With output some 10% lower than it would have been if pre-crisis growth rates had been maintained, it would appear that the margin of spare capacity ought to be large. But the evidence from past sharp downturns after banking crises is that they can have a significant impact on the economy’s supply potential (Chart 8). Downturns typically lead to less investment, more capital scrapping, fewer business start-ups and more business closures and a restriction in the availability of credit is likely to aggravate these effects. Moreover, lower employment can lead to skills atrophying and the long-term unemployed becoming disconnected from the labour market. Business investment has fallen sharply in this recession – down more than a quarter from its peak – though only part of that is likely to reflect a restriction in the availability of credit. Heightened uncertainty is also likely to have played a part. But against that, both business closures and, as noted earlier, unemployment have risen less than feared. So the overall impact of the downturn on the present and future supply potential of the economy is rather uncertain. In addition, in present circumstances the extent of the downward pressure on inflation from spare capacity is also uncertain. Once one allows for the effect of transient factors such as the restoration of the VAT rate, oil price movements and the likely impact of sterling’s depreciation, underlying inflation has been surprisingly resilient. That could be because the impairment of effective supply as a result of the credit crunch is large.
Peak to trough, output fell just over 6% in the United Kingdom, almost 4% in the United States, nearly 7% in Germany and more than 8% in Japan. And in the eight months following the collapse of Lehman Brothers, world trade collapsed by almost a fifth, a figure completely unmatched in peace time. Governments and central banks around the world responded by providing substantial support to their banking systems, relaxing fiscal policy, slashing official interest rates and, in some cases, introducing unorthodox monetary measures. This succeeded in avoiding the worst of the immediate downside risks to activity and employment. China and some other emerging economies have subsequently rebounded strongly, and during the second half of last year, we saw growth resume, albeit at a moderate pace, in most of the advanced economies. It appears to have taken a little longer for expansion to return here but, according to the current vintage of official data, output rose 0.3% in the final quarter of 2009. Production and trade are likely to have been adversely affected by the inclement weather in January, but business surveys suggest that a similar rate of expansion will occur in the first quarter of this year. While a return to growth is certainly good news, it is clear that we still have a very long way to go before recovery from the Great Recession of 2008–9 is complete. A large margin of underutilised resources in the economy remains and it will take time before these are returned to active use.