Slow Recovery of Output after the 2007−09 Financial Crisis: U.S. Shortfall Spillovers and the U.K. Productivity Puzzle

Abstract

Output in the U.S. and the U.K. recovered slowly following the 2007−09 financial crisis, even though unemployment rates returned to pre-crisis levels. To explain this mismatch, by using Okun’s law and a dynamic factor model to estimate the counterfactual recovery, we identify a change in regime in the aftermath of the financial crisis as the main determinant of the slow recovery. Additionally, by applying a trend-cycle decomposition, performed based on the difference version of Okun’s law, we distinguish between three driving forces of the slow recovery: declining trend growth began in the 1960s; unprecedented trend deceleration in U.S. potential output started during the 2007−09 financial crisis; and an unusually sluggish cyclical recovery known as hysteresis effects. Further, we develop an open-economy hierarchical dynamic factor model to demonstrate that spillovers of real activity shortfall from the U.S. explain at least half of the productivity puzzle in the U.K.

Keywords: Slow Recovery, Productivity Puzzle, Business Cycles, Trend-Cycle Decomposition, Okun’s Law, Dynamic Factor Model (DFM), Structural Break, Open-economy Macroeconomics.

JEL Classification: C32, C38, E32, E37, F41, F44, G01, O47.