More explanation for divergence

The causes for the counter-intuitive income divergence between rich and poor countries has been a subject matter for a lot of research for decades.

Valerie Cerra and Sweta Saxena of the IMF add one more to the list. Their fundamental insight is to refute the conventional wisdom that after recessions economies quickly recover back to their pre-recession growth trend. Instead, they use data from 190 countries over the 1974-2012 to show that "all types of recessions - including those arising from external shocks and small domestic macroeconomic mistakes - lead to permanent losses in output and welfare". It would also explain the relatively sluggish post-crisis growth in the world economy. 

They find, 

On average, the magnitude of the persistent loss in output is about 5 percent for balance of payments crises, 10 percent for banking crises, and 15 percent for twin crises... our evidence suggests that a recovery consists only of a return of growth to its long-term expansion rate—without a high-growth rebound back to the initial trend. In other words, recessions can cause permanent economic scarring.

Since poorer countries suffer deeper and more frequent crises and recessions, with attendant permanent output losses, they continue to keep falling behind the richer countries. 

This assumes significance also in the calculation of output gaps that serve as decision-support to both determine pre-crisis overheating and post-crisis slack. We need to use the new trend output rate in both cases to be able to generate credible decision-support. 

Postscript

Ananth has a column which examines their paper in great detail. He writes,

Their simple thesis is that crises alone do not lead to permanent output loss. Even garden-variety recessions have that effect. And it is not because economic growth was unsustainably high before crises. They find that more often than not, signs of financial excess do not show up in economic growth. Second, contrary to what many think, they find that post-crisis growth always tends to belie the optimism of a swift reversal to trend. It’s not because crises result in sudden stops in technological progress or productivity improvements, for it is hard to explain why financial crises should result in such an abrupt reversal in technology and productivity-related developments. But they find that the rise in unemployment and fall in prices, after a crisis or recession, eventually leads to a cumulative shortfall in economic output that never catches up with the pre-crisis trend. In short, and in economics jargon, “demand shocks” eventually morph into “supply shocks” that permanently lower the trend rate of growth... they suggest that fiscal dynamics, post-crisis, should take into account the fact that output would never return to the pre-crisis trend, and, hence, accept that pre-crisis trends in tax revenue would be unlikely to be met... In particular, they are in favour of “more financial regulation, financial stability to be included as a consideration for monetary policy, building a larger war chest of foreign reserves, and maintaining a conservative fiscal stance during booms”... the authors bravely assert that monetary policy actions might be needed to supplement regulation and supervision. Prudential regulations may not be effective as, in practice, they can be sidestepped by misclassifying loans, for example. Further, in a world of international capital flows and shadow banking, there are questions over the full effectiveness of prudential regulations in isolation. For example, asset management companies and hedge funds provide credit through specially structured products that circumvent banking regulations.