January 17, 2011
Cumulative Output Loss
...lest we forget how much the mindless deregulation and irresponsible fiscal policy induced-crisis    and great recession has cost us in terms of lost output, and how difficult the road to recovery remains. (Very important as certain forces seek to gut financial regulation by way of "defunding". )
In our forthcoming book , Jeffry Frieden and I tried to tabulate the likely costs of lost output associated with the Great Recession that followed the financial crisis driven by financial deregulation, lax fiscal and monetary policy, and ample capital supplies abroad. Using the January 2010 CBO projections, we calculated the cumulative GDP loss (relative to potential GDP) from 2007Q4-2014Q1 at 3.53 trillion Ch.2005$, 11349 per person (Ch.2005$), or about $12604 in current dollars).
Macroeconomic conditions, as well as the projections of potential output, have changed somewhat since I undertook that calculation earlier this year, so I decided to update the calculation. I present the estimated cumulative loss from 2008Q1-2010Q3, as well as the cumulative loss from 2010Q4-2011Q4.
Figure 1: GDP, in bn Ch.2005$, 2010Q3 3rd release (blue), mean forecasted GDP from WSJ January 2011 survey (red), potential GDP as projected by CBO. Light green figures are cumulative output gap figures for indicated periods. NBER defined recession dates shaded gray. Sources: BEA, GDP 2010Q3 3rd release, WSJ January 2011 survey, CBO, Budget and Economic Outlook: An Update (August 2010) - additional data on potential GDP, NBER, and author's calculations.
Fears of overheating, when counterbalanced against the costs of lost output, seem somewhat misplaced in this context.  Of course, costs depend upon estimates of potential GDP. OECD and IMF output gap estimates would suggest a somewhat smaller cumulative output loss (see here), although for the loss-to-date, the difference would not be particularly large.
One last point: it is inappropriate to take the trajectory of potential GDP as being unrelated to demand conditions, especially for persistent deviations from full employment, such as those we have seen in the last two and a half years. Consider that depressed investment, largely due to deficient and uncertain demand (rather than regulatory uncertainty) , will eventually lead to a substantially smaller capital stock. Indeed, the argument that substantial long term unemployment will lead to elevated structural unemployment  is inconsistent with the view that potential is unaffected by the size of the output gap. That means that the cumulative output loss relative to a counterfactual where output was higher is probably greater (although the extent is hard to determine).
Posted by Menzie Chinn at January 17, 2011 10:03 PMdigg this | reddit
thanks for the political commentary. one could equally say it the regulation that got us into this thing not the deregulation as you claim.
practically speaking it probably a combination of both, not singularly one or the other.
Posted by: adam sachs at January 18, 2011 05:29 AM
Adam's viewpoint is wrong. One can most certainly point to many, many specific examples of willful dismantling of regulations that, once dismantled, unleashed speculation and leverage--again.
Adam should point to specific, willful layering of new regulations that, once imposed, unleashed speculation and leverage--again.
If he can do that, and I know he can't because nothing of the kind occured, then he can make the statement that 'one could equally say it the regulation that got us into this thing not the deregulation as you claim.'
Posted by: beezer at January 18, 2011 06:56 AM
Uncertain policies but similar developments
IMF G20 meeting OCT 21 2010
IMF world economic outlook "Global slowdown and rising inflation" JULY 2008
"Food,Fuel price increases have pushed some countries at the tipping point"
Posted by: ppcm at January 18, 2011 07:28 AM
adam sachs: Citation of some logical chain, or a fact, might be useful in buttressing your case that regulation was of equal importance in causing the crisis.
Posted by: Menzie Chinn at January 18, 2011 07:34 AM
The financial industry was and is very highly regulated. We have central planning over interest rates via the Fed. We have federal deposit insurance spurring moral hazard by relieving depositors of their efforts to watch bank leverage. We have a mortgage system dominated by state-controlled enterprises.
And oh yes, as always, it's the free market and deregulation to blame. If only we gave even more control over to government and its brilliant econ PhDs, we'd never have any problems.
Posted by: a.west at January 18, 2011 09:01 AM
What was potential GDP back before 2005?
How much of potential was from financials? And increasing debt?
Posted by: aaron at January 18, 2011 10:51 AM
The Obama administration sure hasn't done well in the two years it has had. It can't even get to potential GDP.
Things do seem to be picking after the recent congressional elections.
