Aurora Borealis
1 October 2014 CFA Institute Journal Review

Free Exchange: Wasted Potential (Digest Summary)

  1. Mathias Moersch

The financial crisis severely harmed potential output growth in the world’s major economies. This adverse result came from subpar growth in investments, labor force participation, and productivity of workers and capital.

What’s Inside?

The long-term consequences of the financial crisis are beginning to show up in economic data. Recent estimates suggest that potential output growth is significantly below its pre-crisis level in many industrial countries. All growth determinants—namely, investment, labor force participation, and productivity of workers and capital—contribute to this adverse development.

How Is This Article Useful to Practitioners?

The most useful measure for assessing long-term economic growth prospects is potential output, defined as the highest growth rate an economy can sustain without generating inflation. A comparison of estimates published by the OECD before and after the financial crisis reveals a significant decline in this variable among industrialized countries. By 2015, the weighted average of potential output is projected to be about 8% below its pre-crisis trend. The reduction in potential output indicates that many economies—especially those in Southern Europe—have suffered lasting structural damage as a result of the crisis.

This negative outlook is also confirmed by an analysis of the disappointing growth performance in the United States in 2007–13. The contributing factors are unemployment, labor force participation, capital investment, and productivity. Unemployment was the most important issue after the crisis but has lost relevance over time. In contrast, declining labor force participation was relatively unimportant through 2010 but has gained in importance since then. Given a capital stock that is 13% below its pre-crisis trend, weak investment goes a long way toward explaining the unsatisfactory growth performance. Finally, productivity has been consistently below average since the crisis. This analysis supports the notion that structural issues are to blame for the weak output growth.

Abstractor’s Viewpoint

Although the cyclical effects of the Great Recession have been controlled relatively well by expansionary policies, the structural issues continue to loom large. Consequently, the policy debate needs to shift in the direction of reforms that tackle problems in the labor market or support advances in productivity.

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