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).

DG ECFIN 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 ?

DG ECFIN 3 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 ?

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

DG ECFIN 5

6 Finland

DG ECFIN 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)

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

DG ECFIN 9 Sweden

DG ECFIN 10 Japan

DG ECFIN 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

DG ECFIN 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)

DG ECFIN 13 PF Method : Results for Belgium

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

DG ECFIN 15 Short to Medium Term Effects on Euro Area Potential Growth Rates Comparison of PF results with IMF / OECD

DG ECFIN 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

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

DG ECFIN 18 QUEST III Simulations : Risk Premium Shock

DG ECFIN 19 QUEST III Simulations : Potential Output & Investment Effects

DG ECFIN 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

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

DG ECFIN 22 A Large Agenda

DG ECFIN 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)