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Short & Long Run Impact of the Short & Long Run Impact of the Financial Crisis on Potential Financial Crisis on Potential

OutputOutput

Seminar on Potential Growth & Fiscal Challenges

Federal Planning Bureau

(Brussels – 27 October 2009)

.

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DG ECFIN

Introductory Remarks

Why is « potential » output so important ?

Level of uncertainty needs to be stressed

Presentation tries to answer three basic questions

– 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 ?

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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)

Question 1 : What does the literature / individual country experiences tell us about past financial crises & their effects

on potential output ?

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DG ECFIN2. What do individual country experiences tell us about financial crises & growth ?

3 of the 5 « Big » Financial Shocks(Reinhart & Rogoff)

Sweden JapanFinland

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

Slope = long-term potential growth

No loss in potential output level after some time

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

Same long-term potential growth after the crisis (same slope)

Potential output level

Years

Permanent loss in potential output level

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

Lower long-term output growth after the crisis (e.g. 1.5%)(lower post-crisis slope)

Potential growth before crisis (e.g. 2%)

Years

Potential output level

Potential output loss increasing overtime

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CapitalStock

Working Age Population

Labour Force

Labour Potential Trend TFP

CHANNELS VIA WHICH POTENTIALOUTPUT WILL BE AFFECTED BY THE FINANCIAL CRISIS

COBB-DOUGLAS PRODUCTION FUNCTION

EXTRACTING THESTRUCTURAL COMPONENT

Total Factor Productivity (TFP)

Labour Supply(Employment * Hours

Worked)

Statistical Trend

MethodHP Filtered

SolowResidual

Potential Employment

Potential Output

Trend Participation

Rate

NAIRU

Trend Hours

Potential Labour Supply

LABOURCHANNELS PRODUCTIVITY CHANNELS

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Finland

-8,00

-6,00

-4,00

-2,00

0,00

2,00

4,00

6,00

8,00

1980 1985 1990 1995 2000

GDP Potential Growth

Annual % Change

-0,50

0,00

0,50

1,00

1,50

2,00

2,50

3,00

1980 1985 1990 1995 2000

Capital Accumulation TFP

% Points Contribution

-2,00

0,00

2,00

4,00

6,00

8,00

10,00

12,00

14,00

16,00

1981 1986 1991 1996 2001

NAIRU

% of Labour Force

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DG ECFINWhat 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)

0.00

0.01

0.02

0.03

0.04

0.05

0.06

0.07

0.08

0.09

0.10

0.11

1989-1990 1999-2000

Manufacturing Private Services Rest of Economy

ICT Producing

Intensive ICT Using

Rest of Manufacturing Intensive ICT Using

ICTProd-ucing

Rest of Private Services

% of Total Value Added

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Case of Finland shows clearly that it is not the amount but the efficiency of investment which counts

-0.50

0.00

0.50

1.00

1.50

2.00

2.50

3.00

1980 1985 1990 1995 2000

Capital Accumulation TFP

% Points Contribution to Potential Growth

-0.01

0.00

0.01

0.02

0.03

0.04

0.05

1980 1985 1990 1995 2000 2005

Software Computing Equipment Communications Equipment

ICT Capital (Software, Computing Equipment &

Communications Equipment)% Share of Total Capital Stock

-0.01

0.00

0.01

0.02

0.03

0.04

0.05

1980 1985 1990 1995 2000 2005

Manufacturing (D) Private Services Rest of Economy

ICT Capital in Manufacturing, Private Services & Rest of

Economy Sectors(% Share of Total Capital

Stock)

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Sweden

-3,00

-2,00

-1,00

0,00

1,00

2,00

3,00

4,00

5,00

1980 1985 1990 1995 2000

GDP Potential Growth

Annual % Change

-0,50

0,00

0,50

1,00

1,50

2,00

2,50

1980 1985 1990 1995 2000

Capital Accumulation TFP

% Points Contribution

-0,50

0,50

1,50

2,50

3,50

4,50

5,50

6,50

7,50

1981 1986 1991 1996 2001

NAIRU

% of Labour Force

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Japan

-3.00

-2.00

-1.00

0.00

1.00

2.00

3.00

4.00

5.00

6.00

7.00

8.00

1980 1985 1990 1995 2000

GDP Potential Growth

% Change

0.00

0.50

1.00

1.50

2.00

2.50

3.00

3.50

4.00

4.50

1980 1985 1990 1995 2000

Capital Accumulation NAIRU TFP

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DG ECFINWhat are the possible lessons from Finland, 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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1. PF Method : Short to Medium Term Effects(Overview of Labour, Capital & TFP contributions to Euro Area Potential

Growth)

Question 2 : How can we quantify the impact of the crisis on potential (PF Method + Model Simulations)

-0,40

0,10

0,60

1,10

1,60

2,10

2007 2008 2009 2010 2011 2012 2013

Annual % Change

-0,40

-0,20

0,00

0,20

0,40

0,60

0,80

1,00

2007 2008 2009 2010 2011 2012 2013

Labour

Capital

TFP

% Points Contribution to Euro Area Potential Growth Rate

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PF Method : Results for Belgium

-0,40

0,10

0,60

1,10

1,60

2,10

2007 2008 2009 2010 2011 2012 2013

Annual % Change

-0,20

0,00

0,20

0,40

0,60

0,80

1,00

1,20

2007 2008 2009 2010 2011 2012 2013

Labour

Capital

TFP

% Points Contribution to Belgian Potential Growth Rate

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DG ECFINFinancial 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

1.00

2.00

3.00

1984 1988 1992 1996 2000 2004 2008 2012

Actual TFP Trend TFP

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Short to Medium Term Effects on Euro Area Potential Growth RatesComparison of PF results with IMF / OECD

0.0

0.2

0.4

0.6

0.8

1.0

1.2

1.4

1.6

1.8

2.0

2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017

IMF Commission (PF Method) OECD

% Change

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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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DG ECFINQUEST III Simulations : Risk Premium Shock(Based on actual Interest Rate Spreads + A realistic monetary policy response setting)

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QUEST III Simulations : Risk Premium Shock

0

50

100

150

200

250

2009 2011 2013 2015 2017 2019 2021 2023 2025 2027

% D

ev

iati

on

fro

m B

as

elin

e L

ev

el

Risk Premium (Optimistic) Risk Premium (Pessimistic)

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QUEST III Simulations : Potential Output & Investment Effects

-6

-5

-4

-3

-2

-1

0

2009 2011 2013 2015 2017 2019 2021 2023 2025 2027

Potential Output (Optimistic) Potential Output (Pessimistic)

-30

-25

-20

-15

-10

-5

0

2009 2011 2013 2015 2017 2019 2021 2023 2025 2027Investment (Optimistic) Investment (Pessimistic)

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DG ECFINPart 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)

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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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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)