assume that previous trend growth would quickly resume, was not the extreme that some people suggest. It was instead a compromise between continuing no growth and reverting to the previous trend line, the second being what had happened in previous recessions.

My point of writing about this again is that I think this third error is much more like the GFC mistake than the post-Brexit vote mistake. In both cases something important that forecasters were used to taking for granted started behaving in a way that had not happened since WWII. Standard models were used to treating technical progress as an unpredictable random process. Now it is just possible that this is still the case, and the absence of technical progress in the UK and to a lesser extent elsewhere is just one of those things that will never be explained. But for the UK at least the coincidence with the GFC, austerity and now Brexit seems too great. As as I showed in the earlier post growth has not been exactly zero but has oscillated in a way that could be related to macro events.

If there is some connection, both in the UK and elsewhere, between the decline in economic productivity growth and macroeconomic developments, then this suggests an important missing element in macromodels. And like the financial sector, there is an existing body of research that economists can draw on, which is endogenous growth theory. There are examples of that happening already.

But I want to end with a plea. After the financial crisis too many people who should have know better said that failing to predict the financial crisis meant that all existing mainstream macroeconomics was flawed. It was rubbish, but such attitudes did not help when some of us were arguing against austerity on the basis of standard macroeconomic ideas and evidence. Now with UK productivity, we have Aditya Chakrabortty saying that experts at the OBR “are guilty of a similar un-realism and they have proven just as impervious to criticism” as people like Boris Johnson or Liam Fox. Not content with this nonsense, he says “This age of impossibilism is partly their creation”.

This is just wrong. Look at the elements of neoliberal overreach. Economists didn’t start calling for tight immigration controls and using immigrants as a scapegoat for almost everything. Most academic economists did not call for austerity. Almost all economists did not want to get rid of our trade agreements with the EU. Even if economists had warned about the financial crisis they would have been ignored because of the political power of finance. If all economists had thought productivity would continue flat we would have just had more austerity. [1] And in making this basic mistake, it is ironically Aditya Chakrabortty who has joined Michael Gove and other Brexiteers in having had enough of experts.

[1] Less expected productivity growth means lower future output which means lower future tax receipts which means, given the government’s austerity policy, more cuts in public spending.

The OBR, productivity and policy failures

Chris Giles had an article in the FT yesterday about the UK’s continuing dreadful productivity performance, and the implications this might have for forecasts of the public finances. It has the following chart comparing successive OBR forecasts and actual data.

I want to make two points about this. The first is about the OBR’s forecast. [1] It is easy to say looking at this chart that the OBR has for a long time been foolishly optimistic about UK productivity growth. Too often growth was expected to return to its long run trend shortly after the forecast was published but it failed to do so. Expect lots of articles about how hopeless macro forecasts are in general, or perhaps how hopeless OBR forecasts are in particular. It was obvious, these articles might say, that trend productivity growth in the UK has taken a permanent hit following the financial crisis.

Anyone saying this is ignoring the history of the UK economy for the 50 years before the GFC. After each downturn or recession, labour productivity growth has initially fallen, but it has within a few years recovered to return to its underlying trend of around 2.25% per annum. This means not just returning to growth of 2.25%, but initially exceeding it as productivity caught up with the ground lost in the recession. In a boom sometimes growth exceeded this trend line, but it soon fell back towards it.

This made sense. Productivity growth reflects technical progress and innovation, and they tend to continue despite recessions. A firm may not be able to implement innovations during a recession, but once the recession is over experience suggests they make up for lost ground in terms of putting innovations into practice.

Given this experience, OBR forecasts have always been pretty pessimistic. They have assumed a return to trend growth, but no catch up to make up for lost ground. If they had also forecast, in 2014 say, that given recent experience they expected productivity growth to be almost flat for the next five years that would have been regarded as extreme at the time. Why would UK firms continue to ignore productivity enhancing innovations when the macroeconomic outlook looked reasonable?

And of course in 2014 UK productivity growth was positive. This brings me to my second point, which follows from this quote from the FT article:

“In the Budget, both the OBR and Mr Hammond are likely to stress that the downgraded forecasts do not reflect a new assessment of the damage to the UK economy from Brexit, but a reassessment of likely productivity growth after so many recent disappointments.”