Posted by: Heterosexual at January 18, 2011 11:00 AM
Hetrosexual -- the gdp Gap was never closed under Bush either.
Posted by: spencer at January 18, 2011 12:37 PM
"The Obama administration sure hasn't done well in the two years it has had. It can't even get to potential GDP." ... cracking LOL!
It's like those comedians who play the piano badly as part of the act, but actually have to be good at playing to play that badly... you must be a pretty good economist to say something that dumb!
Posted by: Dr. L at January 18, 2011 12:52 PM
A. West: "The financial industry was and is very highly regulated. We have central planning over interest rates via the Fed. We have federal deposit insurance spurring moral hazard by relieving depositors of their efforts to watch bank leverage. We have a mortgage system dominated by state-controlled enterprises."
Yes, but do you have nothing to say about the large-scale DE-regulation of the past 30 years? Is it your view that this contributed nothing to the crisis? Why did Glass-Steagall give us a generation of financial stability (without apparently undermining real economic growth)if it was such a bad idea?
Federal deposit insurance: - Are you serious? Really, moral hazard based on deposit insurance was an important factor in the financial crisis? And please remember that in the UK, where the BOE had installed a cockeyed partial guarantee scheme, you saw depositors exercising their "efforts to watch bank leverage" by staging a destabilizing run straight out of 1932. Only ideology pushed to the brink of madness would endorse this kind of view.
On the state role in mortgages, you have half a point. Unless, as a I suspect, you want to construct out of this an argument that makes Fannie, Freddie and the CRA the principle villains in the drama--in which case you need to explain why the worst miscreants were unregulated private lenders.
I know, I'm wasting my breath. But sometimes a comment is so obtuse that it has to answered, even if that amounts to talking to a wall.
Posted by: Dave L at January 18, 2011 01:36 PM
Ah yes "a" west. The magically free market. The one thing that does not exist in nature, that free market. Central planning? The capitalists centrally plan everyday. So you are a central planner and a market statist. Get a clue.
Potential GDP has not been met since the height of the Clinton boom years. If you believe that is the signal of recessions end, then we have not been out of a recession since 2000.
Posted by: The Rage at January 18, 2011 01:48 PM
I would have thought that GDP was above potential GDP during the previous boom. It was unsustainable spending based on borrowing. Now things are below potential but not as much as you are suggesting.
Posted by: moom at January 18, 2011 01:57 PM
I believe you are assuming that productivity gains and other things should have gone into more output instead of more retirement (I think economists use the term leisure).
What if people have enough stuff? What should happen to productivity gains then?
Posted by: Get Rid of the Fed at January 18, 2011 02:15 PM
The causes of the crisis are actually pretty straightforward.
For around 30 odd years wages have fallen behind labour productivity growth but been made up by private sector borrowing...however the private sector can run out of money or the ability to service this debt eventually, unlike government, the monopoly provider of money.
As people cut spending to pay off the debt, aggregate demand, incomes, production slumps unless the spender of last resort steps in to fill the consumption gap, funding the private sector's saving/deleveraging desires.
Spending should be maintained by providing a Living Minimum Wage for those who want it whilst cutting expenditure and social/national insurance taxes, funding sub-central/federal governments on a per capita basis would help too.
Whilst there is mass unemployment like we've had coincidentally for the last 30-40 years, clearly there's plenty of spare capacity and insufficient demand needs to be raised to 'soak it up' without much price pressure.
How can mass unemployment averaging around 10% be described as above potential???
Posted by: Will Richardson at January 18, 2011 02:27 PM
It would be a lot more useful to start with a trend line based on growth before the credit bubble took off. Comparing where we are today to the trend in late 2007 is essentially meaningless.
Posted by: wj at January 18, 2011 02:50 PM
"...lest we forget how much the mindless deregulation and irresponsible fiscal policy induced-crisis    and great recession has cost us in terms of lost output,"
This is a strange statement. I would argue the biggest failure of the fiscal authorities was to allow outsized foreign currency interventions to continue without threat of trade sanctions. Krugman has argued that international imbalances, not deregulation, were the biggest cause of the housing bubbles here and abroad. Irresponsible fiscal spending and taxing policies helped, but unless matched with a substantial reduction in foreign currency interventions, greater fiscal prudence would have made the 'jobless recovery' after the dot-com bust slower and more painful. Too much of the demand that was moved forward in time by the expansionary monetary and fiscal policies after the dot-com bust was allowed to leak away in the forein sector. Krugman is openly calling for a halt in the foreign currency interventions, but this call is being largely ignored.
