Financial crisis and potential
output
T
he eurozone economy has faced the worst
recession on record since the 1970s. After
collapsing at the end of 2008 and in the first
quarter of 2009, GDP has gradually recovered, returning
to growth in Q3 2009. Nevertheless there is still a long
road to recovery. History suggests that recessions
caused by financial distress tend to last longer and are
particularly severe. Moreover, the 2009 recession was
also synchronized, an element which exacerbated the
fall in output.
The recession is also likely to have affected
potential output. In particular, the significant fall in
investment is likely to lead to a reduction in capital
stock, with negative effects on potential output in the
short run. Financial turbulence can also have an impact
on Total Factor Productivity (TFP), which measures
efficiency in the use of production factors. Facing
significant drops in demand and profits, firms may have
reduced investment in research and development
(R&D), one of the main drivers of TFP. Last, but not
least, the crisis may affect potential output through the
labour factor. Unemployment has already increased
significantly, notably in Spain and Ireland, two countries
hit hard by the effects of the crisis. A particular concern
is that a large part of the increase in unemployment
could be transferred into structural unemployment, as a
result of what is called the “hysteresis” effect (Blanchard
and Summers 1986). Higher structural unemployment
reduces potential output. Moreover, a long and severe
recession may reduce the labour participation rate, as
discouraged people reduce their efforts to seek a job.
The combination of all these effects has pushed
down significantly short term eurozone estimates of
potential output growth rate. It is worth noting, however,
that it was already moderating due to unfavourable
demographic trends.
March 2010
Clemente De Lucia
The rest of the article is as follows. The first section
puts the last recession into context, comparing it with
other severe financial crises experienced by other
OECD countries. Then the channels though which the
current crisis has affected potential output are analysed.
Lastly, some considerations regarding uncertainty about
potential output estimates and the implications for policy
makers are presented.
Even though the crisis has likely affected potential
output in the short run, the effects on the medium term
are more uncertain. Should the eurozone fail to
implement structural reforms to enhance product and
labour market flexibility, then the most likely medium-
term scenario is one where the growth rate of eurozone
potential output comes back to pre-crisis values, while
the level of potential output remains below.
Severity of the 2008/09 recession
Unprecedented contraction
In 2008 the eurozone economy entered a very deep
and severe recession. From the end of 2008, output fell
significantly, with GDP dropping by almost 2% q/q in
Q4 2008 and by 2.4% q/q in Q1 2009. Eurostat’s figures
showed that GDP returned to growth in the third quarter
of 2009, signalling the end of the recession. From an
historical point of view, this has been the most severe
GDP contraction experienced by the eurozone economy
since the early 1970s (see chart 1)1. The level of output
has decreased faster and more steeply than in previous
recessions and the pace of recovery seems much more
moderate. (see chart 2).
Conjoncture 3
A global financial crisis
Eurozone GDP growth (y-o-y % change)
The 2008 recession was caused by financial
6
distress. History suggests that such financial crises are
particularly acute and are associated with a very gradual 4

recovery. Financial distress is usually associated with 2

balance sheet adjustments which could lead to lower 0
domestic demand against a background of lower credit -2
growth. Vertical bars mean recessions as identified by the Euro Aera Business Cycle
-4
Chart 3 compares the 2008/2009 eurozone Dating Committee of the Centre for Economic Policy Research CEPR)

recession with other episodes of severe financial -6

71 73 75 77 79 81 83 85 87 89 91 93 95 97 99 01 03 05 07 09
distress affecting certain OECD countries2. This shows
Chart 1 Sources: ECB, Eurostat
that Eurozone GDP has contracted more sharply. The
2008/2009 recession was not only a regional financial
crisis but also a global crisis. This element clearly
exacerbated the fall in output, making the road to GDP during recession episodes
recovery longer as the economy cannot take advantage 110
1974Q3
of an external driver. 108
1980Q1
Impacts on investment, exports and imports have 106 1992Q1
104
been much more pronounced in the eurozone than in 2008Q1
102
the other countries which experienced severe financial 100
distress (see charts 4, 5, 6). As the crisis affected the 98
global economy, demand for eurozone exports 96
collapsed. Significant sharp falls in orders pushed down 94 Q= means the peak of activity prior
to the previous crisis
investment, the most cyclical component of domestic 92
90
demand and highly related to export dynamics. Q-8 Q-6 Q-4 Q-2 Q Q+2 Q+4 Q+6 Q+8 Q+10 Q+12 Q+14 Q+16
Moreover, as confidence plunged to historically low Chart 2 Sources: ECB, Eurostat, BNP Paribas calculations

