Transcript ETUI SEMINAR, Brussels 12.06.2001

Short & Long Run Impact of the
Financial Crisis on Potential
Output
Seminar on Potential Growth & Fiscal Challenges
Federal Planning Bureau
(Brussels – 27 October 2009)
.
1
Introductory Remarks

Why is « potential » output so important ?

Level of uncertainty needs to be stressed

Presentation tries to answer three basic
questions
DG ECFIN
– I. What does the literature / individual country experiences tell us about past
financial crises & their effects on potential output ?
– 2. In terms of quantifying the impact of the present crisis on potential, what
can the EU’s agreed Production Function methodology and model
simulations tell us about the short, medium & long term effects of the crisis
?
– 3. Given the expectation that the crisis will have negative potential output
level, & possibly growth rate, effects -what should be the role of policy in
counteracting these effects ?
2
DG ECFIN
Question 1 : What does the literature / individual country
experiences tell us about past financial crises & their effects
on potential output ?
1. Short Overview of Literature

Cerra and Saxena – American Economic Review (2008)

Haugh, Ollivaud & Turner – OECD Working Paper (2009)

Furceri & Mourougane (2009) – OECD Working Paper (2009)

Reinhart & Rogoff – American Economic Review (2009 –
Forthcoming)

Cecchetti, Kohler & Upper (2009) – (Jackson Hole
Symposium)
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DG ECFIN
2. What do individual country experiences tell us about financial crises & growth ?
Financial Crisis & Potential Output : Three possible cases
Case n°1: A "full recovery" scenario
Loss in potential output level entirely recouped after some time
Potential output level
No loss in potential
output level after
some time
Slope = long-term potential growth
3 of the 5 « Big » Financial Shocks
(Reinhart & Rogoff)
Years
Case n°2: Permanent loss in potential output level
No change in potential growth in the long run but permanent shift in potential output level
Potential output level
Permanent loss in
potential output level
Same long-term potential growth after the crisis (same slope)
Finland
Sweden
Japan
Years
Case n°3: Permanent loss in potential output growth in the long run
Potential output loss in level increases over time compared with the pre-crisis regime
Potential output level
Potential growth before crisis (e.g. 2%)
Potential output loss
increasing overtime
Lower long-term output growth after the crisis (e.g. 1.5%)(lower post-crisis slope)
Years
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DG ECFIN
CHANNELS VIA WHICH POTENTIAL
OUTPUT WILL BE AFFECTED BY THE FINANCIAL CRISIS
COBB-DOUGLAS PRODUCTION FUNCTION
LABOUR
CHANNELS
Labour Supply
(Employment * Hours
Worked)
PRODUCTIVITY CHANNELS
Total Factor
Productivity (TFP)
Capital
Stock
EXTRACTING THE
STRUCTURAL COMPONENT
Labour Potential
Trend TFP
Working Age Population
Trend
Participation
Rate
Labour Force
NAIRU
Statistical
Trend
Method
HP Filtered
Solow
Residual
Potential Employment
Trend Hours
Potential Labour Supply
Potential Output
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DG ECFIN
Finland
8,00
Annual % Change
% of Labour Force
% Points Contribution
3,00
16,00
14,00
6,00
2,50
12,00
4,00
2,00
10,00
2,00
1,50
8,00
0,00
1980
1985
1990
1995
2000
6,00
1,00
-2,00
4,00
0,50
-4,00
2,00
0,00
0,00
-6,00
1981
1986
1991
-2,00
-8,00
GDP
Potential Growth
1996
1980
2001
1985
1990
1995
2000
-0,50
NAIRU
Capital Accumulation
TFP
6
DG ECFIN
What matters for TFP is innovation (ICT Technology Shock) + Restructuring
(EU KLEMS : Structural change in Finland over the 1990's :
Industry shares in total value added in 1999/2000 compared with 1989/1990)
7
DG ECFIN
Case of Finland shows clearly that it is not the amount but the
efficiency of investment which counts
3.00
0.05
% Points Contribution to
Potential Growth
2.50
0.05
ICT Capital
(Software, Computing Equipment &
Communications Equipment)
% Share of Total Capital Stock
0.04
2.00
0.03
ICT Capital in Manufacturing,
Private Services & Rest of
Economy Sectors
(% Share of Total Capital
Stock)
0.04
0.03
1.50
0.02
0.02
0.01
0.01
0.00
0.00
1.00
0.50
0.00
1980
1985
1990
1995
1980
2000
-0.50
1985
1990
1995
2000
TFP
1985
1990
1995
2000
2005
-0.01
-0.01
Capital Accumulation
1980
2005
Software
Computing Equipment
Communications Equipment
Manufacturing (D)
Private Services
Rest of Economy
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DG ECFIN
Sweden
5,00
Annual % Change
% Points Contribution
% of Labour Force
2,50
7,50
4,00
6,50
3,00
2,00
5,50
1,50
2,00
4,50
1,00
3,50
1,00
2,50
0,00
1980
1985
1990
1995
0,50
2000
1,50
-1,00
0,00
0,50
-2,00
-0,50
-3,00
GDP
Potential Growth
1980
1981
1986
1991
NAIRU
1996
2001
1985
1990
1995
2000
-0,50
Capital Accumulation
TFP
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DG ECFIN
Japan
% Change
8.00
4.50
7.00
4.00
6.00
3.50
5.00
3.00
4.00
2.50
3.00
2.00
2.00
1.00
1.50
0.00
1.00
-1.00
1980
1985
1990
1995
-2.00
2000
0.50
0.00
1980
-3.00
GDP
Potential Growth
1985
1990
1995
Capital Accumulation
NAIRU
2000
TFP
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What are the possible lessons from Finland,DG ECFIN
Sweden & Japan ?

