Potential output in the post-crisis period

Prepared by Malin Andersson, Bela Szörfi, Máté Tóth and Nico Zorell

Published as part of the ECB Economic Bulletin, Issue 7/2018.

Potential output is typically seen by economic analysts as the highest level of economic activity that can be sustained over the long term. Changes in potential output can be driven by factors such as labour supply, capital investment and technological innovation. Recent estimates by international institutions suggest that the euro area economy is currently operating close to its potential. The ongoing economic expansion appears to have largely absorbed the spare capacity created by the global financial crisis and the sovereign debt crisis. At the same time, the estimated rate of potential output growth also appears to have recovered most of its pre-crisis momentum, underpinned mainly by an expansion of the labour force, a decline in trend unemployment and stronger productivity gains. Looking ahead, projections by international institutions suggest that actual euro area GDP growth will continue to outpace potential growth in the near term. Hence, supply constraints are likely to become increasingly binding going forward, which would be conducive to a gradual strengthening of euro area inflation.

1 Introduction

Potential output is a key economic concept as its evolution determines how fast an economy can grow in a sustainable way. It is typically thought of as the highest level of economic activity that can be sustained by means of the available technology and factors of production, in particular labour and capital, without creating inflationary pressure. Institutions that facilitate and encourage innovation, factor accumulation and an efficient allocation of resources are particularly conducive to faster growth in potential output. Therefore, sound structural policies play a key role in promoting sustainable growth.

For central banks, potential output estimates can support the analysis of the state of the business cycle and the implications for the dynamics of wages and prices. If economic activity exceeds the level of potential output, the increased factor utilisation will typically put upward pressure on factor costs and ultimately on consumer prices. Similarly, such price pressures tend to recede if economic activity falls below the level of potential output. The output gap, defined as the percentage deviation of the actual level of output (i.e. real GDP) from the potential level, is therefore often regarded as an indicator of the state of the business cycle and possible inflationary pressures. Potential output estimates also provide a basis for adjusting government budget balances for the effects of the business cycle and are included in analyses of the long-term sustainability of public debt. Moreover, they are also used to gauge the impact of structural reforms.

As potential output is unobservable, it can only be estimated with uncertainty. There are various methods for estimating potential output on the basis of observed data. However, regardless of the method used, such estimates are subject to considerable uncertainty and often revised heavily over time. Therefore, they need to be treated with caution.

Against this backdrop, this article sheds some light on developments in euro area potential output in the post-crisis period. Section 2 discusses the concept of potential output and its measurement. Section 3 examines recent developments in potential output, while Sections 4 and 5 take a closer look at the main driving factors. Section 6 presents the main policy conclusions.

2 The concept of potential output and its measurement

2.1 Definition and determinants

Potential output is typically defined as the highest level of economic activity that can be sustained by means of the available technology and factors of production without creating inflationary pressure.^[1] Attempts to exceed this level of production will lead to rising levels of factor utilisation, thereby putting upward pressure on factor costs and ultimately on consumer price inflation. Starting from a neutral position in the economic cycle, a sustainable, non-inflationary increase in output needs to be underpinned by an expansion of potential output.

It is important to distinguish between the level and the rate of growth of potential output. If the level of potential output exceeds actual output, a negative output gap emerges. In such circumstances, the closing of a negative output gap would require actual growth to exceed potential growth for a period of time.

Potential output is usually thought to be determined by supply-side factors, highlighting the importance of sound structural policies for sustainable long-term growth. The supply-side determinants include the state of technology and the available factors of production, most notably labour and capital. At a more fundamental level, the long-term capacity of an economy to produce is shaped by its institutional framework, including the structure of property rights, regulations and the judicial and educational systems. Economies with institutions that facilitate and encourage innovation, factor accumulation and an efficient allocation of resources can be expected to record faster growth in the long run.^[2] Indeed, according to Eurosystem estimates, the implementation of best institutional practices in euro area countries could significantly boost their potential growth rates.^[3]

The global financial crisis has led to suggestions that demand-side factors might also have very persistent or even permanent impacts on output.^[4] According to the “hysteresis” hypothesis, demand shortfalls can perpetuate themselves by adversely affecting the supply potential of the economy and thereby lowering the level of potential output or even its longer-term growth rate. For instance, a demand-led recession may discourage workers from searching for jobs or lead to the erosion of their skills. Firms may refrain from undertaking investment decisions or cut their innovation budgets, which would lower the level of production that can be sustained without stoking (dis-)inflationary pressure. According to this view, countercyclical policies could reduce the risks of hysteresis in times of crisis or reverse its effects ex post, with lasting positive impacts on output.^[5] Whether the hysteresis hypothesis is valid is ultimately an empirical question and may also vary across economies and over time.