levels and expectations of future activity collapsed, firms

drastically reduced their stocks with negative side
effects on output and investments. In addition, drops in
orders and income caused a significant fall in imports.
As financial markets and business cycles around the
world are much more integrated today than was the
case in previous decades, the contraction in global
activity was even more pronounced.
By contrast, the fall in private consumption was in
line with previous episodes of severe financial distress
(see chart 7). The exceptional budgetary measures
undertaken to cope with the crisis clearly favoured a
less dramatic contraction in private consumption.
Potential output
Potential output growth reflects the growth which
can be achieved using available production factors
without generating inflationary pressures. However,
potential output is not observable and can only be
estimated with some uncertainty. For this reason it is
quite often revised ex-post.
There are different methods for estimating potential
output. The most commonly used is the production
function approach, which links output to the level of
technology and factor inputs, usually labour and capital.
The commonest functional form is the “Cobb –Douglas”
production function which can be written as
1D
Y AK N
D
(1.1) t t t 1 t
where K is the capital stock, N is labour, and A
is total factor productivity (TFP), measuring the level of
technology. D is the elasticity of labour with respect to
output.
One of the advantages of using a production
function approach is that potential output forecasts can
easily be obtained as projections of input variables
(employment, unemployment, investment and therefore

March 2010 Conjoncture 4

Financial crisis and GDP: Eurozone versus five
OECD countries affected by severe financial crisis Financial crisis and imports
4
Average of 5 OECD countries (*) 10 Average of 5 OECD countries (*)
3 8
Eurozone 6 Eurozone
2
4
1 2
0
0 -2
-4
-1
-6 (*) Spain 1978-79 Finland 1989-93 Sweden 1993
-2 -8 Norway 1988 Japan 1993
(*) Spain 1978-79 Finland 1989-93 Sweden 1993
-10
-3 Norway 1988 Japan 1993
-12
-14
-4
-16
-5 -18
Q-8 Q-6 Q-4 Q-2 Q Q+2 Q+4 Q+6 Q+8 Q+10 Q+12 Q+14 Q+16 Q-8 Q-6 Q-4 Q-2 Q Q+2 Q+4 Q+6 Q+8 Q+10 Q+12 Q+14 Q+16

Chart 3 Sources: Eurostat, OECD, BNP Paribas calculations Chart 5 Sources: Eurostat, OECD, BNP Paribas calculations

Financial crisis and exports Financial crisis and investment

10 8
8 Average of 5 OECD countries (*) Average of 5 OECD countries (*)
6 6
Eurozone
4 4 Eurozone
2 2
0
-2 0
-4 -2
-6
-4
-8 (*) Spain 1978-79 Finland 1989-93 Sweden 1993
-10 (*) Spain 1978-79 Finland 1989-93 Sweden 1993 -6 Norway 1988 Japan 1993
-12 Norway 1988 Japan 1993
-8
-14
-16 -10
-18 -12
Q-8 Q-6 Q-4 Q-2 Q Q+2 Q+4 Q+6 Q+8 Q+10 Q+12 Q+14 Q+16 Q-8 Q-6 Q-4 Q-2 Q Q+2 Q+4 Q+6 Q+8 Q+10 Q+12 Q+14 Q+16
Chart 4 Sources: Eurostat, OECD, BNP Paribas calculations Chart 6 Sources: Eurostat, OECD, BNP Paribas calculations

