How bad is the global downturn- and what can be done?

There is talk of recovery and growth in the western world and in the global economy. In the US, there is celebration because there are more jobs today than at the high point of 2008. We need to hold the celebration, though. We need to compare where output and jobs are today with where we might have been, had the crisis not occurred. An article in the FT sums up some of the findings on this subject.

While several economies have now returned to their previous peak levels of output, very few have approached the previous long term trendlines which had been established for decades before that. For the developed economies as a whole, output remains about 12 per cent below these trendlines.

The trillion dollar question is: can the developed world return to the growth level indicated by the trendlines- and how soon? Now, output can depart from the trendline for two reasons: a permanent loss of capacity and an output gap (that is, output does not fully come up to the output capacity). The article cites a paper that shows that the overwhelming proportion of the departure from trendline is on account of loss of capacity- 7.2%. Only 2.6% of the departure is explained by the output gap.

Now, we can speculate about why the loss of capacity has turned out to be permanent. When you have a protracted recession, labour participation goes down because of a loss of skills, investment spending is crippled, innovation gets a severe setback. Whatever the reason, the fact that only a small portion of the loss of output is on account of an output gap means that fiscal or monetary stimulus can only do so much to restore the developed world to their growth path.

As the article points out, there could be a role for a broader range of fiscal instruments, such as tax cuts, incentives for investment and for work, infrastructure spending etc. But these instruments operate not just on the demand side but also on the supply side. In other words, given the damage that has occurred to economic capacity, there is only so much that demand management can accomplish. Perhaps, that would explain why both the fiscal and monetary stimulus that followed the crisis have yielded so little.