2.2 Measurement

Since potential output cannot be observed directly, it has to be estimated. Simple statistical methodologies (“univariate filters”) – such as the Hodrick-Prescott (HP) filter – derive potential output by smoothing out fluctuations in actual output. They mechanically split the observed output series into a trend component and a cyclical component. More sophisticated statistical approaches (“multivariate filters”) also use information from other economic indicators, such as inflation, to disentangle the trend from the cycle. Another common approach, which is employed by the European Commission and the Organisation for Economic Co-operation and Development (OECD), is based on a macroeconomic production function, i.e. a simple model of the supply side of the economy relating potential output to the trend components of productivity and the available factor inputs (usually labour and capital).^[6] Hybrid methods combine useful elements from both the statistical approach and the production function approach (see Box 1). Other approaches are based on more complex structural economic models.^[7] Importantly, all these methods for measuring potential output have their limitations. Therefore, the analysis below will draw on a broad range of estimates based on alternative methodologies.

Regardless of the method used, estimates of potential output are subject to considerable uncertainty. The choice of a specific statistical or economic model always implies judgement and introduces uncertainty. Since models are simplifications of reality, not all information that is possibly relevant for estimating potential output can be processed. In addition, owing to the typically stochastic nature of these models, a degree of uncertainty inherently stems from the characteristics of their shocks. The uncertainty also relates to the parameters of such models which can only be estimated with imprecision. Moreover, the data – both historical and projected – which are used to estimate the models are subject to revisions. Such modifications can result in significant revisions to the estimated path of potential output. Overall, owing to these different types of uncertainty, any point estimate of the output gap has to be treated with a significant degree of caution.

3 Recent developments in potential output

This section analyses recent developments in potential output in the euro area. It focuses on the post-crisis period (2014‑18), but also briefly revisits the crisis years (2008‑13) and the pre-crisis period (1999‑2007).^[8] The analysis is based on a broad range of estimates by the European Commission, the International Monetary Fund (IMF) and the OECD, along with estimates based on the model presented in Box 1.

Potential growth in the euro area is estimated to have increased over recent years, although it is still weaker than before the global financial crisis. Prior to the crisis, potential growth was judged to be on a secular downward trend (see Chart 1). Between 1999 and 2007, the estimated rate of potential growth gradually declined from around 2.3% to around 1.7%. The outbreak of the global financial crisis seems to have led to a further decline in potential growth to below 1.0%. However, available estimates indicate that potential output recovered in the post-crisis period, reaching growth rates close to 1.5%. Hence, the latest estimates for euro area potential growth are well above those for the crisis years, albeit still below those for the pre-crisis period. All these estimates are subject to considerable uncertainty, as indicated by the shaded bands in Chart 1. At the same time, they all point to an inverted J-shaped path for euro area potential growth in the period between 1999 and 2017. Moreover, estimates of the euro area aggregate mask significant heterogeneity across individual euro area countries.

The level of euro area potential output remains well below the path implied by the pre-crisis trends. This can be illustrated with a simple linear projection in which it is assumed that from 2007 onwards potential output steadily increased at the pace recorded in that year. The European Commission’s latest estimate of potential output in 2017 is around 10% below the level implied by the linear projection (see Chart 2). However, caution is warranted when using such gaps as a proxy for the impact of the crisis. Real-time estimates of potential output are often subject to substantial revisions, especially in times of crisis. In fact, the potential output estimates for the euro area were widely revised downwards following the onset of the global financial crisis, before these revisions went into reverse more recently.

The available estimates imply that the euro area economy is currently operating close to its potential. Following the eruption of the global financial crisis, actual output – i.e. real GDP – declined precipitously. At the same time, potential output apparently continued to increase, albeit at a slower pace than before the crisis. As a result, a negative output gap opened up, signalling slack in the euro area economy (see Chart 3).^[9] During the economic recovery, GDP growth consistently exceeded available estimates of potential growth. Consequently, the negative output gap gradually declined and now seems to be close to zero. Supply constraints are likely to become increasingly binding going forward, which would be conducive to a gradual strengthening of wage growth and underlying inflation.