Financial crisis and consumption

4
Average of 5 OECD countries (*)
3

2 Eurozone

-1

-2
(*) Spain 1978-79 Finland 1989-93 Sweden 1993
-3 Norway 1988 Japan 1993

-4
Q-8 Q-6 Q-4 Q-2 Q Q+2 Q+4 Q+6 Q+8 Q+10 Q+12 Q+14 Q+16

Chart 7 Sources: Eurostat, OECD, BNP Paribas calculations

March 2010 Conjoncture 5

capital stock) are normally available. Nevertheless,
Eurozone: growth accounting decomposition
there are also disadvantages. Often the production
function approach relies on trend components of input 6
TFP Capital
variables3. 5
Labour GDP
4
Growth accounting
3

Assuming perfect competition and constant returns 2

to scale, D in equation (1.1) coincides with the labour
1
wN
share in value added: D , where 0
Y 1960-70 1971-1980 1981-1990 1991-2000 2001-2007 2001-2009

wage w wY is equal to the marginal labour

Chart 8 Sources: European Commission AMECO data set, BNP Paribas calculations

wN
productivity. In this case the GDP growth rate can be
decomposed as:
'Y 'A 'K 'N
(1.2)  (1  D ) D
Y A K N
Equation (1.2) is the key tool in “growth accounting”
which analyses the contribution of supply-side factors to
GDP growth. 1  D of equation (1.2) is the capital
share in value added. In most industrialized economies
capital shares vary between 0.3% and 0.4%, while the
labour share varies between 0.6% and 0.7% (see
among others Cahn and Saint-Guilhem (2007)). After
calibrating D and knowing the growth rate of capital
§ 'A ·
and labour, the growth rate of technology ¨ ¸ is
© A ¹
derived from equation(1.2). This is what is called the
“Solow Residual”, that is the part of actual output not
explained by capital and labour developments. This is
the normal procedure for obtaining an estimate of factor
A in equation (1.1)4.
Using this decomposition, chart 8 shows that the
GDP growth slowdown over recent decades among the
largest economies of the eurozone and for the eurozone
as a whole was due to a decrease in total factor
productivity.
The contribution of capital also eased, albeit by a
smaller amount. Lastly the contribution of labour has
been always particularly weak. Since the 1990s,
however, the contribution of labour has slightly
increased. German reunification and an increase in
immigrant flows since the 1990s might have been
behind this phenomenon, particularly in Spain and to a
lesser extent in Italy and France.
The impact of demographic trends on growth
Growth accounting analysis is also useful in
understanding how demographic trends affect growth. In
particular, higher population growth rates will have a
positive impact on output. Moreover, changes in the
working age population rate, measured as the ratio of
working age population over total population, provides
information regarding the age structure of the economy.
Intuitively, the higher this ratio, the higher the proportion
of people able to work. A growing labour force will have
a positive impact on growth.
Defining y Y as GDP per capita, where
P
P means population and Y real GDP, the growth rate
of the latter can be approximated by the sum of the
population growth rate and per-capita GDP growth rate.
This can be expressed as in the following formula:
(1.3) gY | g y  g p
In addition GDP in per capita terms can be written as:
Y Wap N Y
(1.4) y ˜ ˜
P P Wap N
where Wap means “working age population” and N is
the number of employed persons. Therefore, the growth
rate of GDP per capita can be approximated as
(1.5) g y | g wap  g er  g NP
The components on the right hand side of equation (1.5)
are:
1) g wap , that is the growth rate of the ratio of
working age population (15-64 years) to total population,

March 2010 Conjoncture 6

The impact of demographic trend on GDP: Eurozone France
7 Population 7 Population
Labour productivity Labour productivity
6 6
Employment Rate Employment Rate
5 Working age Pop./Total Population 5 Working age Pop./Total Population
GDP GDP
4 4

3 3

2 2

1 1

0 0

-1 -1
1961-1970 1971-1980 1981-1990 1991-2000 2001-2007 2001-2009 1961-1970 1971-1980 1981-1990 1991-2000 2001-2007 2001-2009