Chris may be right that they will say this, but is it remotely plausible? As my recent post tried to suggest, UK productivity growth can be seen as suffering from three large shocks: the recession following the GFC, the absence of a normal recovery as a result of austerity, and then Brexit. The first two of those shocks led to a period of intense uncertainty, causing UK firms to put on hold any plans to innovate. Just as they thought things had returned to a subdued version of normal they were hit by the third, Brexit. During periods of intense uncertainty, productivity stalls or may even decline a little, as firms meet any increase in demand by increasing employment but not investing in new techniques. [2]

This story involving uncertainty seems to fit the data. Once the recovery (of sorts) finally began in 2013, productivity growth picked up. That sustained growth came to a halt when the Conservatives won the 2015 election, and the possibility of Brexit began to be an important factor for firms. [3]

These two points are related in the following way. The experience of the 50 years before the GFC suggested that you could hit the economy with pretty large hammers, but it would eventually bounce back. However that may have been contingent on a belief by firms that if policymakers were wielding the hammer (using high interest rates for example) they would take it away fairly soon, and replace it by stimulus. That belief was shattered in the UK by the GFC and austerity, where policymakers decided to keep using the hammer. What little confidence remained was destroyed by Brexit.

Discoveries are still be being made in universities around the world, and we know innovations are still being implemented by leading UK firms. It seems completely far fetched to imagine the GFC is still having some mysterious impact on the remainder of UK firms such that they refuse to adopt these innovations. A much more plausible story is that we are seeing what happens when most firms lose confidence in the ability of policymakers to manage the economy.

[1] I am on the OBR’s advisory panel, but as our job when we meet once a year is to be critical of OBR assumptions, and as we have no role in producing their forecasts, I think what I say here can be completely objective.

[2] Productivity can initially fall because new employees are not as productive as those who have been working in the firms for some time, for example.
Postscript (7/10/17) For evidence on the impact of Brexit on productivity, see work by Bloom and Mizen here.

[3] An alternative story is that the UK has settled into a new slow growth ‘equilibrium’, where the majority of firms are so pessimistic they hardly innovate at all.      

Productivity and monetary policy

The Bank are warning of imminent rises in interest rates. As Chris Giles points out, we have been here before, and before that, but that shouldn’t mean we should dismiss this talk, because one day it will happen. [1] They (the MPC) certainly sound serious. But why when current growth is so slow are they even contemplating it? Here is a clue from Mark Carney’s latest speech (my italics).

“On the supply side, the process of leaving the EU is beginning to be felt. Brexit-related uncertainties are causing some companies to delay decisions about building capacity and entering new markets. Prolonged low investment will restrain growth in the capital stock and increases in productivity. Indeed, if the MPC’s current forecast comes to pass, the level of investment in 2020 is expected to be 20% below the level which the MPC had projected just before the referendum. Net migration has also fallen by 25% since the Referendum.

As a result of these factors and the general weakness in UK productivity growth since the global financial crisis, the supply capacity of the UK economy is likely to expand at only modest rates in coming years.”

When people, like me, say how can the Bank be thinking of raising rates when demand is so weak, the response from the Bank would be that supply has been at least as weak.

This pessimism about the supply side comes straight from the data. If I hear people talking about the UK being a ‘strong economy’, I know they either have not seen this chart or are just lying.

UK Output per hour, whole economy (ONS)

The red line is a trend that pretty well matches the trend in the data until the end of 2007, with the amount you can produce with an hours worth of labour increasing by 2.2% a year. Since the global financial crisis (GFC) there has been almost no growth at all. If you want to know the main reason real wages have stopped increasing, this is it. [2]

I hear some people say this is just oil and financial services. It is not, as this table from a recent Andy Haldane speech shows.

Start at the bottom: total average growth has been non-existent since the crisis. The rest of the table looks at the contribution of each sector to that total. To see what productivity growth would be excluding financial services, just add that figure to the total: 1.8% 1998-2008, 0.4% 2009-2016. That table makes it clear that the productivity crisis is economy wide.

It is worth looking at aggregate productivity since the GFC period in more detail (same data). I often hear people say the productivity slowdown started before the GFC. From the chart below, it clearly did not. (We have just seen the tenth anniversary of Northern Rock going bust, and the UK productivity slowdown started shortly after that event.)

