Short

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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) .
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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 EUs
  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
Question 1 What does the literature /
individual country experiences tell us about past
financial crises their effects on potential
output ?

• 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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2. What do individual country experiences tell us
about financial crises growth ?
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(No Transcript)
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Finland
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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)
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Case of Finland shows clearly that it is not the
amount but the efficiency of investment which
counts
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Sweden
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Japan
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What 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)
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PF Method Results for Belgium
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Financial crisis makes trend TFP estimates
particularly uncertain (CU Obsolescence
RDSector level shifts)
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Short to Medium Term Effects on Euro Area
Potential Growth RatesComparison of PF results
with IMF / OECD
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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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QUEST 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
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QUEST III Simulations Potential Output
Investment Effects
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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)
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A Large Agenda
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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)