Euro area potential output growth and the credit crisis Will the potential output method be another victim of the credit crisis? Wim Suyker Head short-term international economic analysis unit CPB (Mr. Output gap at the OECD 1994-1998)
Why potential output and output gaps? Highly relevant: 1. Measure of slack in the economy. Relevant for inflation projections and for assessment budgetary stance. 2. To provide a medium-term baseline to policy makers allowing policy to have a medium-term focus. (This is the preferable policy approach) 3. Output gap is input for Taylor rule on interest rates.
Why potential output and output gaps? Downplaying its relevance at the moment: 1. Measure is highly uncertain real-time and there are other slack measures available (unemployment, capacity utilisation rate). 2. Currently short-term (old-fashioned) macroeconomic policy is highly relevant. This will not change soon. 3. Taylor rule indicates policy rates or -5% or so.
The current situation makes applying the potential output method tough This is the most severe recession since WWII. Output gaps in 2009 and 2010 are huge and highly uncertain. Consequence: it is very challenging to extend the short-term projection with a medium-term baseline (mtb). The more so as the impact of the credit crisis on potential output (growth) is highly uncertain. How to deal with this? / How will be dealt with this?
Content presentation 1. Existing medium-term baselines of IMF, OECD and European Commission. 2. Economic theory and the impact of the credit crisis on potential output growth. 3. Sounds from the blogosphere. 4. The impact of financial crises on trend output 5. My experience as Mr. Output Gap at the OECD 6. Some conclusions and questions for discussion. 7. A reasonable back-of-the-envelope mediumterm baseline for the euro area?
IMF Medium-term baseline euro area (April, 2009) 1 4 3 % 2 1 0-1 -2-3 -4 GDP Potential -5 2001 2005 2009 2013
IMF Medium-term baseline euro area (April, 2009) 2 2.5 2.0 1.5 1.0 0.5 % Potential 0.0 2001 2005 2009 2013
IMF Medium-term baseline euro area (April, 2009) 3 2 1 0-1 -2-3 -4-5 -6 Output gap 2001 2005 2009 2013
IMF Medium-term baseline euro area (April, 2009) 4 4 3 % 2 1 0-1 -2-3 -4 GDP Potential -5 2001 2005 2009 2013 2 1 0-1 -2-3 -4-5 Output gap -6 2001 2005 2009 2013 (Unfortunately, no information given on method applied) Very sharp and surprising drop in potential output growth in 2007-2010. Very low potential output growth 2011-2014: 1.0% p/annum. Output gap does not close at the end of period! Conclusion: mtb is hard to buy given lack of information and volatile potential output growth.
European Commission Spring Outlook euro area (May, 2009) 1
European Commission Spring Outlook euro area (May, 2009) 2 2.5 2.0 1.5 1.0 0.5 % Potential 0.0 2001 2005 2009
OECD short-term projection (March 2009) euro area and possible mediumterm baseline 4 3 2 1 0-1 -2-3 % -4 GDP Potential -5 2001 2008 2015 2 0-2 -4-6 -8-10 Output gap 2001 2008 2015 Source: OECD Economic Outlook, Interim Assessment, March 2009. Explicit footnote: potential output not yet revised. OECD usually closes output gap in 5 years in its mtb s. Assumption made: unchanged potential output growth from 2010 onwards Closing requires very high output growth of 3.5% p/a.
Summarising estimates international organisations IMF Eur. Com. Potential output growth 2008-2010 1 1 Output gap 2010-5 -4 OECD 2-8
Conclusions on potential, gaps and mtbs of international organisations Current medium-term baselines of IMF, EC and OECD not very attractive. IMF and EC estimates of potential (and output gap) too volatile and too cyclical. OECD medium-term baselines based on unchanged potential output growth provides implausibly high GDP growth in the medium term.
Postulates I. Cyclical potential output (growth) estimates (like the recent ones of the IMF and the EC) are useless. They do not provide guidance for the medium term. II. Very cyclical NAIRUs are even dangerous. They can lead to wrong policy advice. [NAIRU up and high >>>> Structural policy needed, while rise in the NAIRU may disappear automatically when GDP growth rebounds]
Guidance from economic theory Higher risk premium means higher costs of capital. A permanently higher cost of capital implies lower equilibrium output. So, impact on equilibrium output straightforward BUT The impact on annual potential growth depends on how quickly supply converges to its equilibrium value. Impact on potential output growth NOT straightforward
Guidance from economic theory (2) OECD estimate of higher cost of capital on equilibrium output: >>>>> -3 to -6 %. Impact on potential output growth: -0.2 to -0.3% per annum
Sounds from the blogosphere (I) Credit where credit is due: President Obama and his economic advisers seem to have steered the economy away from the abyss. But the risk that America will turn into Japan that we ll face years of deflation and stagnation seems, if anything, to be rising.
Sounds from the blogosphere (II) A likely consequence of the fiscal stimuli is a negative impact on the medium- and long-term growth potential of the global economy. Almost any increase in the tax burden will hurt potential output -just the level of the path of potential output if you are a classical growth groupie, both the level and the growth rate of the path of potential output if you are an adept of the endogenous growth school.
Trend GDP per capita: Indonesia
Trend GDP per capita: Hong Kong
Trend GDP per capita: Finland
Trend GDP per capita: Sweden
My experience as Mr. Output Gap 1994-1998 at the OECD Deep recessions lead (sooner or later) to a downward revision of potential output. Long periods of low GDP growth lead (rather late) to a downward revision of potential output.
My experience as Mr. Output Gap 1994-1998 at the OECD (2) 3.5 3.0 2.5 2.0 1.5 1.0 0.5 Potential output growth, Japan 0.0 1991 1992 1993 1994 1995 1996 1997 1998 Estimate 2001 Estimate 1996
Due to the financial crisis, there are many good reasons to expect lower potential output growth in the period 2011-2015. The good reasons: higher risk premium, more regulation, higher tax burden, greater role of the state, substantial sectoral restructuring (cars, financial sector), in recent past overestimated output growth in the financial sector.
Tentative conclusions and questions for discussion Making a medium-term baseline (mtb) is currently much more complicated. Under the current circumstances, not only supply but also demand matters for the medium term. Macroeconomic policy is also crucial (normally structural policy is key). Thus, construction of a mtb is much murkier and less of a guidance for economic policy. My forecast: mtb s will be based on a downward revision of potential output growth (including recent years) and a longer period to close the gap.
A reasonable back-of-theenvelope medium-term baseline? 2.5 2.0 1.5 1.0 % Potential 2001 2008 2015 2 1 0-1 -2-3 -4-5 -6-7 -8 Output gap 2001 2008 2015 Potential output growth of 1.5% per annum from 2008 onwards (Lowering is reasonable given negative impact of the credit crisis). Output gap in 2010: -7% (based on the OECD GDP projection). Closing the gap in 7 years instead of 5 (Reasonable). GDP growth of 1.5+1=2.5% per annum in 2011-2017.
Thanks
Annex
The impact of a drop in investment on potential output growth K = K(-1) -s K(-1) + I (equation 1) K: capital stock; I: investment; s: scrapping rate k = [Inv(-1)/K(-1)] (1+i) s (equation 2) k: change in capital stock; i: change in investment Inv(-1)/K(-1) =.07; s =.05 [Source: Ameco] A drop in investment by 10% is lowering capital stock growth from 2.3% to 1.5%. This is reducing potential output growth by around.25% (based on a capital share of 1/3).