We could describe this data as five phases. 1) Productivity in the recession fell, as it often does in a recession for various reasons. 2) As the economy begins to grow again, so did productivity growth. 3) As it becomes clear, in 2011, that the ‘recovery’ is going to be very weak because of austerity, productivity growth stops growing. 4) By the end of 2013, with stronger growth under way (although still no catch up to previous trends, so not a true recovery) productivity starts growing again, although rather slowly. 5) Since the 2015 election, with the prospect and then the reality of Brexit, even that modest growth disappears. (My data does not include 2017Q2, which saw a very slight fall.) I could shorten the description as follows: recession, modest optimism, pessimism, even more modest optimism, uncertainty.

That is my gloss on the numbers, but I’ve done it to make a point. Productivity growth invariably requires an investment of some kind. It may not be physical investment, but just training someone up to be able to use some new software. Whether a firm incurs that cost will depend, in part, on their expectations about the future. There is a regrettable tendency in macro (I blame RBC theory) to treat productivity growth as manna from heaven. But the idea that potential improvements in technology stopped after the GFC, and just in the UK, is simply ridiculous. The problem is that firms are not investing in new technology. What I call the ‘innovations gap’ has emerged in the UK because of weak growth and the consequent pessimistic expectations of most firms. [3]

The idea that the economy could get itself in a low growth expectations trap is increasingly being put forward by economists: here is George Evans, for example. The UK has got itself into that trap because on the two occasions that a recovery of sorts appeared to be under way, the economy has been hit with terrible policy errors (austerity and Brexit). But the idea that UK firms are incapable of upgrading their production techniques is nonsense. They will do so initially if they can be confident that the demand for their products will increase, or subsequently when the innovation pays for itself even though demand is flat.

Which is why an increase in interest rates right now would be very bad news. It would confirm the pessimistic expectations of most firms that demand is not going to grow fast enough to make innovation worthwhile. Formally, the job of the MPC is not to worry about productivity but to control inflation. But elsewhere, where the same process may be happening to a lesser extent (the productivity slowdown is worldwide, just most acute in the UK), central banks are puzzled at why inflation just refuses to rise. 

The concept of an innovations gap is one solution to that puzzle. Expanding demand allows firms to invest in more productive techniques, and so there is less incentive to choke of demand by raising prices. I suspect in an alternative world where Brexit had not happened the Bank of England would also be puzzling over why prices were not rising. As a result, if the MPC do finally raise interest rates this year, it would be one more mistake to add to the growing list under the heading Brexit.

[1] On each occasion I also wrote a post saying that they should not raise rates, starting I think at the beginning of 2014.

[2] I discussed in earlier posts why real wages are falling by even more than output per head.

[3] Or perhaps the pessimism of the bank manager lending money to those firms. The Haldane speech shows that productivity growth has remained strong among the top, frontier companies. Why? Because these companies, given their position, will be seeing growth relative to the average, and have got to the frontier through a culture of innovation.

Cherry picking economic statistics and Project Fear

It is often said that the left-right description of politics is not a straight line but a circle, with left and right becoming more similar as they get more extreme. It is mostly nonsense, but one thing that can make it appear so is ideology. If you start to let your view of the world be dominated too much by a particular ideology or conviction (whether of the left or right), you tend to exhibit the same characteristic denial of both reality and the wisdom of expertise.

One of the symptoms of this denial is the cherry picking of statistics. The example that quickly comes to mind is output, employment and productivity. Since the GFC, UK output growth has been insipid but employment growth has been strong. The counterargument to the claim that the UK’s recovery from recession was the weakest for more than a century has been to applaud employment growth. But of course the combination of weak output growth and strong employment growth is awful labour productivity growth, which is a major factor behind slow wage growth. Those that applaud strong employment growth as a counter to [1] weak output growth are in effect saying what a great thing the productivity standstill is. (I made fun of this in one of my better posts.)

One of the little homilies I used to trot out when I taught first year undergraduates was that economics is not about making lists. In any economic situation you can make a list of what is good and bad about the economy, and then make some kind of judgement based on comparing the lists. For example you might observe that output is strong, unemployment is low but inflation is rising, and judge that the first two outweigh the third. But to do this avoids any understanding of what is going on. Once you try to relate the data to some kind of framework or model (e.g. of the business cycle) you realise you are describing a boom which needs to be moderated.

We have seen this in spades with Brexit. When the economy initially appeared unaffected by the Brexit vote, those promoting Leave said this was the ultimate proof of Project Fear. They did not bother to look at the composition of growth: consumption led, supported by falling savings and higher debt. This was not sustainable, and sure enough growth in output per head in the first half of 2017 has been minuscule. Consumers, by borrowing, had simply delayed the short term Brexit slowdown. But I have been told that this means nothing: growth has been low in the odd quarter since the recession, so this is just two of those quarters together and to suggest otherwise is Project Fear.

