Systematic forces , shocks and economic growth *

Systematicforces, shocks and economic growth* Leszek BalcerowiczWarsaw School of Economics December2017 *I am grateful to AleksanderŁaszek and Tomasz Dróżdż for their assistance in preparing this presentation.

Table of content: Growth trajectories, growth breakdowns (crises). The systematic growth forces vs. factors responsible for growth breakdowns. Growth mechanisms: transitional and innovation based. What causes the growth breakdownsorslowdowns? Crises under the non-market systems. Crises under the market systems. The differences in the post-crisis growth. How to explain differences in post-crisis growth? Recent European experience; the euro area. What model for the euro area?

1. Growth trajectories, growth breakdowns (crises): Spain versus Mexico • 1960-1971 Spain was growing faster than Mexico due to trade liberalization and FDI inflow • 1972-2008 the main source of divergence were economic crises in Mexico in 1982, 1986 and to lesser extend in 1995 caused by expansionary monetary policy, growing external indebtedness, peso overvaluation and poor banking supervision GDP per capita in 1990 US$ (converted at Geary Khamis PPPs) Source: The Conference Board and Groningen Growth and Development Centre, Total Economy Database, January 2009; L. Balcerowicz, A. Rzońca, „The Puzzles of Economic Growth. The Propelling Forces and the Crises: the Comparative Analysis”, 2010; World Bank, 2014

1. Growth trajectories, growth breakdowns (crises): Austria versus Switzerland • Austrian successful catching up can be explained to large extend by two periods of depressed growth in Switzerland (1974-1976 and 1991-1996). • Appreciation of Swiss franc (regarded as safety haven) during the periods of worldwide economic turbulences undermined growth of Swiss economy. Another important factor were procyclical monetary and fiscal policies in Switzerland. GDP per capita in 1990 US$ (converted at Geary Khamis PPPs) Source: The Conference Board and Groningen Growth and Development Centre, Total Economy Database, January 2009; L. Balcerowicz, A. Rzońca, „The Puzzles of Economic Growth. The Propelling Forces and the Crises: the Comparative Analysis”, 2010

1. Growth trajectories, growth breakdowns (crises): Australia versus New Zeland • In 1970 GDP/c in New Zealand was only 7% lower than in Australia. In 2008 GDP/c in New Zealand was 26% lower than in Australia. Nearly all of this difference can be attributed to two crises in New Zealand: • 1975-1980 – terms of trade shock (Oil shocks and loss of preferential access to UK market) • 1987-1992 – result of expansionary fiscal and monetary policies in previous years. 1987-1992 Second crisis in NZ * For both countries trend was fitted to before crisis observations from 1970-1974; all presented data have been smoothed with HP filter (λ=6.25) ; GDP per capita in 1990 US$ (converted at Geary Khamis PPPs) Source: The Conference Board and Groningen Growth and Development Centre, Total Economy Database, January 2009; L. Balcerowicz, A. Rzońca, „The Puzzles of Economic Growth. The Propelling Forces and the Crises: the Comparative Analysis”, 2010

2. The systematic growth forces versus factors responsible for growth breakdowns • It is analytically useful to distinguish two kinds of forces which shape the growth trajectories: • The systematic forces - by definition they operate all the time or for a long time, albeit with variable intensity. These forces are responsible for the periods of growth, stagnation or gradual decline. • Factors responsible for the growth breakdowns (crises). • Both types of forces depend on the domestic institutional systems as well as on the other factors. • Growth breakdowns result from: • Serious misallocationof resources. • Credit booms which give rise to the bust. • While crises are usually ascribed to capitalism the deepest growth breakdowns had occurredin the socialists autocracies.

(1) Domestic Institutional System Propelling institutions Stabilizing institutions Long-run economic growth (3) (2) (4) (5) Policies (8) Institutional (reforms) Fiscal, monetary policies. Direct interventions (6) External shocks (7) Other determinants of policies: - personality factors - political shocks, etc. 2. The systematic growth forces versus factors responsible for growth breakdowns

3. Growth mechanisms: transitional and innovation-based • There are two main kinds of growth mechanisms: • Situation-specific and transitional, e.g.: • Raising the employment ratio • Allowing the catching up growth of previously repressed sectors (e.g. services under the socialism) • Shifting part of the bureaucracy to more productive occupation • Innovation-based growth (including the technology transfer): the only universal and potentially lasting mechanism. The strength of this mechanism ultimately depends on the quality of propelling institutions: the property rights, the extent of competition, the scope of free (flexible) markets, the fiscal, regulatory and corruption burdens, etc.

4. What causes the growth breakdowns or slowdowns? The main factors responsible for the growth breakdowns: Persistent and pronounced decline of the working population (aging) External shocks, including the global financial shocks Wars and internal conflicts Natural disasters Weakening of the propelling institutions through various destructive reforms, e.g.: a substantial reduction of the intensity of competition (protectionism, creation of domestic monopolies), decline in the protection of private property rights, a substantial increase in the fiscal, regulatory or corruption burdens. Other domestic shocks, i.e. policy-induced shocks which happen under a given institutional system (fiscal and/ormonetary policy; direct misallocation of resources). Policy shocks Some of these shocks may jointly hit the same country, e.g. the global financial crisis plus domestic credit booms which went bust (e.g. Ireland, Spain, Britain, the Baltics) of plus the fiscal crisis (e.g. Greece).

