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«Do Financial Crises Erode Potential Output? a cross country analysis of industrial and emerging economies Fernando N. de Oliveira and Myrian Petrassi ...»

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Do Financial Crises Erode Potential Output?

a cross country analysis of industrial and

emerging economies

Fernando N. de Oliveira and Myrian Petrassi

June, 2015

ISSN 1518-3548

CGC 00.038.166/0001-05

Working Paper Series Brasília n. 388 June 2015 p. 1-25

Working Paper Series

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Our objective in this paper is to analyze empirically if financial crises have decreased potential output for a selected group of economies. We estimate different stylized Phillips curves to verify if inflationary pressures were stronger on the recovery periods after financial crises, relative to the recovery periods after recessions. Our results, in general, do not show any clear empirical evidence that financial crises erode potential output.

Moreover, there are no apparent differences in terms of the effects of financial crises over potential output between emerging and industrial economies.

Keywords: Financial Crises, Potential Output, Inflation, Hyperinflation, Phillips Curve JEL Classification: E3, E30, E31 * Research Department, Banco Central do Brasil. E-mail: fernando.nascimento@bcb.gov.br ** Research Department, Banco Central do Brasil. E-mail: myrian.petrassi@bcb.gov.br

1. Introduction Financial crises are related to relevant changes in credit volume and asset prices, severe disruptions in financial intermediation, balance sheet problems of firms and households, and the need for large scale government intervention. The macroeconomic implications of crises are typically harsh, with large output losses and other macroeconomic variables typically experimenting significant declines.

Financial crises may also impair aggregate supply. As Blinder (1987) points out widespread credit rationing can constrain current production by restricting the availability of working capital for firms, and also reduce future production by inhibiting investment spending and the future capital stock.1 What is still an open empirical question in the literature is if financial crises also erode potential output. If so, this would show up through decreasing the amount of spare capacity, which normally opens up following economic downturns, such that inflationary pressures would be stronger than otherwise.

Our objective in this paper is to analyze empirically if financial crises have affected potential output for a selected group of economies. For this, we estimate different Phillips curve to verify if inflationary pressures, as mentioned above, were stronger on the recovery periods after the financial crises relative to the recovery periods after normal downturns, such as recessions. 2 Our definition of financial crises is taken from Laeven and Valencia (2010), who define a systemic banking crisis as relevant signs of financial distress in the financial system, followed by significant financial policy intervention measures.

As Cechetti et al show (2007) both the volatility and level of inflation have decreased in industrial economies. In these economies, the decades of 1960 and 1970 were considered periods of high and persistent inflation, while the more recent decades, 1990 and 2000, have low levels of inflation as well as low persistence.

Contrary to industrial countries, emerging economies have experienced high levels of inflations for a longer period. Some of these countries, such as Brazil, An economy's potential output is generally defined as the production level consistent with stable inflation. At this level, the economy is considered to be at full employment or unemployment is at the natural rate. In the course of the past decades, several methods have been employed to estimate potential output and the output gap.

There are other ways to verify empirically how financial crises affect potential output. See Cecchetti et al (2009), Cerra and Saxena (2008) and Benati (2012) for some papers that investigate whether financial crises constitute adverse long term supply shocks to trend output with different approaches from our paper.

Argentina, Peru, Mexico, among others have had periods of hyperinflation in the last thirty years. Only recently, in the decade of 1990, the levels of inflation have started to decrease in these countries. This, in part, is due to the important changes in the conduct of their macroeconomic policies.3 Considering these differences in the behavior of inflation, we ponder that inflationary pressures may differ depending on the fact that the country is industrial or emerging. We think that in the case of latter, differences of inflationary pressures between recovery periods after financial crises and after recessions should be more pronounced that those observed for the former.

We select a representative group of 16 industrial and 10 emerging economies. In the case of emerging economies, we separate them among those that have and have not experienced hyperinflation in the recent years.

We use quarterly data of inflation, GDP and foreign exchange rate for each of our countries. The sample period for each country varies, depending of the availability of these data. For most countries, we have very long sample periods for the inflation series. For some we have almost 50 years of quarterly data.4 Our results, in general, do not show any clear evidence that financial crises erode potential output. Depending on the Phillips curve model used, one or another economy shows a loss in potential output. But the majority of economies do not show any loss at all. Moreover, there are no apparent differences between emerging, either with or without hyperinflations episodes and industrial economies in terms of the effects of financial crises over potential output.

Several factors may lead financial crises to affect potential output. Traditional crowding out might lead to higher longer-term risk-free real interest rates following the sharp increases in government debt arising from the combination of fiscal stimulus and support for the banking system. Actual and expected inflation could rise because of the inflationary impact of central bank balance sheet expansion.