So I would agree at least somewhat with the first sentence of the first comment.
Posted by: don at January 18, 2011 03:05 PM
wj: If you had read the supporting CBO document, or any of the past Econbrowser posts on measuring potential GDP [a] [b], you would know that the measure depicted in the Figure is not a trend line. Now, certain researchers do use filtered (say HP, or BK) GDP -- in which case your critique would be relevant. But not in this case.
Posted by: Menzie Chinn at January 18, 2011 03:10 PM
What real growth rates underlies the linear extrapolated potential GDP lines? From eye-balling the numbers, I estimated 1.95% which is certainly not excessive.
Even that modest trend growth rate is likely misleading in my opinion. It presupposes omniscient, competent, socially-minded economic managers; a painless, no cost resolution of America's growing debtor status; no economic consequences to the support for not one but 3 military occupations in the Mid- and Near-East; as well as unusually gifted abilities to cope with steadily rising oil prices.
Posted by: westslope at January 18, 2011 04:15 PM
Regulation is not a binary function that's either on or off.
Intelligent regulation can be useful, but the political system does not support it very well. It requires industry expertise, and in complex fields like oil & gas and finance, a collaborative approach. Crude command-and-control systems are likely to mis-regulate and increase costs without a commensurate reduction in risks.
If you want to regulate risks, step one is to pick up the phone and call people. Most of the investment bankers I know and virtually all the high level oil and gas guys I know are decent people, only too aware of the risks of their profession. They'll happily talk to you, if they believe you are trying to reduce risk rather than dismantle their industry.
The Obama administration has unfortunately chosen, in both finance and oil and gas, aggressive rhetoric with these industries ("addicted to oil", "fat cat bankers"), and consequently, will struggle for the goodwill of even well-intentioned technical professionals.
Posted by: Steven Kopits at January 18, 2011 04:56 PM
I second westslope's comment.
Posted by: Nestor J at January 18, 2011 06:15 PM
Glass-Steagall repeal Senate vote- 90-8 for, brief recap
REPUBLICANS FOR (52): Abraham, Allard, Ashcroft, Bennett, Brownback, Bond, Bunning, Burns, Campbell, Chafee, Cochran, Collins, Coverdell, Craig, Crapo, DeWine, Domenici, Enzi, Frist, Gorton, Gramm (Tex.), Grams (Minn.), Grassley, Gregg, Hegel, Hatch, Helms, Hutchinson (Ark.), Hutchison (Tex.), Inhofe, Jeffords, Kyl, Lott, Lugar, Mack, McConnell, Murkowski, Nickles, Roberts, Roth, Santorum, Sessions, Smith (N.H.), Smith (Ore.), Snowe, Specter, Stevens, Thomas, Thompson, Thurmond, Voinovich and Warner.
DEMOCRATS FOR (38): Akaka, Baucus, Bayh, BIDEN, Bingaman, Breaux, Byrd, Cleland, Conrad, Daschle, Dodd, Durbin, Edwards, Feinstein, Graham (Fla.), Hollings, Inouye, Johnson, Kennedy, Kerrey (Neb.), Kerry (Mass.), Kohl, Landrieu, Lautenberg, Leahy, Levin, Lieberman, Lincoln, Moynihan, Murray, Reed (R.L), Reid (Nev.), Robb, Rockefeller, Sarbanes, Schumer, Torricelli and Wyden.
REPUBLICANS AGAINST(1): Shelby.
DEMOCRATS AGAINST(7): Boxer, Bryan, Dorgan, Feingold, Harkin, Mikulski and Wellstone.
NOT VOTING: 2
REPUBLICANS (2): Fitzgerald (voted present) and MCCAIN
Posted by: tj at January 18, 2011 06:21 PM
I always wonder if deregulation was the problem what happened to Sarbanes Oxley? I remember talking to a terribly ill-informed woman, who blamed the recession on Reagan. I wondered why Reagan and not Carter, or Nixon, or Johnson. Personally, I blame Einshouer.
I do know of one case where regulation helped cause the housing bubble. Basel I. In line with the European banking regulation, the banks had to consider the equity stake of a CDO, subprime MBS CDO to be precise, at 100% multiplier for capital adequecy, which meant that they had to keep 8% in reserves for the equity piece if they sold off the rest of the CDO. Also, the European banks could buy the AAA sections, which is why so much of the money flowed from AIG into the French, German, and UK banks, as well as Goldman. Back to my story, instead of keeping 8% of the entire bond, they only kept 8% of the risk of the bond, which meant the banks had too little cash in reserves. It created the demad for these instruments. I guess the deregulation was the ability of banks to provide teaser rates, which blew up on the borrowers.