Chart 9 Sources: European Commission AMECO data set, BNP Paribas calculations Chart 11 Sources: European Commission AMECO data set, BNP Paribas calculations

Germany Italy
6 Population 8 Population
Labour productivity 7 Labour productivity
5
Employment Rate 6 Employment Rate
4 Working age Pop./Total Population Working age Pop./Total Population
5
GDP GDP
3 4
3
2
2
1 1
0
0
-1
-1 -2
1961-1970 1971-1980 1981-1990 1991-2000 2001-2007 2001-2009 1961-1970 1971-1980 1981-1990 1991-2000 2001-2007 2001-2009
Chart 10 Sources: European Commission AMECO data set, BNP Paribas calculations Chart 12 Sources: European Commission AMECO data set, BNP Paribas calculations

Spain
10 Population
Labour productivity
8 Employment Rate
6 Working age Pop./Total Population
GDP
4

-2

-4
1961-1970 1971-1980 1981-1990 1991-2000 2001-2007 2001-2009
Chart 13 Sources: European Commission AMECO data set, BNP Paribas calculations

March 2010 Conjoncture 7

or what is called the “working age population rate”. This
element reflects the effect of changes in the
demographic structure on per capita GDP growth
(Benalal et all (2006));
2) g er , that is the growth rate of employed persons
in the working age population, called the “employment
rate”;
3) g NP the growth rate of the GDP-employment
ratio, which is labour productivity.
By substituting equation (1.5) into equation (1.3), it
is possible to analyse the effects of demographic
changes on real GDP growth. Chart 9 shows the results
for the eurozone.
The population growth rate has played a quite
limited role in explaining growth over the past few
decades, while labour productivity has recorded
the largest contribution to growth. However, its
contribution has been decreasing over the past few
decades.
The contribution of the employment rate has been
increasing over the last two decades. Labour market
reforms implemented over recent years have clearly
contributed to raising employment. The use of
temporary contracts and part time jobs has
been increasing constantly since the 1990s (see
EC 2009a).
By contrast, the working age population growth rate
has been rather weak and has been acting as a drag on
growth over the last decade. This is a particularly
worrying sign. It means that the age structure of the
population is not sustaining growth. This trend is likely
to strengthen in the future due to a more rapid increase
in the proportion of older persons to the total population.
Germany seems particularly exposed to this problem.
Over the last decade the contribution of the population
growth rate to GDP growth has been nil. Moreover,
Effects of the crisis on potential
output
Financial market turbulence, credit shortages and
higher unemployment have likely affected potential
output in the short run through various channels:
Effects on capital
As shown above, in the aftermath of the financial
distress, investment, one of the most cyclical
components of GDP, collapsed.
A lower level of investment can decrease the stock
of capital and its efficiency. Usually in growth theory
capital stock, K , evolves as follows:
(1.6) K t (1  G ) K t 1  I t
where G is the depreciation rate and I is the level of
investment in period t.
In 2009, eurozone investment contracted by almost
10% compared with the previous year and is likely to
remain subdued throughout 2010. The capital-to-output
ratio has increased markedly over recent quarters (see
chart 14), meaning that there is a large excess of
spare capacity in the economy, limiting the need for
further investments. Capacity utilization in the
manufacturing sector, as measured by the European
Commission, was still close to its historical low in
Q4 2009.
Capital and output ratio
1.35 Average four largest EZ countries
1.30
1.25

Germany recorded the largest drag on growth from 1.20

the working age population component among the 1.15

largest economies in the region. (see charts 10, 11, 1.10
12, 13). 1.05
To sum up, growth accounting analysis shows that 1.00
the demographic structure of the economy is weighing 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009

on eurozone growth perspectives. Chart 14 Sources: OECD, BNP Paribas calculations