5. Crises under non-market systems. Great Leap Forward: China 1958-1962 Source: Maddison, Statistics on World Population, GDP and Per Capita GDP, 1-2006AD

5. Growth breakdowns in quasi-socialism - most of the oil countries, e.g.: • The same fall in oil prices did not lead to GDP growth break down in other countries, e.g. Norway Source: Maddison, Statistics on World Population, GDP and Per Capita GDP, 1-2006 AD, Data smoothed with HP filter (λ=6.25).

5. Crisesunder the crony-capitalism Source: Maddison, Statistics on World Population, GDP and Per Capita GDP, 1-2006 AD, Data smoothed with HP filter (λ=6.25)

6. Crisis under the market systems • Fiscal crisis ←persistent expansion of public (social) spending (e.g. Greece) • Crises in the enclaves of socialism, e.g.: • Fannie May and Freddie Mac in the USA • „Landesbanken” in Germany • „Cajas” in Spain • Slovenia’s state banks • Financial crisis – the causes: • Proximate level: the credit boom which goes bust; • The deeper level: what is the relative role and interactions of institutions, policies and markets in producing such booms? Conventional view: financial markets and systems are inherently fragile and therefore require stabilizing policies of the state, including those of the central banks. Unconventional view (G. Selgin, L. White, Ch. Calomiris): certain government interventions and regulations tend to destabilize the market economies.

6. Growth breakdowns • Average annual output loss during sovereign crisis (external debt crises), 39 sovereign crisis episodes 1970-2000 (De Paoili et al. 2009)(average difference between output level consistent with pre-crisis trend and actual outcome during the crisis period; crisis ends when areas fall below certain threshold): • Sovereign crises only (-9.9% GDP) • Sovereign and banking crises (-20.3% GDP) • Sovereign and currency crises (-8% GDP) • Sovereign debt crisis reduces GDP on average by 10% eight years after the crisis, 154 countries from 1970 to 2008 (Furceri and Zdzienicka 2011) • Average output loss after banking crises, 56 countries 1973-1997 (Bordo &Eichengreen 2002)(difference between actual GDP level and the level consistent with precrisis growth rates ; crisis ends when GDP growth rates return to precrisis level) • Banking crises -6% GDP • Currency crises -6% GDP • Banking and currency crises -18% GDP • Banking crisis reduces GDP on average by 6% after 5 years, 14 developed countries after 1945 (Taylor and Schularick 2009)

7. Crises and economic growth Output loss during sovereign debt crisis episode (%), 1970-2000 For each episode output loss is calculated as an average difference between actual GDP growth path and precrisis trend. During the crisis. Crisis starts with default on external obligations to private creditors and ends when areas fall below certain treshold. Source De Paoli et al. 2009; Paraguay, Congo (1985) and Cameroon not shown on the graph due to large disparencies in output loss depending on the method of estimates;

7. GDP per capita 10 years after banking crisis relative to precrisis trend, 1970 - 2010 Source: AleksanderLaszek 2015

7. The differences in the post-crisis growth Methodology: GDP per capita in 1990 US$ (converted at Geary Khamis PPPs) Different types of crisis (banking, debt, terms of trade, etc.) Precrisis trend - linear trend fitted to at least 6 annual observations with the last observation before the crisis truncated see also: Growth Dynamics: V. Cerra, Ch. Saxena, The Myth of Economic Recovery, IMF 2005; A. Abiad et al. What’s the Damage? Medium-term Output Dynamics After Banking Crises, IMF 2009, Data smoothed with HP filter (λ=6.25)

7. Crises and economic growth: Chile and Mexico „(…) In 1981–82, both countries were hit by the shocks of rising world interest rates and falling international prices of the commodities that they exported — copper for Chile and petroleum for Mexico. These shocks exposed weakness in the banking systems in both countries and produced financial crises. (…)” • Chilean government: • took control of majority of banks; within three years the insolvent banks were liquidated, while the solvent ones were and reprivatized; • set up a new regulatory scheme to avoid mismanagement; new regulations allowed the market to determine interest rates and the allocation of credit • Mexican government: • nationalized the entire banking system, and banks were only reprivatized in the early 1990s. • in an effort to maintain employment and investment, the government-controlled banks provided credit at below-market interest rates to some large firms and no credit to others. The differences in economic performance in Chile and Mexico since the early 1980s have been in productivity. In Chile unproductive firms have died and workers and capital have been channeled from unproductive to productive firms. In Mexico, a poorly functioning financial system has impeded this process. Source: T.Kehoe (2009) The Current Financial Crisis: What Should We Learn from the Great Depressions of the Twentieth Century?