The similarity in estimates by international institutions understates the uncertainty surrounding the current output gap in the euro area. In particular, it has been argued that economic slack might still be larger than indicated by the consensus view of international institutions. This argument is often based on the observation that the underlying potential growth estimates and their revisions tend to co-move with economic activity.^[10] This procyclicality could partly be a statistical artefact due to methodological issues, such as the well-known end-point problem of filtering procedures. There may therefore be reason to believe that the degree of economic slack in the euro area over recent years has been larger than indicated by the estimates of international institutions.^[11] This could also help explain the relatively muted dynamics of underlying inflation over this period. However, the procyclicality of potential growth and output gap estimates may also stem from hysteresis, the downward rigidity of prices and wages, and other effects that pull down potential growth during economic downturns and gradually wane during upturns (see Section 2.1).

4 Dissecting recent developments in potential output

In an accounting sense, potential output is determined by the trend components of the factors of production – capital and labour – and total factor productivity (TFP). A macroeconomic production function can be used to decompose potential growth into the contributions from labour, capital and TFP (see Section 2.2). TFP captures the overall efficiency of the use of the factors of production and its evolution is therefore often seen as a rough indication of technological progress. In practice, TFP is not directly observable and is typically calculated as a residual term in a growth accounting exercise. Thus it cannot be considered a pure measure of productivity.

Both the decline in potential growth during the crisis and its subsequent recovery were largely driven by the contributions of capital and labour. Both contributions declined during the crisis, before recovering in the post-crisis period (see Chart 4). The latest estimates for 2017 indicate that the contributions of labour and TFP to potential growth are broadly in line with those in 2007. However, the contribution of capital is still weaker than before the crisis, explaining why potential growth has not yet fully recovered. The downward trend in potential growth in the pre-crisis period mainly reflected a secular decline in TFP growth.^[12]

While the inverted J-shaped path of potential growth found in the euro area has also been observed in other major advanced economies, there are notable cross-country differences in the underlying driving forces. Box 2 illustrates this for the United States and Japan. Moreover, from a long-term perspective, potential growth in the euro area has fallen short of that in other major advanced economies, in particular the United States.

5 A closer look at the factors driving potential output

This section takes a closer look at some of the underlying factors driving recent developments in potential output in the euro area. In particular, it seeks to answer the question of why the contributions of labour and TFP to potential growth have broadly returned to their pre-crisis levels, while the capital contribution remains subdued. The section concludes by looking at the longer-term outlook for potential growth.

5.1 Labour

The contribution of labour to potential growth can be traced back to trends in the labour force, the unemployment rate and hours worked per employee. The labour force includes all those in work or seeking work. Changes in the labour force, in turn, can be decomposed into changes in the working age population (15‑74 years of age) and the labour force participation rate (i.e. the percentage of the working age population participating in the labour force).

The enlargement of the working age population on account of immigration has supported potential growth over recent years. Following a contraction between 2009 and 2015, the working age population has been increasing over recent years. These developments reflect two countervailing forces (see Chart 5). On the one hand, “natural” population growth has been negative for some time now, since the “baby-boomer” generation is reaching retirement age and fertility rates are low. On the other hand, there has been a net inflow of people of working age, in particular from other EU Member States.^[17]

Labour force participation has continued to increase during the recovery, underpinned by increased participation of the older generations and women.^[18] While the euro area labour force is ageing, more people are remaining economically active later in life. In line with this longer-term trend, the participation rate of those aged 55 to 74 has continued to increase during the recovery. This reflects increases in the pension age in many euro area countries, as well as other factors, most notably rising education levels. In addition, the labour force participation of women has continued to increase, which is also partly due to rising education levels.^[19] All these structural changes have contributed to a steady increase in the participation rate over recent years (see Chart 6). Coupled with a growing working age population, this trend has led to an expansion of the labour force during the ongoing economic recovery. However, the rate of growth of the labour force still remains below that recorded in the pre-crisis period.

A decline in the trend unemployment rate is estimated to be another important driver of the post-crisis recovery in potential growth. The trend unemployment rate broadly corresponds to the unemployment rate that is consistent with non-accelerating wage (or price) inflation.^[20] Available estimates overall suggest that the trend unemployment rate in the euro area increased in the crisis period, partly due to hysteresis effects, before declining to around 8.0‑9.5% more recently (see Chart 7). To some extent, these developments reflect transitory factors. Since wages tend to adjust slowly to shocks, the macroeconomic adjustment partly operates through persistent changes in the unemployment rate. However, the post-crisis decline in the estimated trend unemployment rate is also likely to be driven by structural factors, most notably the labour market reforms undertaken in some euro area countries.