March 2010 Conjoncture 8

 Higher debt funding costs and the collapse in
demand were among the main factors causing the fall in
investment. A proxy for the lower bound of banks’
funding costs is given by the sum of the CDS premium
and the 5-year German government bond yield. The
spread between the refi rate and this measure was
about 130 bp before the crisis, but is now around 325 bp
(see chart 15). This is a particularly worrying sign given
that the banking system remains by far the most
important source of funding for non-financial
corporations.
Bank funding costs
7 Refi rate
6
Proxy for the lower bound of the
5 banks’ funding costs
4 Effects on labour
3
2 Last but not least, the financial crisis may have a
1
0
05 06 07 08
Chart 15 Sources: Datastream, ECB, BNP Paribas calculations
In addition, two other factors could make conditions
even tougher: On the one hand, budgetary measures
taken by national Governments to cope with the crisis
have pushed up deficits and public debt significantly.
Concerns regarding the sustainability of country debt
dynamics could push long-term interest rates higher. On
the other hand, high levels of uncertainty lead to an
increase in risk premia, with negative effects on
investment. Higher interest rates could thus crowd out
private investment. Moreover, uncertainties about fiscal
sustainability and expectations of future fiscal tightening
may prompt consumers to increase their saving, with a
negative feedback on demand and thus again on
investment.
Lastly, the rate of depreciation is likely to have
increased, at least temporarily, as existing equipment
becomes obsolete.
Effects on TFP
The financial crisis may also have an impact on
Total Factor Productivity (TFP), which measures
efficiency in the use of production factors. Given current
circumstances, firms may have reduced investment in
research and development (R&D), one of the main
drivers of TFP and long-term growth. The postponement
of key investment in innovation may have a lasting effect
on productivity and, consequently on growth.
Protracted Government support schemes risk
delaying the restructuring process. “Zombie lending” in
Japan is a clear example where large firms benefited
from political support and were able to find funds at the
expense of smaller, innovative but vulnerable firms
(Cabaillero et al 2006).
On the other hand, financial crisis may force firms to
abandon their least productive business lines. Contrary
to what said above, this may increase the economy’s
average productivity.
significant impact on the labour factor. Eurozone
employment has been contracting since Q3 2008.
09 10 Survey data suggest that labour market conditions
continued to deteriorate in the last quarter of 2009. The
unemployment rate rose to 10% in December, the
highest rate since June 1998, and could increase further
throughout the year.
A particular concern is that a significant increase in
unemployment may be transformed into structural
unemployment, a result of the so called “hysteresis”
effect (Blanchard and Summers 1986). This occurs
because long unemployment periods may cause
destruction of human capital. The long-term unemployed
therefore no longer compete with those in jobs and
consequently do not exert downward pressure on
wages, increasing the persistence of unemployment.
Under these conditions, the structural unemployment
rate or NAIRU (non accelerating inflation rate of
unemployment), that is the unemployment rate
consistent with stable inflation, could increase. In this
case an economy can be characterized by higher
unemployment and higher inflation rates.
In addition, a protracted recession may also
discourage workers from seeking a job, reducing the
labour force participation rate. Higher structural
unemployment will weigh on the labour input 5 ,
decreasing potential output.
March 2010 Conjoncture 9
 Long-term unemployment, defined as those who Long-term unemployment and
actual unemployment in the USA
remained unemployed for more than 12 months, is a key
determinant of the hysteresis effect and it tends to rise 0.4

Change long-term UN rate

with total unemployment. Charts 16 and 17 show the 0.3

relationship between changes in long-term 0.2

unemployment and changes in actual unemployment in 0.1

the US and the eurozone. The data seem to suggest 0

that the impact is stronger in the eurozone than in the -0.1

US. This is confirmed by a simple dynamic equation -0.2

relating the two variables (Table 1). -0.3

-1.0 -0.5 0.0 0.5 1.0 1.5 2.0
(1.7) Change UN rate
n n
LUN t ¦ i 1
D i LUN t i  ¦ i 0 E iUN t i  H i Chart 16 Sources: ECB, Eurostat

