Will the world regain its past growth path or remain below it?

“In normal recessions, however disruptive they are to businesses and jobs, things turn around predictably. The current global recession is far from normal.

Usually, to fight a recession, the central bank lowers interest rates, which results in increased demand and output. People resume buying durable goods such as appliances and cars. Firms start delayed investment projects. Often, an exchange rate depreciation gives a boost to exports by making them cheaper. The lower-than-normal growth during the recession gives way to higher-than-normal growth for some time, until the economy has returned to its normal growth path.

But the world is not in a run-of-the mill recession. The turnaround will not be simple. The crisis has left deep scars, which will affect both supply and demand for many years to come.

Some parts of the economic system have broken. Some firms went bankrupt that would not have in a normal recession. In advanced countries, the financial systems are partly dysfunctional, and will take a long time to find their new shape. Meanwhile, financial intermediation—and, by implication, the process of reallocation of resources that is central to growth—will be impaired. In emerging market countries, capital inflows, which decreased dramatically during the crisis, may not fully come back in the next few years. Changes in the composition of world demand, as consumption shifts from advanced to emerging economies, may require changes in the structure of production. In nearly all countries, the costs of the crisis have added to the fiscal burden, and higher taxation is inevitable.

All this means that we may not go back to the old growth path, that potential output may be lower than it was before the crisis.

How much has potential output decreased? It is very hard to tell: we do not see potential output, only actual output. The historical evidence is worrisome, however. The IMF’s forthcoming World Economic Outlook presents evidence from 88 banking crises over the past four decades in a wide range of countries. While there is large variation across countries, the conclusion is that, on average, output does not go back to its old trend path, but remains permanently below it.”

Olivier Blanchard, “Sustaining a Global Recovery”, Finance & Development (September 2009).

http://www.imf.org/external/pubs/ft/fandd/2009/09/blanchardindex.htm


Olivier Blanchard is Economic Counsellor and Director of the Research Department of the International Monetary Fund. He is on leave from the Massachusetts Institute of Technology, where he serves as Class of 1941 Professor of Economics.

Potential output refers to the highest level of production that can be sustained over the longer-term, and assumes that all available human, capital and natural resources are being employed to the best effect within the limits of technology and managerial skills. In technical terms, it means that a country is producing on its production possibilities frontier, rather than inside it, indicating that it can produce more of one item only if less of some other item is produced. Clearly, with over 9 per cent unemployment, the United States is not operating on its production possibilities frontier and is not operating at its potential.

In this article, Professor Blanchard says that the recovery will not be robust and that if history is any guide economic growth will be slower than it has been in the past. He is also of the view that the any immediate recovery will weak and for that reason will not reduce unemployment for some time and the normal factors supporting a longer-term recovery, government fiscal policy and inventory rebuilding, will soon begin to play out.

What, he asks, will sustain the recovery and provide an impetus for longer-term world growth?

He points to two needed adjustments: A rebalancing of public and private spending, where higher private demand replaces unsustainable public spending through limiting the future growth of entitlements, and A rebalancing of demand across countries, where the huge external deficits of the United States were matched by huge external surpluses of China and other countries. The adjustments required to rebalance the world economy, he also points out, will not be easy.