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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) 3 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 4 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 5 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 8 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 9 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 10 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 11 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 13 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 14 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 15 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 16 QUEST III Simulations : Risk Premium Shock DG ECFIN (Based on actual Interest Rate Spreads + A realistic monetary policy response setting) 17 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) 18 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) 19 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 20 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 22 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) 23