LUN is the long-term unemployment rate and UN is

the actual unemployment rate. The regression analysis Long-term unemployment and
shows that the long run impact of higher actual actual unemployment in the Eurozone
unemployment on long-term unemployment is much 0.4
stronger in the eurozone than in the US. After a
Change long-term UN rate

0.3
permanent unemployment shock, as many as 60% of 0.2

the unemployed become long-term unemployed in the 0.1

0
eurozone, compared with only 16% in the United States,
-0.1
in line with the OECD's findings (2009a). This is a result
-0.2
of the United States having a much more dynamic and -0.3
flexible labour market than the eurozone. -0.4
The relationship between long-term unemployment -0.4 -0.2 0.0 0.2 0.4 0.6 0.8 1.0 1.2
Change UN rate
and NAIRU is more complex. A number of research
articles (see, for example, Llaudes (2005)) show that in Chart 17 Sources: OECD, BNP Paribas calculations

OECD countries, the long-term unemployed exert less

pressure on wages than the short-term unemployed and
that this pressure is much more moderate in Europe
than in the US. This implies that a larger part of any
increase in long-term unemployment is translated into
NAIRU in Europe than in the US. This impact may be
estimated as 0.75% in the eurozone and 0.25%
elsewhere (OECD 2009a). However, to take into
account labour market reforms implemented in Europe
over recent decades, the OECD has reduced the impact
of long-term unemployment on structural unemployment
to 0.66% (OECD 2009a). As a result, based on our
projections for the actual unemployment rate for this
year and next (the unemployment rate is a lagging
variable of activity and is expected to peak at around
10.6%-10.7% in mid 2010, then remain at that level or
slightly below for a while), the estimated increase in
long-term unemployment can be derived from equation
(1.7). Then, using the rule suggested by the OECD,
we can forecast the impact of higher long-term
unemployment on NAIRU. From around 8% in Q2 2009,
according to the latest OECD estimate (OECD 2009b),
NAIRU could increase to around 8.8% in mid 2011. By
contrast, the rise of structural unemployment is
projected to be less pronounced in the US. From 4.9%
in Q2 2009 (OECD estimates), it is expected to increase
to 5.1% at the end of 2011. Not surprisingly, both the
level of NAIRU and changes to it will be smaller in the
US than in the eurozone.
Taking into account all these factors, the estimated
potential output growth rate6 for 2009 and 2010 is in the
range of 0.6-0.7%, in line with the European
Commission Autumn forecasts (EC 2009a). This would
generate an output gap (defined as percentage of
potential output) in the range of [-3;-4] % for 2009,
around -3% in 2010, more than -2% in 2011 and more
than -1% in 2012. The European Commission output
gap estimates are broadly similar. (see Table 2). The
OECD (2009b) has slightly higher estimates for the

