By Ajai Chopra

Potential output seems to be on everybody’s mind these days, at least if you talk to economists. What would be merely a curiosity during better times—after all, potential output is a largely abstract concept measuring the level of output an economy can produce without undue strain on resources—has become a particular worry in the context of the global economic crisis.

So what is all the fuss about? In a nutshell, policymakers across Europe are concerned that the deep and long recession will affect supply capacity and weigh down the prospects for recovery.

But even if the danger seems clear and present—people are still losing their jobs and businesses are still closing down with alarming speed—there is little clarity about just how big the drop in potential output is likely to be. For instance, Davide Furceri and Annabelle Mourougane at the OECD estimate that potential output in a typical financial crisis will drop between 1.5 percent and 2.5 percent for most countries. And Gert Jan Koopman and Istvàn Székely at the European Commission reckon that the level of losses for the European Union as a whole during the current crisis could be between 0.5 percent to 4.5 percent.

Policymakers dislike this kind of uncertainty because it muddies the waters and makes it harder for them to make the right decisions. Right now, budget planners across Europe are scrambling to estimate the strength of the blow the crisis has dealt to public finances, and not knowing the growth potential of their economies greatly complicates their task. If they overestimate potential growth, they would underestimate the need for fiscal adjustment once the crisis has dissipated, raising thorny issues of fiscal sustainability in the longer run.

Central bankers, too, are looking for guidance on the path of potential output. Their decision on when to start winding down current crisis policies depends on the difference between potential and actual output, the so-called output gap. If the output gap is closing faster because of a drop in potential, policymakers might decide to increase interest rates a little earlier and a little higher to prevent inflation from rising. Although this might sound farfetched at a time of falling headline inflation in Germany, the United Kingdom and elsewhere, those who are charged with safeguarding price stability have to look ahead to when the recovery will finally happen.

Bank of England: central banks' decision on when to start winding down current crisis policies depends on the difference between potential and actual output (photo: Shaun Curry/AFP)

Central banks' decision on when to start winding down current crisis policies depends in part on the difference between potential and actual output. Photo shows Bank of England (photo: Shaun Curry/AFP)

So what are policymakers to do? The first step is to ask economists to do their best to correctly estimate potential output in the aftermath of the crisis. The more that is known about what is happening to potential output, the less reason there is to worry about getting it wrong. The IMF is one such source of independent advice on potential output. Recent country reports produced by IMF staff have used a variety of methodologies to produce such estimates. Examples from the European Department include reports on France (Box 3 of the report), Ireland (Box 1), Sweden (Box 5), the United Kingdom (Annex 3), and similar work is in the pipeline for other countries. Another example is the report on the United States.

Naturally, the assessments by individual country desks take into account specific country circumstances. For instance, the hit to potential output in the United Kingdom is estimated to be larger than in, say, France because of the larger role of the financial sector as an engine of growth of value added in the United Kingdom in recent years, implying a bigger hit to the capital-labor ratio and total factor productivity after the crisis. Complementing such individual country analysis, the forthcoming World Economic Outlook and the Regional Economic Outlook for Europe, both to be released in early October 2009, will have a deeper discussion of the impact of the crisis on potential output in a cross-section of countries.

The second step for policymakers is to deal with the unavoidable uncertainty. For fiscal policy, there is a good case to err on the side of caution. Enough is known about the fiscal costs of the crisis to suggest that the need for consolidation is large, even if its precise size is still debated. In light of the looming fiscal pressures from Europe’s aging societies, this calls for decisive action as soon as the cycle allows.

As for central bankers, they should also act on the information they have, although researchers such as Athanasios Orphanides (now Governor of the Central Bank of Cyprus and member of the ECB’s Governing Council) have sensibly suggested that central banks should tread carefully by reducing the importance of the output gap in their decision making.

More generally, policymakers—be they in the central bank or in the ministry of finance—would do well by communicating their assumptions about potential output growth to the public. When the time comes to wind down stimulus packages and raise interest rates, the public will be better prepared to understand why fiscal adjustment has become necessary and will better absorb the guidance they receive on inflation expectations.

Again, these issues will be discussing more fully in the forthcoming October issue of the Regional Economic Outlook for Europe—so stay tuned.