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