Hours worked per employee have continued to decline over recent years, although there are some signs of stabilisation.^[21] The longer-term downward trend in average hours worked per employee mainly reflects secular changes in the composition of euro area employment. Most importantly, the shares of part-time workers and the services sector (where hours worked are typically lower than in other sectors) in overall employment have increased over the past decade.

5.2 Capital

The capital stock is another essential determinant of potential output, but data are not easy to obtain. The gross capital stock is the physical capital available in the private and public sectors of the economy for production processes.^[22] The true potential capital stock is not directly measurable but can be calculated using the “perpetual inventory” method. The current net capital stock is then derived from the past capital stock, subtracting depreciation and adding new investment. Such capital stock data come with a long publication lag.^[23] The real capital stock also depends on price trends of capital goods. These trends could be very different from those of intermediate and consumer goods. Over the past two decades, the investment deflator – and in particular the quality-adjusted prices of information and communications technology (ICT) goods – has been less dynamic than the overall value added deflator, which has supported the capital-output ratio in real terms.^[24]

The rising share of intangible investment increases capital consumption and poses challenges to measuring the capital stock. The capital stock in the construction sector generally depreciates very slowly, while the business sector capital stock, particularly intangibles, depreciates much faster.^[25] Aggregate depreciation rates are likely to increase gradually as countries’ income levels rise, assuming that the share of assets with shorter lifespans (such as intangible assets) grows in economically more advanced countries. As a result, the amount of investment required to offset the consumption of capital and to maintain the capital stock at a constant level increases. At the same time, it is possible that the size of the capital stock remains underestimated owing to insufficient incorporation of intangible investment^[26] in the national accounts (see also the box entitled “Investment in intangibles in the euro area” in this issue of the Economic Bulletin).^[27] Intangible investment has long been considered largely as intermediate consumption – as opposed to investment – on the balance sheets of firms, reflecting the fact that such investment was thought to exclusively benefit firms themselves. Available estimates suggest that GDP (and gross saving and investment rates) in Europe would be 5 to 10 percentage points higher if all intangibles were classified as investment.^[28]

The cyclical recovery in overall investment since the crisis has given some positive impetus to the capital stock in the euro area, although its contribution to the capital stock has been lower than in the pre-crisis period. Increasing demand, low financing costs and better access to finance as a result of the ECB’s accommodative monetary policy have supported the recovery in investment.^[29] As a result, capital stock growth rates have accelerated in the euro area in the period since the crisis (see Chart 8). However, lower than pre-crisis growth rates of investment^[30] have weighed on capital stock contributions to potential growth in the recovery period (see Chart 4). There are a number of factors behind the lower growth rates. First, it took time to unwind excess capacity accumulated during the crisis in the construction sector – particularly in housing, but also in commercial and industrial construction – which resulted in underutilised capital and excess capacity. Second, recent years have still been characterised by persistently high uncertainty, slowing growth expectations related partly to population ageing, and remaining deleveraging needs, both in the private and public sectors. Third, in the early phase of the recovery the average scrapping rate might have been higher due to crisis-related company liquidations. Also, in this period public investment was subdued owing to fiscal constraints in some countries. Public investment has been shown to have considerable spillover effects on private investment.^[31]

5.3 Total factor productivity

In the decade leading up to the global financial crisis, TFP growth was on a downward trend in the euro area and in other advanced economies. Between 1999 and 2007, trend TFP growth gradually slowed from 1.0% to 0.5%, according to European Commission estimates (see Chart 9). Several explanations have been proposed for this deceleration, some of which are complementary.^[32] Mismeasurement problems, for instance with regard to intangible investments, may have led to an underestimation of TFP growth. More fundamentally, recent innovations might have been less pervasive than earlier technological advances, such as the railways and electricity. Moreover, there is evidence that it takes longer for technological innovations by pioneering firms to be incorporated into the production processes of other firms.

