More from CBO’s Update of the Budget and Economic Outlook: Persistent Effects of the Recent Recession on Potential Output

September 2, 2011

Last week CBO released its annual summer update of its budget and economic outlook. Blog postings on Wednesday and Thursday discussed two aspects of that outlook—the amount of discretionary spending that will occur over the coming decade under current law, and the estimated impact of fiscal policy on near-term economic growth. Today we’ll summarize CBO’s estimate of the persistent effects of the recent recession on potential output (the amount of output that corresponds to a high rate of use of labor and capital), which is discussed on pages 54 and 55 of the report.

The financial crisis that began in 2007 had a sharp impact on the U.S. economy, nearly freezing credit markets and pushing the economy into the most severe recession since World War II. International experience shows that downturns following financial crises tend to be more prolonged than other downturns, and the return to high employment tends to be slower. In addition, because such recessions—more so than typical recessions—raise the level and duration of unemployment, reduce the number of hours that employees work, and dampen investment, they are more likely to reduce potential output for some time.

CBO projects that the recession will have a persistent impact on the quantity of productive capital. Investment plunged during the recession because of a spike in financing costs and the decline in demand for goods and services. Although investment is currently on the rise—and CBO projects it to grow more strongly in the next few years—that rebound will probably not be enough by 2021 to offset all of the capital accumulation that was forgone during the recession and early recovery.

CBO also expects that the recession will have lingering effects on hours worked. The shortage of jobs relative to the number of job applicants has led some people to retire earlier than they might have otherwise or to leave the labor force in other ways, such as to receive disability benefits. (Applications for disability benefits tend to rise in recessions, as discussed in CBO’s reports on Losing a Job During a Recession and Social Security Disability Insurance: Participation Trends and Their Fiscal Implications.) In addition, the high level of long-term unemployment will impede the recovery because when people are out of work—especially for a protracted period—their skills and connection to the workforce tend to erode and thus they may be unable or unwilling to pursue new job opportunities intensively. CBO has incorporated those factors into its economic forecast: As a result, the levels projected for the potential labor force, potential employment, and potential hours worked through 2021 are slightly lower than CBO would have forecast in the absence of the recession, and the projected unemployment rate is higher.

The recession could also reduce the growth of potential total factor productivity (average real output per unit of combined labor and capital services) over the next five years by delaying the reallocation of resources to their most productive uses, slowing the rate at which workers gain new skills as technologies evolve, and curtailing businesses’ spending on research and development. To account for the possibility of such effects, CBO has trimmed its estimate of the growth rate of potential total factor productivity by a small amount between 2010 and 2014.

Combining estimates of the effects on capital accumulation, potential hours worked, and potential total factor productivity, CBO projects that potential output will be about 2 percent lower, on average, between 2017 and 2021 than it would have been without the financial crisis and the recession. Slightly more than half of that effect is attributable to slower capital accumulation; the rest results from the smaller labor supply and lower total factor productivity, according to CBO’s projections. Some researchers who have studied the impact of past recessions induced by financial crises report effects that large or larger, but other researchers report smaller persistent effects or none at all. Consensus does not yet exist about the magnitude of the long-term impact of financial crises.