7. Crises and economic growth: Japan and Finland Both Japan and Finland suffered a financial crisis in the early 1990s • Japan: • kept otherwise insolvent banks running, providing credit to some firms and not others; • used massive fiscal stimulus programs to maintain employment and investment. • Finland: • restructured banking sector • let the market dictate the allocation of the credit to private sector The Finnish economy has grown spectacularly since then, while Japan has „lost a decade”. Source: T.Kehoe (2009) The Current Financial Crisis: What Should We Learn from the Great Depressions of the Twentieth Century?

7. Output loss not recuperated, the rate of growth lower than during precrisis period (log(GDP/c) on vertical axis) GDP per capita in 1990 US$ (converted at Geary Khamis PPPs) precrisis trend is fitted to at least 7 observations; last observation before the crisis is truncated Only Japan did not experienced significant negative rate of growth. In all 4 cases GDP growth rate after the crisis was lower than before. Source: , The Conference Board and Groningen Growth and Development Centre, Total Economy Database, January 2009;

7. Output loss is not recuperated, but the rate of growth returns to precrisis trend (log(GDP/c) on vertical axis) GDP per capita in 1990 US$ (converted at Geary Khamis PPPs) precrisis trend is fitted to at least 7 observations; last observation before the crisis is truncated Source: , The Conference Board and Groningen Growth and Development Centre, Total Economy Database, January 2009; see also: Growth Dynamics: V. Cerra, Ch. Saxena, The Myth of Economic Recovery, IMF 2005

7. Output loss is recuperated and the rate of growth is at least as high before the crisis Effect of the global financial crisis (log(GDP/c) on vertical axis) GDP per capita in 1990 US$ (converted at Geary Khamis PPPs) precrisis trend is fitted to at least 7 observations; last observation before the crisis is truncated Source: , The Conference Board and Groningen Growth and Development Centre, Total Economy Database, January 2009; see also: Growth Dynamics: V. Cerra, Ch. Saxena, The Myth of Economic Recovery, IMF 2005

8. How to explain differences in the post-crisis growth? • Why some growth breakdowns have lasted for so long? • Factors independent from the crisis, e.g.: has the crisis been preceded by a major technological wave which than subsided (the US in the 1920’ and during 1990-2005?) • The initial conditions (just before the crisis): • High initial level of public debt do GDP – the „debt overhang” may depress the post crisis growth – the case for radical fiscal consolidation? • The initial level of the private debt – how strong is the deleveraging process? • How distorted is the structure of output because of the previous boom, e.g. the size of the construction sector? • How rigid (or „dual”) is the labor market, e.g. Spain vs. Britain during 2008-2010? • How many situation specific growth mechanisms are „contained” in the initial conditions? • The policies during the crisis, including the crisis management: • -strengthening the systematic forces of growth („structural reforms”) or weakening them? • The crisis management: wrong in kind, proper in kind but insufficient in the dose, proper in kind but excessive in the dose? • The underlying channel – political: what are the professional and popular interpretations of the causes of the crisis? => policies • Market failures and/or previous market reforms? • Policy failures, including the lack of reforms?

9. Recent European Experience: the euro area Aggregate performance of the EU masks huge variation: 12 countries outperformedthe US, while 17 underperformed. GDP per capita change 2008 - 2017 Source: AMECO.

9. Recent European experience; the euro area Macroeconomic imbalances Measure of macroeconomic imbalances in 2007 (taking into account CAD, GG structural balance, changes in NIIP, credit growth, investment rate and saving rate) explains up to 30% of differences in post crisis economic growth after 2007. Stronger deviation from Taylor rule between 2004-2007 led to bigger imbalances in 2007 Microeconomic rigidities Countries with more rigid product market in 2008 fare worse during the crises. Fiscal policy Countries that used aggressive fiscal stimulus between 2007 and 2009 (measured by increase in cyclically adjusted public expenditure ) had worse results in 2013. Growth of public expenditure was unrelated to precrisis imbalances – it was political choice; Eurozone members were more willing to use fiscal stimuli (unlimited liquidity support from ECB was important factor); also countries with worse long term fiscal outlook were particularly willing to stimulate Change in cyclically adjusted GG expenditures can be explained by initial imbalances. Bank supervisory policy Eurozone members benefited from unlimited liquidity support, which allowed delays in restructuring of banking sector (see delays in Spain!) 25 Source: AleksanderLaszek (mimeo)

9. Fiscal policy: case of Greece Source: IMF Reports

9. Monetary policy Aggressive non-conventional monetary policy is certainly not a free lunch.It cannot substitute for properly structured fiscal and structural reforms Price to book ratios of banking sectors following past financial crises Source: Bank of England, Financial Stability Report XI 2012

10. What model for the euro area? How to mitigate private credit booms in the euro area countries? What is „fiscal” union? What is „political” union?Larger cross-country transfers or a non-bail out clause (US, Australia, Switzerland)? Can top-down fiscal monitoring substitute for market monitoring and domestic monitoring

Systematic forces , shocks and economic growth *