How to overcome the crisis of the European growth potential? The role of the government.

• Author: Elekes, Andrea

1. Introduction

   In Europe, the pain caused by the current crisis has been particularly acute. We suppose that the dramatic loss of the European output is more than a cyclical diversion from the potential output. There were clear signs of the European growth potential moderating for a long time. The previously latent elements began 'to come to the surface' from the mid-1990s. At the same time, the financial and economic crisis that began in 2008 has had significant impacts on the European growth potential too. The impacts of the crisis and the slow recovery on the potential output are also reviewed in our paper. These tendencies are examined in detail through the quantitative analysis. In order to test our hypothesis we perform a medium term quantitative analysis combining data based on the production function and growth accounting approach.

2. Methodology of the potential growth analysis

   Potential growth is a cumulative measure showing the sustainable and non-inflationary growth generating capacity of the economy. Growth rate of the potential output reflects the steady-state economic dynamics (growth potential). Unlike the actual growth rate it does not contain cyclical factors (2).

   The difference of the actual and the potential growth is the so called output gap, a fundamental measure of business cycles. Instruments of the economic policy strongly depend on the development of the output gap. However, it is very difficult to estimate the value of the output gap. Potential growth cannot be directly observed, while data on actual output could be updated from time to time.

   The literature about growth is mainly dominated by articles discussing actual growth trends. These trends reflect the business (and other kind of) cycles and they provide important information. However, actual growth cannot permanently differ from potential growth.

   The European growth model and the performance of its sub-models can be analysed also on the basis of potential growth. Potential growth can be analysed on the one hand based on the past development path. There is an advantage in the ex post analysis, namely that the degree of the actual output is known. At the same time, potential growth can be measured through future projections too. Methodological difficulties may occur in both cases.

   Calculation (or estimation) of potential growth creates an opportunity to separate structural development from cyclical development. There are different approaches. Potential output can be estimated by trend outputs resulting from moving averages of GDP time series and different filtering approaches. The most commonly used application is the Hodrick-Prescott (HP) filter. It is a simple and transparent method. Data with the highest frequency are utilized through the application of the filter3 *. However, there are significant problems too. The method of HP filters does not have its roots in economic theories. Its features depend on the specific value of the smoothing parameters (4).

   On the other hand, as all centered filters, they are loaded with endpoint distortions, i.e. real time trend output estimates should be based on extrapolations of GDP, possibly with subsequent revisions. Finally, similarly to other methods applied for filtering GDP series, it cannot utilize information adequately to separate cyclical and structural changes.

   An alternative to simple data filtering is based on the supply side model of the economy. Potential output is calculated in this case on the basis of a production function, which is the result of the combination of contributions of production factors and technological level. Compared with simple growth accounting, the production function based approach of potential output is consistent with the balanced utilization of the available resources (i.e.: oversupply or excess demand can be excluded).

   However, although there are clear benefits relative to the HP filter, this approach has its limits too. Its credibility depends on both the accessibility and the quality of data on the contribution of production factors. This is a great challenge, especially as regards the new member states of the EU.

   We follow the growth accounting and production function approach in order to calculate potential growth. This approach focuses mainly on the supply-side of the economy, on the quantity and quality of labour, accumulation of capital and on the total factor productivity as a driver of the output. The objective of this paper is to identify the impacts of these drivers and to decompose the growth rate of the output based on their impacts. In the production function approach potential growth can be calculated on the basis of the development of labour and capital inputs and of the total factor productivity. In order to apply the method, equilibrium rates of unemployment are required too. These are provided by the NAIRU or NAWRU approaches (5).

   Under the framework of the production function approach, the determining factors of the neoclassical growth model are taken into account. Recent growth (and development) theories emphasize also the importance of further, mainly quality factors (innovation, geographical location, institutional system, macroeconomic policy etc.). (6) The latter factors are important also in the ex post analyses. The uncertainty involved in the ex ante analyses is, however, extremely high. In the production function approach these factors have an impact through the development of the total factor productivity. (The important qualitative factors of the economic system are taken into account in an implicit way.) At the same time, it is difficult to quantify some of the factors mentioned. That is why the ex ante analyses need to be carried out very cautiously. After all these considerations, the production function approach can be applied in researches on growth and development.

   The production function and growth accounting approach has recently received increasing attention in the literature. As regards to their long term application, studies, e.g. on ageing in the European Union, are considered significant contributions to the literature (e.g.: EC, 2011, 2012; Carone et al., 2006). As an example of the short term approach and the mid-term extension of the growth accounting analysis we can mention the database of the EU EPC Output Gaps Working Group (OGWG). (For their methodology see Denis et al., 2002; Denis et al., 2006 and D'Auria et al., 2010.) The methodology of the production function approach is described in the Appendix.

3. Impact of the crisis on the potential growth

   After the outbreak of the financial and economic crisis the world economy was week for years and the growth rate was well below the pre-crisis level (7). Although the significant decrease in the prices of oil and other raw materials and the monetary expansion resulted in lower interest rates, they couldn't meet the positive growth expectations. Japan has been facing the problems of negative inflation for a long time, this time even the euro zone was forced to take steps in order to ease the pressure of negative inflation. The introduction of the quantitative easing was one of the most important steps. It had certain positive impacts as regards the deflation risk management, however, couldn't succeed in increasing inflation to the targeted level. Euro zone interest rate spreads decreased, share prices increased and the euro faced a huge level depreciation. High level of state and private sector debt played also an important role in holding back growth (8).

   OECD outlooks (OECD, 2015, 2016) forecasted even in 2016 that growth rates can't reach their pre-crisis level either on the longer term. However, a growth in the level of GDP can be seen for most of the EU countries from 2016-2017 onwards. Growth can mainly be attributed to the improving investment environment (more favourable financing costs, increasing profits and better business outlook) (9).

   The recovering growth rate had a high price: a relatively high rate of unemployment, especially as regards youth and minority groups (10). There are also several other risks that may threaten the positive growth expectations: a sudden rise in financial market volatility, increasing costs of borrowing money, higher level of international trade protectionism and geopolitical risks.

   Constant monetary adjustment and negative inflation expectations have resulted in decreasing long term bond yields in several countries. Most of the euro zone short and long term sovereign bonds e.g. have had negative yields. Long lasting low interest rates may challenge several money market players. Continuous higher risk-taking behaviour and search for greater yields may distort the evaluation of certain assets. The low interest rate environment is a challenge for the long term investors, e.g. for weaker European life insurance companies. Insurance companies must hold a significant part of their capital in liquid investment assets so as to be able to perform in case of a sudden payment need. Due to the low interest rates however, certain companies may not be able to meet the compulsory capital requirements. As (with their investments) there's a strong link between insurance sector and the other players of the financial system, a problem arising at the level of the insurance sector may spill-over to other players and other sectors.

   Technological development, more regulated markets and a change...