Financial crises have the capacity to result in either
temporary (Fin, SW) or more longer lasting declines
in potential growth (Japan)

Finland & Sweden : recovery was shaped by the TFP
enhancing restructuring & innovation policies
pursued by both governments

Japan : highlights the dangers of allowing banking
problems to persist & of avoiding essential
restructuring
 Efficient allocation of capital impaired
 Weak pattern of tangible & intangible investments
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DG ECFIN
Question 2 : How can we quantify the impact of the crisis on
potential (PF Method + Model Simulations)
1. PF Method : Short to Medium Term Effects
(Overview of Labour, Capital & TFP contributions to Euro Area Potential
Growth)
Annual % Change
1,00
2,10
% Points Contribution to Euro Area Potential Growth Rate
Capital
0,80
TFP
1,60
0,60
1,10
0,40
0,20
0,60
0,00
2007
2008
2009
2010
2011
2012
2013
0,10
-0,20
2007
-0,40
2008
2009
2010
2011
2012
2013
Labour
-0,40
12
DG ECFIN
PF Method : Results for Belgium
% Points Contribution to Belgian Potential Growth Rate
Annual % Change
1,20
2,10
Capital
1,00
1,60
0,80
TFP
1,10
0,60
0,40
0,60
0,20
0,10
0,00
2007
2008
2009
2010
2011
2012
2007
2013
2008
2009
2010
2011
2012
2013
Labour
-0,20
-0,40
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DG ECFIN
Financial crisis makes trend TFP estimates
particularly uncertain
(CU; Obsolescence; R&D;Sector & level shifts)
Euro Area : Actual + Trend TFP
3.00
2.00
1.00
0.00
1984
1988
1992
1996
2000
2004
2008
2012
-1.00
-2.00
-3.00
Actual TFP
Trend TFP
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DG ECFIN
Short to Medium Term Effects on Euro Area Potential Growth Rates
Comparison of PF results with IMF / OECD
% Change
2.0
1.8
1.6
1.4
1.2
1.0
0.8
0.6
0.4
0.2
0.0
2006
2007
2008
IMF
2009
2010
2011
2012
2013
Commission (PF Method)
2014
2015
2016
2017
OECD
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DG ECFIN
2. Medium to Long Run Model Simulations

Overall Objective : To assess the likelihood & extent of
permanent level & growth rate effects from the crisis

Method adopted
– Disruptions in financial markets
– Shifts in attitudes towards risk
– « Risk Premium » shock
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QUEST III Simulations : Risk Premium Shock
DG ECFIN
(Based on actual Interest Rate Spreads + A realistic monetary policy response setting)
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DG ECFIN
QUEST III Simulations : Risk Premium Shock
% Deviation from Baseline Level
250
200
150
100
50
0
2009
2011
2013
2015
2017
Risk Premium (Optimistic)
2019
2021
2023
2025
2027
Risk Premium (Pessimistic)
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DG ECFIN
QUEST III Simulations :
Potential Output & Investment Effects
0
0
-1
-5
-2
-10
-3
-15
-4
-20
-5
-25
-6
-30
2009 2011 2013 2015 2017 2019 2021 2023 2025 2027
Potential Output (Optimistic)
Potential Output (Pessimistic)
2009 2011 2013 2015 2017 2019 2021 2023 2025 2027
Investment (Optimistic)
Investment (Pessimistic)
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DG ECFIN
Part 2 of Presentation : What conclusions should we draw from
quantifying the effects ?
Short Run (2009 / 2010) : Consensus that the crisis will have a large negative
impact on potential (PF / OECD / IMF)
Medium run : Since PF method is simply based on an extrapolation of past
trends, the slow recovery process highlighted by the OECD & IMF seems more
plausible
Medium to Long Run Model Simulation Results
Optimistic scenario (Long run level & growth rate effects are small but both
negative)
Pessimistic scenario (Long run effects are substantial)
Balanced “no policy change” view : “Permanent level loss” + strong risk of
a small negative effect on potential growth rates
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Question 3 : Is there a case for policy action?
(TFP already on a pre-crisis downward trend + Financial
Crisis + Ageing)
DG ECFIN
21
DG ECFIN
A Large Agenda
Key Issues (EU 2020)
1.Sort out the
problems in financial
markets
2. Support essential
restructuring &
adaptation of
business models
(« Rescue » /
« Mitigation »
policies ?)
3. Labour market
policies
(Focus on easing
labour market
transitions &
reducing
structural
unemployment)
4. Sustaining
investments in
physical &
intangible capital +
promoting
innovation
(Environmental
technology shock ?)
5. Avoiding the policy mistakes of past crises
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DG ECFIN
Overall Conclusions

Past Crises : Literature review / country experiences
– Financial Crises lead to prolonged, even permanent reductions in the level of
potential output – more uncertainty surrounding potential growth rate effects
– Cases of Finland & Sweden highlight the importance of TFP enhancing
restructuring & innovation policies as part of an effective crisis recovery
strategy

Quantitative estimates of the long run (no policy change) impact
of the present crisis
– Significant risk of a permanent loss in potential output levels as a result of the
crisis
– Long run potential growth rates are also likely to be negatively effected but
the effect is likely to be small

Uncertainty - close monitoring of potential output developments
– Financial market conditions (availability / cost of capital)
– Labour market
– TFP

Policy response
– 5 broad strands of action – « EU 2020)
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