I’ve been told exports are booming, unemployment is still falling (and low by EU standards), falls in real wages are nothing new and much else. Yet ask almost any economist what they think is currently going on, and they will tell you it is a downturn caused by a decline in incomes (and flat investment) following the Brexit depreciation that has - as yet - not been offset by strong growth in net exports. I looked at why Brexit could be the reason for the absence of a net trade boost here. I may not be right, in so far as any commentary of this kind based on limited data as things are happening could prove wrong. This of course gives ample scope to those who want to see a particular result to poke holes and stress uncertainties.

In the grand scheme of things, the short term effect of the Brexit vote are minor compared to the potential long term impact of Brexit, and of course a great deal depends on the form of Brexit when it happens. The short term matters because of what it shows. Those who promoted Brexit used the Project Fear label to discount economic expertise: the overwhelming view of academic economists that Brexit would reduce long term GDP, and cause a short term slowdown before it was implemented. They did this not because they came to a different view based on the economic evidence, but because they wanted to believe Brexit would be painless (or, more cynically, because the pain would be felt by others). Brexit is a classic example of an ideology driven project that discounted evidence.

Going on to deny that Brexit has caused an economic slowdown is simply the next step in denial: denial of past evidence extends to denial of current evidence. It is just like Trump and climate change (or Trump and much else), which is why I and others have related Brexit and Trump. But the reality of Brexit is now being felt by the UK negotiators. Back in March I said that the obvious outcome for the immediate negotiations was to stay in the Single Market and Customs Union for a transition period, but the UK team would try and dress this up as something else to save face. What the UK negotiators are doing only makes sense once you understand that Brexit can cause huge economic damage, but those that said otherwise must cling on to the pretense of Project Fear.

The use of the term Project Fear was an attempt to shut out expertise and evidence from the Brexit debate, just as it was used in the same way during the Scottish Referendum. [2] Hopefully we will never know what the costs of a Hard Brexit will be, because we will get a Labour government which will keep us in the Single Market and Customs Union (or better still, Brexit somehow collapses before then). But the concept of Project Fear deserves to be exposed and degraded nevertheless. So, following on from the spirit of my last post, here is a definition:

Project Fear: a term once used by those who wish to discredit economic evidence and expertise as just the exaggerations of one side in a debate.

Background. Initially used by Scottish Nationalists in an attempt to hide the short term fiscal costs of independence, and then in the European referendum to hide the economic costs of leaving the EU. Fell out of use after Sterling’s depreciation following the Brexit vote, and the subsequent decline in real incomes and economic slowdown.

[1] Given weak output growth, strong employment growth and a decline in real wages may be preferable to stronger productivity growth and high unemployment. But that is to talk about the characteristic of a weak economy. I am talking here about employment growth being used to counter the claim that the recovery is weak.

[2] Please, no more comments about how the SNP did not invent the term. The desperation to show (correctly) that ‘they used it first’ indicates a recognition that the term was used in that referendum to hide reality from the voters.

Underestimating the impact of austerity

There have been many ideas put forward to explain the low growth in UK productivity, but among mainstream accounts the impact of austerity is not usually high up on the list of possibilities. I have talked before about what I call an ‘innovations gap’, and how the UK is currently suffering a particularly large innovations gap. The idea of an innovations gap can link inadequate demand, like austerity, to low productivity growth.

Let me use a very simple example to explain how an innovations gap can arise after a deep recession followed by austerity. Assume that improvements in technology and production techniques are constantly taking place, or being learnt from other firms/countries, but they need new investment to put them in place. This is what economists call embodied technical progress.

Imagine a firm where demand is not increasing. Will that firm invest to become more productive? Only if the additional profits it can make as a result of investing (suitably discounted) is greater than the cost of the investment. For this firm we therefore need quite a big innovation gap before it is worth its while to undertake investment and before its productivity increases.

Now imagine that demand increases. The firm now has to undertake some additional investment to increase its output. It makes sense to invest in techniques that embody the latest technology. The increase in demand leads to both higher investment (what economists call the ‘accelerator’) and higher productivity.

