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

1. Short & Long Run Impact of the Financial Crisis on Potential Output Seminar on Potential Growth & Fiscal Challenges Federal Planning Bureau (Brussels – 27 October 2009) .

2. 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 ?

3. 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)

4. 2. What do individual country experiences tell us about financial crises & growth ?

6. Finland

7. 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)

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

9. Sweden

10. Japan

11. 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

12. 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)

13. PF Method : Results for Belgium

14. Financial crisis makes trend TFP estimates particularly uncertain (CU; Obsolescence; R&D;Sector & level shifts)

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

16. 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

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

18. QUEST III Simulations : Risk Premium Shock

19. QUEST III Simulations : Potential Output & Investment Effects

20. 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

21. Question 3 : Is there a case for policy action? (TFP already on a pre-crisis downward trend + Financial Crisis + Ageing)

22. A Large Agenda

23. 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)