Three ways

Scenarios for post–crisis economic growth

Gross domestic product (GDP) seems to have stabilized after its off–the–cliff experience between Q4 2007 and Q4 2009 where it saw a gigantic cumulative fall of just over 25%, see figure below. Q3 2010 figures are due very soon and are likely to show a small increase year–on–year indicating that the recession – but not the hangover – may be over.

GDP in constant prices, 2004 = 100, seasonally adjusted data:

Source: Central Statistical Bureau

But what about future growth? What can we expect? IMF working paper may cast some light on that issue and it does not provide all that optimistic reading – but it indirectly provides some lessons and that is not too bad.

In the figure below I have tried to employ my rather inferior drawing ability to sketch Latvia’s GDP development before the crisis and some post-crisis scenarios.

During the boom, 2004 – 2007, GDP grew at sometimes double-digits leading to a massive overheating of the labour market with actual growth (the ‘Actual GDP’ line) being above trend growth/outpacing potential growth. 2008 and in particular 2009 saw massive declines in GDP and the three scenarios, A, B and C suggest different recovery paths to be discussed below.

A is obviously the too–good–to believe scenario that would see swift catching–up to pre–crisis GDP via growth rates even higher than in the boom days. If you believe that scenario, please go and see a shrink…

B is more interesting – it suggests a return to a growth rate equal to the trend growth rate of the past, which at first seems very plausible but this is where the IMF research based on the experience of many countries that have suffered recessions suggests otherwise, instead arguing that the trend growth rate may be permanently lowered (a structural break as the econometricians would say) and that scenario C is thus more likely.

This is not the place for a long theoretical discussion of this so allow me just a couple of points that could suggest the plausibility of scenario C:
– A lot of business investment during the boom was in real estate (office space, apartments etc.) – this certainly added to GDP at the time but to the extent that these offices and apartments remain empty it won’t add to capital and thus not to future GDP. The third ''Panorama Plaza'' tower is a good example: The partial construction of it was an addition to GDP but the productive capacity of that skeleton is nil;
– Emigration as a result of the crisis is lost labour force that cannot contribute to future GDP.

Does this matter? Yes – let’s say that the economy’s trend growth rate is reduced to a still respectable 4%, then catching up to GDP of Q4 2007 will take another 7,4 years. Add to that the two plus years of recession and you have a lost decade. And such low growth may not reduce unemployment significantly fast, thus leading to further migration and a worsening of the problem.

Lesson? The powers that be must work even more eagerly to raise the trend growth rate of the economy through structural reforms – education, training, infrastructure, public sector efficiency and what have you. Yes; same old, same old you may say – but this little piece of analysis is yet another strong reason for why it is so important.

Morten Hansen is Head of Economics department, Stockholm School of Economics in Riga