March 2010 Conjoncture 10

potential output growth rate in both 2009 and 2010. Impact of actual unemployment rate on long term
However, like the European Commission, the OECD unemployment
has revised down its potential output estimates. Dep. Variable long term UN
rate
Eurozone United States
Policy implications Explanatory variables 0.18
(-1.88)
-0.03
(-1.76)
Long term UN rate (-1) 1.43 1.43
Nonetheless, some caution is needed. Since (13.40) (21.80)
potential output is not observable, it is subject to Long term UN rate (-2) -0.58 -0.49
significant uncertainty. Given that the financial crisis has (-6.83) (-7.87)
affected potential output from several channels, making UN rate 0.09
an estimate is even more complicated. Nevertheless, it (3.62)
is extremely useful for policy makers. The output gap, UN rate (-1) 0.05
defined as the percentage deviation of actual output (5.00)
from potential, can be seen as: UN rate (-2) -0.04
(-3.99)
i) a measure of the degree of utilization of
production factors
ii) an indicator of the state of the business Sample 1991 Q3 1970 Q1
2009 Q1 2009 Q1
cycle R2 0.98 0.97
iii) and an indicator of inflationary pressures.
DW 2.13 2.17
Statistically, there is a clear correlation between the
output gap and core inflation (see chart 18) which Table 1 Sources: OECD, BNP Paribas calculations
provides important information regarding future moves
in key monetary policy rates. A projected large and GDP growth, potential output growth and output gap
negative output gap for the eurozone in the quarters Potential
Actual GDP Output gap
ahead will continue to exert significant downward Output
pressure on core inflation. In addition, the ongoing 2009 -4.0 0.7 -2.9
deterioration in the labour market should limit wage European 2010 0.7 0.7 -3.0
inflation, one of the biggest drivers of core inflation. As a Commission 2011 1.5 1.2 -2.5
result, taking into account the continuing weakness of 2012 n.a. 1.5 n.a.
the economy, the ECB is likely to leave the refi rate 2009 -4.0 1.2 -4.5
unchanged for an extended period of time, and at least
2010 0.9 0.9 -4.5
until the end of 2010. OECD
2011 1.7 1.0 -3.8
2012 n.a. n.a. n.a.
Core inflation and output gap 2009 -3.9 0.6 -3.5
3.0 Output gap (12-month lag) 3.0 BNP 2010 1.3 0.7 -2.8
2.0 Core Inflation (% 1-year change) 2.0 Paribas 2011 1.5 0.9 -2.2
1.0 1.0 2012 2.5 1.4 -1.1
0.0 0.0 Table 2 Sources: European Commission, OECD, BNP Paribas
-1.0 -1.0

-2.0 -2.0 Nevertheless, uncertainty about estimates of

-3.0 -3.0 potential output could cause problems for monetary
-4.0 -4.0 authorities. Higher estimates of potential output, if
1996 1998 2000 2002 2004 2006 2008 2010 proved to be wrong, risk overestimating the output gap.
Chart 18 Sources: Eurostat, BNP Paribas
As a result, monetary authorities might leave key policy

March 2010 Conjoncture 11

rates at lower levels for too long, creating upward
pressure on inflation and potentially inflating asset price
bubbles. On the other hand, lower estimates of potential
output could produce smaller output gap estimates. In
these circumstances, central banks could be tempted to
raise key policy rates too early, potentially undermining
an ongoing but still fragile recovery.
Measures of potential output are also used to derive
other indicators such as the cyclically-adjusted budget
balance, which provides information on a country’s fiscal
stance. In particular, a too small output gap estimates
will imply too high estimated structural components of
fiscal deficits. This means that countries which aim to
stabilise their fiscal positions could implemented more
painful actions than actually needed.
ˆ ˆ
ˆ
All in all, although useful for economic analysis and
for policy makers, potential output is difficult to estimate
and subject to ex-post revisions. The effects of the
global financial crisis risk exacerbating the uncertainty
surrounding measures of potential output. While it is
widely accepted that the financial crisis has affected
potential output in the short run, estimating the impact
on potential output over the medium term is
complicated.
The impact on potential output in the medium term
will depend crucially on policy factors. In particular, if the
crisis were to lead to a new “equilibrium” with higher
public debt, this would mean that sooner of later the
level of taxation has to be increased, with negative
effects on growth perspectives. Note that demographic
developments are already exerting downward pressure
on potential output. This is what is called a “continuous
widening loss” scenario (EC 2009b), where both the
level and the growth rate of potential output are below
their pre-crisis levels (see chart 19). After the 1990
crisis, Japan experienced exactly this situation where
potential output was estimated to be well below the mid-
1990s period.
Projections of potential output
Level shift
Trend
Permanent loss
14.24 Full recovery
14.14
2005 2006 2007 2008 2009 2010 2011 2012
Chart 19 Source: BNP Paribas
By contrast, the crisis could even trigger an
acceleration of structural reforms in the eurozone.
Making eurozone product and labour markets more
flexible and more open to competition could increase
growth prospects, creating the conditions for a “full
recovery”. Under this more optimistic scenario, the level
of potential output returns to its pre-crisis period.
Finland, which faced a serious banking crisis in the early
1990s, is an example of output recovering completely
from losses due to financial distress. (see EC (2009b)
for details).
Lastly there is an intermediate scenario where
potential output growth might return to the pre-crisis
rate, but not the potential output level, which will be
lower. This is what is called the “permanent level loss”
scenario. In this case, financial sector problems are
resolved, but no further actions on structural reform are
undertaken.
It is currently very uncertain which the future path of
potential output will be over the medium term.
Nevertheless, the materialisation of one scenario rather
than another will depend on what policy reforms
eurozone countries undertake over the coming years.
26 February 2010
clemente.delucia@bnpparibas.com

