Impact of the financial crisis on Belgian potential output
The concepts of potential growth and the output gap are important tools, respectively, for assessing the supply- side capacity of an economy and evaluating the state of the business cycle. They have also become an essential ingredient of the European fiscal surveillance process. In this Working Paper we compare, in the context of the financial crisis, revisions of potential output for Belgium made recently by the Federal Planning Bureau and international organizations. Those comparisons aim at highlighting the uncertainty associated with those revisions as well as having a better understanding of some of the channels through which the crisis may reduce potential output.
One way of measuring the impact of the financial crisis on potential GDP is to compare estimates made before and after the onset of the crisis. Comparing potential growth estimates, as published in the FPB’s Economic Outlook for the Belgian economy in May 2008 and 2009, reveals important downward revisions as potential growth is reduced by almost 1%-point in 2009 as well as in 2010. Notably, potential growth for the years before 2009 has also been reduced, reflecting the view that the economic growth experienced during the years preceding the breaking out of the financial crisis was in fact unsustainable.
On the whole, the cumulated potential output loss is estimated at around 7%-points of GDP by 2017, compared to the pre-crisis trajectory. The output gap estimates have also been revised considerably for the past: while in 2008 business cycle conditions were considered as neutral for the years 2006-2007, they now appear to have been very favourable.
Those results are fully in line with the estimates produced for Belgium by the European Commission, which supposes, through the use of univariate time series methods, a progressive re-emergence of long-run historical patterns for capital accumulation and total factor productivity. The OECD has a different approach. Firstly, it refuses to review the past, considering that a large positive output gap before the outbreak of the crisis would be in contradiction to the absence of substantial upward pressure on core inflation. Secondly, it considers only the consequences of the shock, i.e. a reduction in the equilibrium level of the capital stock and an increase in the structural unemployment rate through hysteresis-type effects. As a matter of consequence, OECD estimates for potential growth and the output gap are very different from the ones produced by the FPB or the European Commission.
Another way of quantifying the effects of the financial crisis on potential GDP is to use model simulations. The S3BE model developed recently by the FPB is well suited for this purpose as GDP is computed as the contribution of the different production factors. Simulations with the model show that a permanent shock of 150 basis points on the risk premium combined with a shock on the structural unemployment rate as a consequence of hysteresis-type effects will lower GDP by 4.7% in the long run. The difference with the above-mentioned output loss of 7%-points can essentially be explained by the fact that, in the S3BE model, total factor productivity is exogenous and consequently not influenced by the simulated shocks while in the Economic Outlook, a slower pace of total factor productivity growth is accounted for.