Is economic recovery a myth?

Most recessions are temporary, as economies quickly recover ground. Or so I had thought. But a recent BIS working paper by Valerie Cerra and Sweta Chaman Saxena questions that assumption. Their paper, Growth dynamics: the myth of economic recovery, finds that "when output drops, it tends to remain well below its previous trend":

Using panel data for a large number of countries, we find that economic contractions are not followed by offsetting fast recoveries. Trend output lost is not regained, on average. Wars, crises, and other negative shocks lead to absolute divergence and lower long-run growth, whereas we find absolute convergence in expansions. The output costs of political and financial crises are permanent on average, and long-term growth is negatively linked to volatility. These results also imply that panel data studies can help identify the sources of growth and that economic models should be capable of explaining growth and fluctuations within the same framework.

The authors conclude that cross-country regressions can mislead by masking determinants of turning points: "panel regressions that control for the timing of shocks or policy changes offer a better chance of explaining sources of growth". The paper also highlights the costly impact of political and financial crises:

Crises contribute to half of the episodes of negative growth, and there is no evidence that they typically lead to economic reforms or policy adjustments that restore output to trend. Change to a more democratic government system, on the other hand, improves the rebound from a recession.

And they highlight an area for future research;

Countries that experience many negative shocks to output tend to get left behind and their long-term growth suffers. Thus, while standard growth theory may work well in explaining expansions, a fruitful direction for future research would be to explain the proclivity to wars, crises, and other negative shocks.

Worth a read.

Comments

[Arthur Eckart]

There's nothing new in this study, and it's political. It seems, the study used panel data of 112 countries in a 40 year period. It concluded Sweden's period of slow growth after 1990 was caused by a severe financial crisis rather than large increases in welfare (the Lucus regression of the U.S., cited in the study, showed a small permanent output fall with a relatively small increase in welfare, or small effect, and the U.S. also had a severe financial crisis in 1990 where output largely recovered much more quickly). Moreover, the Sweden example contradicts the high income chart. Each country has its own determinants of growth. Even U.S. states have unique growth factors (one study showed an increase in the minimum wage raised employment when comparing New Jersey and Pennsylvania, although it should have the opposite or no effect, which may be another political statement).

[Arthur Eckart]

Also, normally, government (or welfare) lowers volatility, which should contribute to growth. However, higher government can lower overall growth. When government is "too generous," the net effect should be negative, since more will stay on welfare for longer periods after recessions (e.g. unless wages rise enough). Poor countries have less welfare. However, various crises would have more powerful and longer-lasting effects (that increase volatility and country risk). The study minimizes the effect of welfare, although a shift to a more democratic system can add to an expansion.

[Lafayette]

VC/SS: Trend output lost is not regained, on average. Wars, crises, and other negative shocks lead to absolute divergence and lower long-run growth, whereas we find absolute convergence in expansions.

These two are suspending the theory of the business cycle? Wars, crises? In Europe? In the US? Europe is not richer now than before WW2?

Can’t imagine where they are coming from …

future research would be to explain the proclivity to wars, crises, and other negative shocks.

Now that’s interesting, particularly the word “proclivity”. Is it anything like “propensity” in traditional economic thinking? Yep, the words are synonymous.

So, maybe some countries have a propensity to war/crises, whilst others do not? Interesting conjecture. I’d like to see it proven.

[Arthur Eckart]

Lafayette, I agree, the terminology doesn't seem right (more negative shocks in the past mean more in the future?, and what about positive shocks?). Also, "trend output lost is not regained" to lower long-run growth seems incorrect for world growth, although larger economies expand more slowly. However, the chart in the link below suggests world real output has expanded steadily (or accelerated) from 1950 to 2004.

http://www.earth-policy.org/Indicators/Econ/2005.htm

[Lafayette]

AE: Also, "trend output lost is not regained" to lower long-run growth seems incorrect for world growth, although larger economies expand more slowly.

Yes, and I must admit that there is something missing in their explanation, but I can’t put a finger on it. Frankly, I shouldn’t complain too loudly, since I decided not to read the entire article – so I don’t really know the details of the research.

I wonder about the approach, however. Negative impacts to undeveloped countries are surely more difficult to overcome than for larger more developed and therefore more diverse economies. And, as you say, not all impacts are negative …

I am not sure what good sense there was of making an analytical amalgam of all countries, when perhaps more segmentation analysis would have provoked perhaps other insight? But, that is merely speculation on my part.

[Arthur Eckart]

Real per capita output should be used, since some countries had declining (or negative) population growth, while other countries maintained high population growth. Also, other factors contribute to rising living standards (e.g. greater specialization and trade), which may not show up on the production side.

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Poor countries have less welfare and I am not sure what good sense there was of making an analytical amalgam of all countries, when perhaps more segmentation analysis would have provoked perhaps other insight? But, that is merely speculation on my part.

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