March 2010 Conjoncture 12

References

Benalal N. Diaz del Hoyo, J. L., Pierluigi B. Vidalis N. (2006) “Output Growth differentials across the Euro Area
Countries; Some Stylised Facts”, ECB Occasional Paper Series No. 45, May 2006

Blanchard, O. and Summers, L. (1986) “Hysteresis and the European Unemployment Problem” NBER Working
Paper Series, N. 1950

Caballero, R.J., T. Hoshi and A.K. Kashyap (2006), “Zombie lending and depressed restructuring in Japan”, NBER
Working Paper Series N. 12129

Cahn, C. and Saint-Guilhem, A. (2007) “Potential output growth in several industrialised countries: A comparison”
ECB Working Paper Series, N. 827, November

EC (2009a) “European Economic Forecasts, Autumn”, October

EC (2009b) “Impact of the current economic and financial crisis on potential output” Occasional Papers N. 49, June

ECB (2009) “The latest euro area recession in a historical context” Monthly Bulletin, November

ECB (2000) “Potential output growth and output gaps: concepts, uses and estimates”. Monthly Bulletin, October

Fagan, G. Henry, J. Mestre, R. (2001) “An Area-Wide Model (AWM) for the Euro Area” ECB Working Paper Series N.
42, January

IMF (2009a) “From Recession to Recovery: How Soon and How Strong?” Chapter 3, World Economic Outlook, April

IMF (2009 b) “Regional Economic Outlook: Europe”, October

Llaudes, R. (2005) “The Phillips Curve and Long-term Unemployment” ECB Working Paper Series, N. 441, February

OECD (2009a) “Beyond the Crisis: Medium-Term challenges relating to Potential Output, Unemployment and Fiscal
Positions”, Chapter 4, Economic Outlook N. 85

OECD (2009b) “Economic Outlook” N.86

March 2010 Conjoncture 13

NOTES

1 The Euro Area Business Cycle Dating Committee of the Centre for Economic Policy Research (CEPR) has
identified 3 recessions in the eruozone since the 1970s before the 2008/2009 recession. From peak to through the
periods are [1974Q3; 1975Q1]; [1980Q1; 1975Q1] [1992Q1; 1993Q1].
2 Five episodes of financial distress were considered: Spain (1978-79), Finland (1989-93); Sweden (1993), Norway

(1988), Japan (1993). See IMF (2009a) and or ECB (2009) for more details.
3 Statistical methods used to de-trend variables are subject to some uncertainty. Moreover these methods suffer from

end of period problems. Users normally add forecasts to the original series in order to avoid this problem. However,
this procedure adds uncertainty to the whole process (ECB 2000).
4 Once estimated the TFP as residual, the series is normally de-trended using the HP filter. To avoid end of period

problems, forecasts are normally added.

5 Potential employment is the employment level consistent with the unemployment rate being at the Nairu. It can be
P
computed as follows: Emp (1  Nairu ) LF where LF means labour force.
6 The capital series for the Eurozone has been derived starting from the Database of Fagan et all. (2001). Capital

evolves according to the equation(1.6). For investment, employment and the unemployment rate we used Eurostat
figures and BNP Paribas forecasts until the end of 2012. TFP series is derived as residual. Then the series has been
de-trended using the HP filter. To avoid end of period problems, forecasts have been added. D and G have been
parameterized as suggested by Fagan et all (2001). The production function used is a Cobb-Douglass as in
equation(1.1).

March 2010 Conjoncture 14

Economic Research Department
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