In a normal recovery from a recession, demand recovers rapidly (growth easily exceeds past trends), leading firms to invest in the latest technology. Any innovations gap that might have opened up in the recession is quickly closed. In contrast, a very slow recovery caused by austerity will reduce the need for investment, allowing a large innovations gap to open up.

This idea fits in with some recent work which suggests that productivity growth in ‘frontier’ firms (firms that already have relatively high productivity) has not slowed, and a gap has opened up between these frontier firms and laggards. (See also here.) This would make sense if the frontier firms are growing (because they are the most productive) but the laggard firms are not. Growing firms need to invest to expand, but stagnant firms are not expanding.

The same model could also suggest how wage led productivity growth could occur (see Ben Chu here for example). As most innovations are likely to be labour saving, then higher wages can increase the profits that come from any particular investment, without necessarily increasing the cost of that investment. So an increase in wages caused by an increase in the minimum wage, for example, could increase investment and therefore increase productivity. The other side of that coin is that the period of stagnant wage growth we have had since the recession provided no incentive for firms to invest in higher productivity techniques.

I doubt that this story explains more than a part of the UK’s productivity gap. In the UK investment in plant and machinery fell sharply in the recession, and has not yet recovered to pre-recession levels, but its decline is unlikely to be enough to explain a productivity standstill. (For an account of some other key factors that could explain the UK productivity puzzle, see here.) But if it explains even a little, it makes austerity a lot more costly.

One way of describing what I’m saying is that austerity influences supply as well as demand. You could say austerity ignores the accelerator as well as the multiplier, which is cute but does not capture the idea of embodied technical progress which is crucial to this argument. It is why it is always best to run a high pressure economy (see Martin Sandbu here who links to an interview between Jared Bernstein and Josh Bivens).

As I explain here, I do not use austerity as just another name for any fiscal consolidation, or fiscal consolidation involving cuts to spending. Fiscal consolidation need not reduce output for the aggregate economy if monetary policy is able to offset its impact. But if interest rates are at their lower bound, as they are once again in the UK [1], fiscal consolidation will reduce output and lead to another needless waste of resources. Since Brexit we have a second period of UK austerity. In assessing how costly this will be, we need to look not just at whether it creates a negative output gap, but also how it creates an innovations gap that reduces productivity.

[1] We know this, because the Bank is increasing the amount of QE.

Explaining the last ten years

The Great Recession was larger than any previous post WWII recession. But that is not what it will be mainly remembered for. Unlike previous recessions, it appears to have led to, or coincided with, a permanent reduction in the productive potential [1] of the economy relative to previous trends. As unemployment today in the US and UK is not very different from pre-recession levels, then another way of saying the same thing is that growth in labour productivity and real wages over the last seven years has been much lower than pre-recession trends. (As employment has not yet recovered in Europe, I will focus on the US and UK here.)

I have posted charts showing this for the UK many times, so here is something similar for the US. It plots the log of real GDP (green) against the CBO’s (Congressional Budget Office) estimate of potential output (yellow). Unlike the UK, potential growth in the US does not appear constant from 1955, but the CBO has potential output growth between 3 to 3.5% in most years between 1970 and the early 2000s. The break created by the Great Recession is clear: potential growth fell to as low as 1% immediately after the recession, is currently running at 1.5%, and the CBO hopes it will recover to 2% by 2020.

US Actual (green) and Potential (yellow, source CBO) Output, logged. Source: FRED.

There seem to be two ways of thinking about this decline in potential output growth. One is that the slowdown in productivity growth was happening anyway, and has nothing to do with the global financial crisis and recession. This seems unlikely to be the major story. For the UK we have to rewrite the immediate pre-recession years as boom periods (a large positive output gap), even though most indicators suggests they were not. A global synchronised slowdown in productivity growth seems improbable, as some countries are at the technological frontier and others are catching up. As Ball notes, “in the countries hit hardest by the recession, the growth rate of potential output is much lower today than it was before 2008.” However the coincidence story is the one that both the OECD and IMF assume when they calculate output gaps or cyclically adjusted budget deficits. The CBO numbers for the US shown above adopt the coincidence theory to some extent, reducing potential growth from 3.5% in 2002 to 2.0% by the end of 2007.

If we stick to the more plausible idea that this is all somehow the result of the financial crisis and recession, we can again split explanations into two types: those that focus on the financial crisis and argue that crises of this type (rather than other types of recession) impact on potential output, and those that look at the impact of the recession itself. The distinction is important in understanding the impact of austerity. If the length and depth of the recession has permanently hit potential output, as Fatas and Summers suggest, then the cost of austerity is much greater than we could have imagined.

