Recessions and Potential Output: Disentangling Measurement Errors, Supply Shocks, and Hysteresis Effects*

AuthorJonas Dovern, Christopher Zuber
DOIhttp://doi.org/10.1111/sjoe.12385
Publication Date01 Oct 2020
Scand. J. of Economics 122(4), 1431–1466, 2020
DOI: 10.1111/sjoe.12385
Recessions and Potential Output:
Disentangling Measurement Errors, Supply
Shocks, and Hysteresis Effects*
Jonas Dovern
Friedrich-Alexander University Erlangen-N¨urnberg (FAU), DE-90403 N¨urnberg, Germany
jonas.dovern@fau.de
Christopher Zuber
Heidelberg University,DE-69115 Heidelberg, Germany
christopher.zuber@awi.uni-heidelberg.de
Abstract
This paper investigates expert revisions of potential output (PO) estimates followingrecessions.
Using data from the Organisation for Economic Co-operation and Development (OECD), we
show that downward revisions are substantial, permanent, and mostly driven by supply shocks.
In contrast, PO estimates do not significantly react to demand shocks. Revisions are also partly
caused by mismeasurement of PO before recessions. In particular, weshow that the length of the
preceding boom and pre-recession values of the current account balance and credit volumes are
correlated with post-recession PO revisions. Our results call for improvedmethods for estimating
PO and provide evidence against the existence of substantial hysteresis following demand
shocks.
Keywords: Hysteresis; OECD; output gap; potential output; trend
JEL classification:C52; E32
I. Introduction
Estimates of potential output (PO) are important for making decisions about
monetary and fiscal policy. Although PO estimates are meant to proxy the
level of economic output that is sustainable in the long run and independent
of cyclical (demand-driven) fluctuations, for many countries they have been
revised downwards in response to the Great Recession (see Benati, 2012;
Ball, 2014). This has led to renewed interest in the question of how sensitive
*We would like to thank Pia Pinger; the participants of seminars at Heidelberg University, the
University of Birmingham, and the ifo Institute; and the participants of the 13th Conference
on Real-Time Data Analysis hosted by the Banco de Espa˜na for their helpful comments. We
also thank two anonymous referees for their valuablecomments on an earlier draft of our paper.
J. Doverngratefully acknowledges financial support from the Ministry of Science, Research and
theArts of Baden-W ¨urttemberg. Part of the research was conducted while J.Dovern was affiliated
with the AlfredWeber Institute for Economics at Heidelberg University.He is also affiliated with
the CESifo research network.
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The editors of The Scandinavian Journal of Economics 2019.
1432 Recessions and potential output
PO estimates are to severe economic downturns and which factors might
help to anticipate and avoid post-recession revisions of such estimates.
Against this background, this paper addresses the following research
questions. Do recessions have permanent effects on PO estimates? What are
the reasons behind downward revisions of PO estimates in the aftermath
of recessions? To empirically investigate these questions, we use a newly
compiled dataset with real-time vintages of the Economic Outlook (EO)
provided by the Organisation for Economic Co-operation and Development
(OECD), which allows us to trace the development of revisions to the level
of PO after recessions.
Avoiding PO revisions (and policy mistakes caused by them) in the
future requires a better understanding of the underlying reasons for PO
revisions. We distinguish between four main explanations as to why PO
estimates are revised downwards following a recession. If recessions are
caused by permanent supply shocks, the revisions are a reflection of
the lower-than-previously-expected long-run output path of the economy
(explanation 1). If recessions are caused by demand shocks, revisions of PO
estimates would indicate that the analysts believe that hysteresis effects lead
to permanent output effects (explanation 2). If PO is overestimated before
a recession, subsequent revisions of PO estimates are “merely” a correction
of previous measurement errors (explanation 3). Finally, causation could run
in the opposite direction, as suggested by Blanchard et al. (2015, 2017). In
this case, declining income expectations induced by the PO revision lead
to a fall in aggregate demand and a recession (explanation 4). Note that,
in this case, PO revisions should precede recessions.
Our paper presents three main findings regarding the revision of PO
estimates. First, we document substantial post-recession revisions of the
level of PO estimates that are predictable and partly result from pre-
recession estimation errors. We also show that revisions happen very
gradually over a period of up to five years. Second, we find little evidence
that PO revisions precede recessions. Finally, supply shocks systematically
lead to PO revisions while demand shocks prove to be unimportant for
revisions of the level of PO.
We contribute to a number of strands of the literature. First, our paper
adds to the literature that investigates the reliability of PO estimates.
Starting with Orphanides and van Norden (2002) and Orphanides (2003),
the unreliability of such estimates in real time is documented in many
studies (see Orphanides et al., 2000; Camba-Mendez and Rodriguez-
Palenzuela, 2003; Marcellino and Musso, 2011; Jacobs and van Norden,
2016), with Edge and Rudd (2016) presenting more optimistic findings for
output gap estimates published by the Federal Reserve Board since the
1990s. A number of contributions suggest broadening the information set
that is used to estimate PO to obtain more stable estimates. Garratt et al.
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J. Dovern and C. Zuber 1433
(2008) show how one can use information from different data vintages
and model data revisions explicitly to obtain more reliable PO estimates.
More recently, Borio et al. (2014, 2017) suggested using information
about the financial cycle to improve estimates. Our paper expands on this
body of literature as being the first study that systematically documents
the instability of estimates of PO levels after recessions as well as the
underlying reasons.
Second, our paper relates to other studies that analyze whether
recessions or financial crises affect potential output (estimates) or the
corresponding growth rates. Based on OECD real-time data for 23
countries, Ball (2014) shows that PO estimates remain permanently below
pre-recession trends after the Great Recession of 2008–2009.1Haltmaier
(2012) (using the Hodrick–Prescott (HP) filter) and Martin et al. (2015)
(using exponential trends) use PO estimates obtained ex post by filtering
the most recent data vintage. Both papers find that PO growth decreases
permanently following recessions. Using the production function approach
to estimate PO, Furceri and Mourougane (2012) document a similar effect
for the times after financial crises for a sample of 30 OECD countries.
Finally, Benati (2012) uses a structural vector autoregressive (VAR) model
to provide evidence that PO growth slowed down after the Great Recession
in the United States (US), the euro area, and the United Kingdom. So far,
none of these papers have used comprehensive real-time data on actual
estimates of PO levels. Such real-time data are however necessary to
understand the exact timings and causes of PO revisions.
The lack of use of real-time data is also a shortcoming of the third
strand of literature to which our paper contributes. This body of literature
analyzes whether recessions or financial crises affect actual output or its
growth rate. The most notable study in this context is by Cerra and Saxena
(2008), who show that output losses following financial or currency crises
were very persistent in the period 1960–2001. Other studies, such as Papell
and Prodan (2012) and Abiad et al. (2009), confirm these findings. Based
on data for 100 financial crises over the last 150 years, Reinhart and Rogoff
(2009, 2014) broaden the view and show that financial crises have negative
impacts on a wide range of variables, such as asset prices, employment,
and government debt. Finally, a number of studies (see Hosseinkouchack
and Wolters, 2013; Blanchard et al., 2015) provide evidence that regular
recessions also tend to permanently reduce the level of output.
In a wider context, our paper is related to the literature on
macroeconomic hysteresis effects, i.e., the notion that temporary shocks,
1Using PO estimates from real-time vintages of the International Monetary Fund (IMF) World
Economic Outlook, Fat´as and Summers (2018) provide evidence that fiscal consolidations
contributed to the decline of PO during this period.
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