Output growth and gap

One of the classical narratives in the Greek (tragedy) story is how Greece is the outlier in an otherwise successful implementation of austerity and adjustment programs throughout Europe. Other European countries thoroughly introduced and implemented austerity policies, liberated their labor and product markets, adjusted their economies towards an export and investment-led growth model and are now enjoying the benefits of their efforts.

In this short essay I would like to point at two important problems for this story. The first one is that the periphery experienced large and persistent output gaps during the European crisis since 2011. Spain had a negative output gap of 8.5% in 2013 while Italy and Portugal registered gaps more than 4% of potential product. All number were significantly larger than the relevant numbers at the start of the crisis during 2011.

An increase in the output gap is consistent with a rebound in economic growth in the immediate years during which the gap closes. Obviously this does not mark a policy of increasing output gaps and inflicting recessions as «successful», nor is a rebound not expected as soon as fiscal and monetary policy are relaxed. This is made clear from economic growth projections for 2017-18 period during which the closing of output gaps will lead to a significant decrease of output growth compared to 2015-16.

The second point is the fact that a clear indicator of success for an adjustment policy is not economic growth during the period when output gap closes but rather if the adjustment has permanent positive effects on potential output. An adjustment program which is supposed to increase productivity, efficiency, growth prospects and lower macroeconomic imbalances would be assumed to lead to a corresponding increase of potential output.

Yet recent research suggests that austerity policies implemented during the Eurocrisis have had permanent negative effects on potential output which actually increase overtime:

The results show a coefficient close to one for 2014 and around 1.6-1.7 for 2019. This suggests that every 1% fiscal-policy-induced decline in GDP during the years 2010-11 translated into a 1% decline in potential output by 2014 and even more for 2019. The results are significant for both samples and the coefficient is similar for the Europe and Euro.

If one takes a look at potential output for various European countries (base = 2011) the results are that crisis countries had a serious blow on their economic potential. Only Spain will achieve a level equal to 2011 by 2018, while Italy and Portugal will still be quite lower than their 2011 levels. At the Euro-12 level, potential product will be only 6% higher than 2011, a result driven to a large extent by the positive dynamics of the German economy (an increase close to 11%). If Germany is excluded from Euro-12, growth falls to 4% with half the increase occurring during 2017-18 (the 2016 level is only 2% higher than 2011).

Obviously there are other structural factors playing a role in these developments (such as labor force growth dynamics), yet these results, especially compared to the German outcome, clearly suggest that adjustment programs did not provide a medium term boost to potential product. Claiming to return countries on a path of sustainable, strong growth yet keeping potential at 2011 levels for almost a decade can hardly be regarded as a sign of success.

Euro area permanent economic losses

Despite the large economic losses in the Eurozone since 2008 one will hear the same constant argument: Most countries (especially those in the periphery) lived ‘beyond their means’ and the correction that followed was inevitable. Austerity might cause short-term pain but the subsequent economic recovery (however weak and thin) vindicates its use and merits.

In this short post I will take a rather simplistic approach. Since the ECB inflation target is 2% while the usual assumption about long-run growth in per capita real output is also 2% we can compare the path of NGDP per capita in European countries to a 4% trend:

What we see is quite significant. It is true that before 2008 Greece and Spain had a NGDP path that constantly diverged from the 4% long-run trend (this pattern is especially strong in the Greek case). France, Italy and Portugal roughly followed the long-run trend while Germany quickly suffered significant losses due to its stagnant domestic demand environment and low inflation.

What is especially interesting is the path of NGDP/capita since the Great Recession. All countries seem to have suffered significant and permanent losses with their expected expansion path moving to a new and lower level. This is even more visible in the case of Greece and Italy where their projected 2016 NGDP per capita level will only be 70% of the long-term trend. Interestingly, Spain seems to be the country that has suffered the least losses compared to the trend line while France, Germany and Portugal are quite far from the 4% growth path (France at 74% while Germany and Portugal are close to 78%) with France actually growing only by 1.5% since 2012.

Yes, the path of Greece and Spain up to 2008 seems to have been unsustainable (in the context of a monetary union). Yet their correction entailed significant and permanent losses while the whole of the Eurozone is now on a new growth path at least 20-25% lower than the long-term 4% trend. Austerity and tight monetary conditions result in large output losses that are lost forever. Adding a few years of income 20-25% lower than trend implies a permanent loss of more than a year’s worth of income which in the context of a person’s lifespan is more than important.