18 November 2009

Lost Income

What happens to a country's income after a financial crisis? Obviously, if there is a recession then income falls and then, if there is a recovery, it goes back up. Does it ever catch up?

The IMF answered this question in a study it published last month in its World Economic Outlook. The figure shows GDP rising at a steady rate before the crisis, falling in the recession and then rising again at the same steady rate. It doesn't show GDP returning to the old track but rising at a lower level parallel to it. That matters because we previously thought that the economy would get back on track.
This month the Bank of England included a new chart in its Inflation Report. Spot the similarity?
My first thought on this chart is how smooth the upward curve of GDP was leading up to the crisis. We talk about the trend rate of growth but here we see a chart of how consistent the trend is.

My second thought is: do we never get back to the old trend line? The IMF study only looks at the medium term (7 years), perhaps growth is higher after 7 years?

If not my next question is what happens to unemployment? The trend line is often taken to represent the economy's full potential. If GDP is below the trend then resources are idle and more people are without work. Growth at the trend rate should be enough to keep pace with an expanding labour force but not enough to absorb the pool of unemployed labour.

IMF graphic thanks to Samual Britten and the FT, BoE graphic thanks to Stephanie Flanders and the BBC.

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