Root cause, baby boomers looking to invest retirement money moved from stock market to real estate because of inflation concerns from war and low fed rates. This created the beginning. The banks looking for yield since the fed was trying to indirectly tax the banks, negative real interest rates, looked for yield in more risky instruments. Housing seemed less risky because no-one defaulted because they could make profits from selling their homes. The banks lent more, including fannie and freddie. Those two did have a giant accounting scandal where the CEOs overstated earings to get bigger bonuses, while taking on more risk. (Just saying) The government, both parties, encouraged lower lending standards. People speculated in the housing market, which was the whole point of ARMS. I had a mortgage broker explain it to me, you sell in 3 years, period. Once the bottom fell out, the government continue to subsidize and encourage housing while increasing the capital requirements on the banks. The banks reduced their portfolios, and increased lending to the government. Hence, people like my father, who owned a small manufacturing plant, had all his loans called and was forced out of business when the customers looked for companies that had financial backing. The company was sold, and my parents have to sell their house, which will cover just the mortgage since money was used to keep the business going, i.e. boom!
Posted by: Robert at January 18, 2011 06:44 PM
tj: In my view, of greater import was Commodity Futures Modernization Act (which omitted CDS from regulation), as well as deregulation -- or regulatory abdication -- by executive branch agencies, such OTS and SEC. Sometimes this was intentional (see links 1-3 in the post) and sometimes because of inadequate funding. The latter is something I worry about now, as certain policymakers seek to defund Dodd-Frank.
Posted by: Menzie Chinn at January 18, 2011 06:57 PM
Christopher Cox, SEC chair appointed by GWBush and former GOP Congressman from SoCal, said, “The last six months have made it abundantly clear that voluntary regulation does not work."
The basic concept has been that private firms are best suited to understand their own risks and that maybe one or two firms might make large mistakes, large enough to go under, but that these private actors with their own capital and jobs at stake were the best evaluators and thus the industry was itself secured by self-interest. Now we hear that the government "led" or "induced" firms into making huge bets on subprime, Alt-A, etc. mortgages and of course various derivatives. This is the kind of utter illogic that passes for thought: the firms could not be induced to harm themselves any more than a gunman could be induced to murder a Congresswoman because these were private actors with their own capital and jobs at stake. The government didn't require them to invest, but at most provided relatively cheap money. One would need to throw away the basic idea of private self-interest to blame the government.
As to the idea that it was the CRA or Fannie/Freddie, that's just lying. I can better accept partisan lying than self-contadicting illogic.
Posted by: jonathan at January 18, 2011 08:52 PM
If the market were truly free then all government interference ought be eliminated. No doubt all free market types are also in favor of abolishing incorporation. Limited liability for investors is the ultimate moral hazard because it relieves shareholders and bondholders not only of "their efforts" to "watch" corporations but it encourages malfeasance for short-term profit.
It's odd that free-marketeers go on and on about government regulation with nary a peep about the ultimate government interference that is a government granted charter of incorporation limiting investor liability.
So are free marketeers willing to go the distance and be individually liable for the acts of the entities in which they invest or do they seek to hide behind a government charter? Or in the example above if the depositors bear the risk of loss should not the bank's shareholders be held individually liable for those losses as they were lax in their oversight of an institution they owned?
Posted by: dd at January 19, 2011 05:40 AM
You can't just take an unsustainable high point and then draw and upward line and call it 'potential' and then claim there was a 'loss' from that.
That's not very sound thinking.
Posted by: wally at January 19, 2011 05:44 AM
Yesterday President Obama had an editorial printed in the WSJ recognizing that our government has a problem with the foolishness of regulation. It was so important to him that he made it an Executive Order. Here is an excerpt.
... today, I am signing an executive order that makes clear that this is the operating principle of our government.
This order requires that federal agencies ensure that regulations protect our safety, health and environment while promoting economic growth. And it orders a government-wide review of the rules already on the books to remove outdated regulations that stifle job creation and make our economy less competitive. It's a review that will help bring order to regulations that have become a patchwork of overlapping rules, the result of tinkering by administrations and legislators of both parties and the influence of special interests in Washington over decades.