Looking at previous financial crises in individual countries, as Nick Oulton has done for example, does suggest a permanent hit to potential, but I have noted before that this result leans heavily on experience in Latin American countries, and Sweden’s recovery from its 1990 crisis suggests a more optimistic story. Estimates based on OECD countries alone suggest more modest impacts on potential output, of around only 2%.

What about the impact of the recession itself? Here it is helpful to go through the textbook story of how a large negative demand shock should impact the global economy. Lower demand lowers output and employment. Workers cut wages, and firms follow with price cuts. The fall in inflation leads the central bank to cut real interest rates, which restores demand, employment and output to its pre-recession trend.

We know why this time was different: monetary policy hit the zero lower bound (ZLB) and fiscal policy in 2010 went in the wrong direction. Yet employment has recovered to a considerable extent (although less so in the US than the UK). A recovery in employment but not output (relative to pre-recession trends) means by definition a decline in labour productivity growth. How could this happen?

The table below shows the rate of growth of real and nominal wages in the UK and US in pre and post recession periods.

US	2002-7	2008-15
Annual wage growth (1)	3.8%	2.1%
Annual price growth (2)	2.5%	1.5%
Difference	1.3%	0.6%
UK
Annual wage growth	4.5%	1.7%
Annual price growth	2.8%	2.1%
Difference	1.7%	-0.4%

1. Compensation per employee, source OECD Economic Outlook
2. GDP deflator, source OECD Economic Outlook

Nominal wage growth followed the textbook story. But price inflation did not fall to match, implying steadily falling real wages, particularly in the UK. This could just reflect the decline in productivity, which occurred either coincidentally or as a result of the financial crisis and recession.

The financial crisis could have reduced productivity growth if a ‘broken’ financial sector had stopped financing high productivity investment projects, or kept inefficient firms going through ‘pretend and extend’ lending. The recession could have reduced productivity growth by reducing investment, and therefore embodied [2] technical progress. Perhaps this loss of embodied technical progress occurs in all recessions, but we do not notice it because recoveries are quick and complete.

However the causality could be the other way around. Falling real wages led firms to switch production techniques such that they employed more labour per unit of capital. Workers priced themselves into jobs. The big question then becomes why did firms let this happen? Why did firms not take advantage of lower wage increases to reduce their own prices, and choose instead to raise their profit margins?

One story involves a secular increase in firms’ profit margins (Paul Krugman’s robber barons idea), either because of a reduction in goods market competition (profit margins are sometimes called the degree of monopoly), or a rise in rent seeking as Bob Solow suggests (HT DeLong). [3] However it is not obvious why this should be connected to the recession. If it is not, it is like the coincident and exogenous productivity decline. We will not get back to the earlier productivity growth path without reversing whatever caused this secular rise in profit margins.

Another, in some ways more optimistic, story involves different degrees of nominal rigidity: nominal wages are less sticky than nominal prices. As a result nominal wages led prices in reacting to the recession, but now prices are ‘catching up’ and profit margins will fall back. That would fit nicely with inflation continuing below target for some time, and real wages and productivity recovering. It is an optimistic story, because an additional demand stimulus would increase wage but not price inflation, and we would see rapid growth in labour productivity as firms reversed their earlier labour for capital substitution.

Unfortunately recent data suggests this is not happening. Instead core inflation is now above target in the US and rising to target in the UK.    

So is there some other way that a large recession in itself can cause a large reduction in potential output? Macroeconomists group such explanations under a general heading called ‘hysteresis mechanisms’: mechanisms whereby recent history can have permanent effects. Ball summarises the three main types of mechanism that economists have identified: “it appears that recessions sharply reduce capital accumulation, have long-term effects on employment (largely through lower labour force participation), and may slow the growth of total factor productivity.” If technical progress is embodied, we can link the first and last. That will be the subject of a later post.  

[1] For those not familiar with the term, a traditional way of thinking about potential output is that it is what output and incomes could have been if we had avoided booms and recessions, or equivalently if we had avoided domestically induced variations in inflation. Potential output can increase either because the labour force increases, or because labour productivity increases due to either technical progress and investment.

[2] Embodied technical progress is greater labour productivity brought about through new machinery i.e. it needs investment for it to happen.

[3] Postscript (just): Here is Martin Sandbu on the same issue