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Permanent! Do recessions and economic depressions cause permanent damage to the economy, or do we see a catch-up period in the years that follow? In some ways it is like asking whether going on holiday damages your total level of productivity. Do you work extra hard in the days before going away and then when you return, so that within a few weeks, as far as backlog of work is concerned, it is as if you never went away? Do holidays cause permanent damage to output?

The answer to that question is quite important because it may determine whether the UK will boom later this decade. One thing we can say is this. The Great Depression in the US during the 1930s was very nasty, but within a decade or so of it ending, US GDP was much greater than it would have been had growth followed the pre-depression trajectory.

Recessions caused by financial crises tend to be different. They tend to be more severe and it can take longer for recovery to occur. Various economists have had a go at calculating the permanent loss of GDP that occurs after a recession caused by a financial crisis. Estimates vary, but, according to Capital Economics, they are all – or nearly all – within the 2 to 10 per cent mark. That is to say once the dust has settled and things have returned to normal, total GDP is between 2 and 10 per cent less than what it would have been had the financial crisis never occurred.

Of course the causal link may be the other way round. It may be that GDP in the years leading up to a financial crisis is illusionary. It is not so much that such a crisis causes permanent loss; rather it is that total output was not real, not really real, and largely constructed from the economic equivalent of smoke and mirrors.
Right now

UK GDP is around 15 per cent short of what it would have been had things carried on, or as most forecasters had predicted before 2008. By the end of next year, the gap between actuality and what one might loosely call potential is likely to be around 16.5 per cent.

So let’s say that permanent damage caused to the economy lies somewhere halfway between the 2 and 10 per cent figures, and is 6 per cent. That means the UK will eventually claw back no less than 10.5 per cent of GDP lost during the downturn. Let’s say this happens between 2015 and 2020 – not an unreasonable assumption – and that underlying growth is 2.5 per cent. During this half a decade annual growth should average around 4 per cent a year. And funnily enough, this is precisely what Capital Economics expects to happen.

In the build-up to the financial crisis Capital Economics was definitely one of the more bearish of commentators, and made its name for forecasting something of a crash in UK house prices. Indeed, when it comes to forecasts of UK house prices it remains distinctly bearish. Yet, earlier this week it forecast what one can only really call a boom for the UK economy within two or three years.

It suggests the loss to the UK’s permanent output was limited by two key factors. Firstly, spending on R&D as a proportion of GDP has actually been higher since the recession began. Theoretically potential output continued to grow, even if actual output didn’t. It also suggested that because unemployment did not rise to the kind of levels seen in the past, there was less permanent damage. The rationale behind this is that people who have been unemployed for an extended period of time often lose hope, and become less productive in the future.

© Investment & Business News 2013

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