My only question is why does it take an Executive Order to get rid of regulations that cost our country dearly?
Posted by: Ricardo at January 19, 2011 06:07 AM
wally: If you had read the supporting CBO document, or any of the past Econbrowser posts on measuring potential GDP [a] [b], you would know that the measure depicted in the Figure is not a trend line. Now, certain researchers do use filtered (say HP, or BK) GDP -- in which case your critique would be relevant. But not in this case.
Posted by: Menzie Chinn at January 19, 2011 06:49 AM
Menzie Chinn: If inflation or inflationary pressures are your concern, why not simply use capacity utilization measures?
We can't accurately forecast changes in GDP beyond 12 months, let alone make an accurate level-point projection. And yet, here you are tracing virtual GDP levels 3 years into the future.
With all due respect, I view this normative construct as one of the contributers to the current high unemployment situation in the USA.
Posted by: westslope at January 19, 2011 08:10 AM
westslope: Gee, you don't think "capacity utilization" figures reported by the Fed aren't normative? You should investigate how those figures are compiled. The Fed sends out a questionnaire...
And by the way, industry, let alone manufacturing, doesn't account for most of the value added in the US economy.
Posted by: Menzie Chinn at January 19, 2011 12:10 PM
westslope We can't accurately forecast changes in GDP beyond 12 months, let alone make an accurate level-point projection.
What we cannot forecast well is actual GDP. The (sort of) straight line on Menzie's chart represents potential GDP. Unless you're an RBC type the inputs to potential GDP do not change dramatically from year to year. Population growth is fairly predictable. And while the actual unemployment rate might bounce around, the NAIRU or natural unemployment rate is fairly stable over the near to mid term. And factories don't just disappear overnight. The intuition behind potential GDP is that it represents what kind of output we should expect if there were no shortfall to aggregate demand...or for that matter if there were no excess stimulus to aggregate demand. Note that in the late 90s the economy frequently operated above potential GDP. There is such as thing as working overtime. Ah yes...the halcyon days of intelligent macroeconomics.
Of course, if you're a believer in the Real Business Cycle fairy, then there is no difference between potential GDP and observed GDP. But I'm assuming you're smarter than that.
Posted by: 2slugbaits at January 19, 2011 02:13 PM
To take another part of Wally's comment, let's just suppose that the financial sector actually had a negative product in 2007 (despite having received outsized compensation) and that housing built that year was substantially overvalued. Wouldn't GDP for 2007 be overstated?
Posted by: don at January 19, 2011 03:36 PM
"The (sort of) straight line on Menzie's chart represents potential GDP. Unless you're an RBC type the inputs to potential GDP do not change dramatically from year to year."
Potential GDP is a sore subject for me: I don't think I've ever seen an even remotely acceptable way to calculate it. Certainly it is not acceptable to extrapolate from your favorite economic period, which is what most economists seem to do.
The main problem I see is twofold: run-on bubbles have distorted the US economy for about 15 years, making it difficult to get a grip on what is sustainable, and large increases in private, corporate and public debt artificially increase GDP. In my estimation, any reasonable calculation of potential GDP should be below actual GDP for much of the past 15 years. It would be really interesting to get a decent calculation, as it would be good to know whether the current GDP (minus debt increases) is still above potential GDP or not. If it is below potential GDP, a recovery "simply" needs to push the existing economy into higher gear, it if is still above potential GDP, the economy needs to change structurally for a recovery to be sustainable.
Posted by: endorendil at January 20, 2011 01:59 AM
Gee don. Next thing you know, people will be suggesting new government spending shouldn't be counted in GDP.
Posted by: aaron at January 20, 2011 03:11 AM
So, Krugman answered my question, more or less exactly, with this:
"Charles Steindel emails to remind me that he actually did a quantitative assessment [pdf link in original]. In that analysis, he asked how much our estimates of actual growth are affected if we consider the possibility that (a) what Wall Street was doing wasn’t actually productive (b) much of the housing will end up being less useful than expected (e.g. ghost towns at the edge of urban areas)."
Steindel finds the effect to be fairly small. Krugman goes on to remind us that, for one thing, Wall Street produces an intermediate input. On this point, however, I still wonder if undervalued imports could not lead to overstatment of GDP, in the sense that we might expect growth from current levels to be retarded if we expect the terms of trade to move towards the longer run equilibrium.
Posted by: don at January 20, 2011 09:27 AM