What Mark Will the Crisis Leave?

Bruegel Director Jean Pisani-Ferry writes about the prospects for post-crisis growth in the world economy in a column published in both the French newspaper Le Monde and the German newspaper Handelsblatt. He explains that the decrease in the labor force and the reduction of capital stock will likely lead to a much slower recovery in mature economies in Europe and the United States. The approach from Europe and the U.S. has differed thus far, Pisani-Ferry writes, but they must both act proactively to ensure a smooth recovery.

The crisis is not yet behind us but the climate of depression which had hovered over the winter is showing signs of lifting. Financial conditions have improved markedly and, even if it is very hard to know to what extent they have been implemented, recovery plans have started to have an impact. As for international trade, which plunged and had thereby caused the crisis to spread, it is now effectively the engine of the upturn. However unbearable it may seem to those who are losing their jobs, there are grounds for optimism about immediate prospects.
It is therefore time to look a little further afield and to ask what mark the crisis will leave on the years to come. Experience does not give us cause to be sanguine. Several papers, for example one very recently by the IMF, have shown that financial crises leave deep wounds. Not only does government debt balloon, not only are production losses of recession years not recouped, but output levels drop over the long term. Once the shock of the crisis and the subsequent rebound is over, output generally settles on a growth path which is parallel to what it was previously, but one notch lower.
The reasons for the slippage are numerous. First, there is the permanent sidelining of workers deprived of their jobs – sometimes encouraged by early retirement schemes – and the structural nature of the rise in unemployment. Crises disrupt whole sectors of the economy and restructuring implies longer job searches between employment and thus on average higher unemployment. Second, there is the collapse of firms and the fact that those which have survived have cut their investments, so reducing the available capital stock. Third, there is the contraction of the financial sector and the fact that someone working in this sector finding another job may have a greater social utility but will definitely have lower productivity, at least at the outset. All in all, it is not uncommon for a serious banking crisis to trigger a permanent drop in GDP of the order of five percentage points or more.
A step down of that magnitude may have a limited impact on a fast-growing economy. For an emerging country, it may often represent no more than the loss of a few months. But for the mature economies of Europe, five points amounts to a reverse of two or three years with a corresponding drop in tax revenue, a hole in the budget, inevitable belt-tightening measures, rows over who bears how much of the burden and, last but not least, the risk of a vicious circle of stagnation. The danger for Europe is that it may suffocate tomorrow under the weight of the burden left over from the crisis. .
Of course not everyone is in the same boat. Given the size and the state of the financial-services sector in the UK, the problem is more serious there than in France where the recession has been shorter and less brutal. It may very well be especially tough in Spain where growth relied on immigration and real estate. But attitudes differ. Europeans remember vividly the errors of the past. Since the middle of the 1970s essentially every shock has resulted in a deterioration of its prospects, in general without economic policy having anticipated this. This time people are swearing that they will not be caught out again and are starting to prepare for the tough times. Americans, who have never known the same trauma, have the opposite mindset. They do not believe in a permanent rise in unemployment and expect the recovery to
return economy to the same trajectory as before. In consequence, they are not readying themselves to spend as much.
Who is right and who is wrong ? The danger for the US is to underestimate the size of their problems and for Europe to be caught up in a self-fulfilling prophecy. Neither of these two stances is helpful. The US should for once relent and draw a lesson from international experience. As for Europe, rather than wallowing in self-pity, it should use its pessimism as a lever for action. Whether it is labour markets, education, the efficiency of public spending or the reconstruction of a financial system capable of supporting economic development, there is no lack of reforms to choose from if it wants to boost the growth potential of its economies.