The global financial crisis exacerbated the decline in TFP growth. In fact, TFP growth is even estimated to have turned negative during the crisis, albeit largely driven by its cyclical component. Firm-level evidence indicates that bank forbearance and inadequate insolvency regimes locked capital into firms with low levels of productivity, weakening the cleansing effects typically associated with recessions.^[33] Following the unwinding of macroeconomic imbalances in euro area countries, structural rigidities may have hampered the necessary reallocation of resources towards more productive sectors and firms. Moreover, protracted private sector balance sheet repair has weakened investment, thereby potentially limiting technological innovation.

TFP growth has increased during the ongoing economic recovery, broadly returning to its pre-crisis rates. The adverse effects of the crisis on TFP growth, for instance through disruptions in financial intermediation, cuts in research and development budgets and subdued spending on public infrastructure, have started to wane. There is also evidence that the crisis has ultimately led to a reallocation of resources towards more productive firms (e.g. through the elimination of unviable businesses). Moreover, it may simply take some time for innovations in the field of digitalisation to be widely adopted throughout the economy. Sustained improvements in educational attainment also continue to support TFP growth.

5.4 Longer-term outlook

Euro area potential growth will remain broadly stable over the coming years, according to the projections by international institutions. On average, the European Commission, the IMF and the OECD envisage potential growth of 1.4% in 2018 and 1.5% in 2019 (see Table 1). The projections are below those for actual GDP growth, implying that supply constraints will become more binding.

While the longer-term outlook for potential growth is more uncertain, population ageing looks set to exert increasing downward pressure.^[34] According to projections by Eurostat, the euro area’s old-age dependency ratio (i.e. the number of people aged 65 or over as a percentage of the working age population) will increase from around 30% at present to around 50% by 2050 and the working age population will decline by around 23 million over the same period (see Chart 10). This forecast already takes into account net immigration of around 800,000 persons per year. The expected decline in the working age population could be partly offset by further increases in the overall participation rate on the back of previous pension reforms and rising education levels. However, on the basis of these projections, the euro area labour force looks set to decline over the coming decades, exerting downward pressure on potential growth.

The impact of population ageing on potential growth could be partly offset by other factors. In particular, automation and digitalisation could support TFP growth (see Box 3). However, when and to what extent this will happen is highly uncertain.

With regard to the capital stock, it could be expected to continue growing and to contribute positively to potential growth. International institutions also expect capital stock growth to accelerate further in the next few years. The reasons for continued capital accumulation include sustained cyclical demand, near-full capacity utilisation in the capital goods-producing sector and a continued need to replace and upgrade capital in order to face the challenges posed by globalisation and the digital economy. In the longer term, expectations of further advances in technology – and the resulting changing composition of the capital stock – point to an accelerating need for capital accumulation to keep up with rising overall depreciation rates. Recent research has also found that the capital stock of intangible assets adjusts more slowly to fluctuations in the economy than tangible investment,^[35] given the irreversible nature of intangible investment. This could result in a capital stock that is becoming less sensitive to the business cycle.

Conclusions

Available estimates indicate that euro area potential growth has increased over recent years, although it remains weaker than before the global financial crisis. Following a significant slowdown during the crisis, potential growth is estimated to have recovered since the start of the ongoing economic recovery. Over recent years, potential growth has been underpinned by an expansion of the labour force, a decline in trend unemployment and stronger productivity gains. While capital formation has also accelerated over recent years, it remains weaker than before the crisis.

Supply constraints are expected to become increasingly binding going forward, which would be conducive to a gradual strengthening of wage growth and underlying inflation. During the ongoing economic recovery, real GDP growth has consistently exceeded available estimates of potential growth. This has led to a gradual shrinking of the output gap that opened up during the crisis. The economy now seems to be operating close to its potential. It should be noted, however, that estimates of potential output and the output gap are fraught with uncertainty.

Given the imminent challenges arising from population ageing, well-designed structural policies with a focus on enhancing productivity are essential to boost potential growth.^[37] Population ageing is expected to exert downward pressure on euro area potential growth over the coming decades. This could be offset at least partly by sound structural policies for labour, product and services markets that can be expected to raise the labour or TFP contribution to potential growth. To exploit the full potential of digitalisation, the euro area economy needs improvements in the quality of the digital infrastructure and the availability of digital skills. The deepening of the Single Market and competition-enhancing product market reforms, in particular in the services sector, would also foster productivity growth. In addition, the cutting of red tape would facilitate firm entry and exit and the efficient reallocation of resources across firms. Labour force and employment growth could be supported by policies that help the long-term unemployed, migrants and other groups whose participation rates remain low to enter or return to the labour market, or to find jobs that better match their skills.