Increased risk aversion could lead to lower capital accumulation in the long run.

In addition, reduced leverage and slower financial innovation may prevent financing for projects that otherwise would have added to productivity growth. Finally, a possible As examples of some macroeconomic policies we can list: inflation targeting adoption, reduction of budget deficits, improvement of financial regulation, trade liberalization and flexible exchange rate policies among others. It is also important to add that for Latin American countries the renegotiation of the external debt was a pre-condition and basis for inflation stabilization, particularly in Brazil.

The following countries have inflation series starting at the second quarter of 1960: Finland, Greece, France, Japan, New Zealand, Switzerland, United Kingdom and United States.

reversal of financial globalization may reduce growth by inhibiting trade and development.

Furthermore, by reducing labor demand, financial crises can lead to an increase in the structural unemployment rate. The high unemployment rate may discourage workers to search for a new position. Workers exiting the labor force will reduce human capital accumulation, hence decreasing potential output in the short if not in the longer run.

Finally, the effect on total factor productivity is a priori uncertain. On one hand, spending on innovation is pro cyclical and is likely to be massively reduced at times of crisis. On the other hand, firms may have stronger incentives to restructure and improve their efficiency in periods of crisis to limit their losses.

Our paper is in line with Bijapur (2012). Bijapur uses a panel specification and tests for erosion of potential output in the aftermath of financial crises for a group of 11 industrial economies. The conclusions are that financial crises affect negatively potential output. We think the differences from our results may occur because we estimate a more comprehensive group of individual and panel Phillips curves, taking in consideration in all of them other possible structural breaks rather than financial crises and recessions. We also contribute to the empirical literature by looking at a greater and more diversified group of countries, including several emerging ones, and by using a much longer sample period for all economies in our sample.

Cechetti et al (2009) studies the output costs of 40 systemic banking crises since

1980. Most, but not all, crises coincide with a sharp contraction in output from which it took several years to recover. Cechetti et al find that the output losses of past banking crises were higher when they were accompanied by a currency crisis or when growth was low at the start of the crisis. 5 Reinhart and Rogoff (2009) examine the depth and duration of the slump that invariably follows severe financial crises. The authors general findings are that: asset market collapses are deep and prolonged; banking crises are associated with profound declines in output and employment; the unemployment rate rises an average of 7% over Cecchetti et al (2009) highlight a number of complementary linkages from the financial to the real economy that may cause output losses Increases in funding costs reduces investment. So does decreased credit availability. Higher risk aversion drives up risk premia, leading to flights to quality. The worsening of firms’ net worth leads to an impairment of their borrowing capacity from lower equity and property prices.

the down phase of the cycle, which lasts on average over four years and output falls an average of over 9%.

The rest of the paper is the following. Section 2 describes the data. Section 3 presents the empirical analysis. Section 4 concludes.

2. Data Our data are quarterly and the sample periods differ depending on the country.

We select 27 countries: 16 industrial and 10 emerging. Our data source is the International Financial Statistics of the International Monetary Fund. Our measure of

inflation is headline CPI inflation. We also use as exogenous the following variables:

growth of real seasonally adjusted GDP and GDP gap, which is the difference between seasonally adjusted real GDP and potential GDP, obtained through Hodrick-Prescott filtering.6 For the purpose of our analysis, we separate our sample of countries in three groups. The first group is comprised of industrial countries (Austria, Belgium, Denmark, Finland, France, Germany, Greece, Iceland, Italy, Netherlands, Norway, Portugal, Sweden, Switzerland, United Kingdom and United States). The second group has emerging countries that did not experience hyperinflation in the recent past (Colombia, Czech Republic, South Korea, Philippines, South Africa, and Thailand).

The third group has emerging economies that have had hyperinflation, such as Argentina, Brazil, Peru and Mexico.

Table 1 Panel A shows the sample periods of data for all countries in our sample. Panel B lists the Financial Crises and Panel C the recessions. As one can observe, most countries experienced more than one Financial Crisis and several recessions.

Table 2 Panel A shows descriptive statistics of inflation for industrial economies. As one can observe, average inflation is 1.30%, while average standard deviation was 0.70%. Table 2 Panel B presents descriptive statistics of inflation for the group of emerging economies that did not have hyperinflation episodes in the last thirty years. We can see that average inflation was 2.09% and average standard deviation was 2.09%. Table 2 Panel C shows descriptive statistics of inflation for the group of

Growth is the first difference of log (real adjusted GDP).

emerging economies that have had some hyperinflation episode recently. We can see that average inflation for this group was much higher than in the previous groups, 13.08%, and the same happened for average standard deviation, 0.26%.

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