Potential Output Pessimism and Excessive Austerity in the European Union

2017-12-14

      SpeakerDr Pei Kuang

      SiteB228

      Time 1400-1530 Monday Dec.18 2017

A business cycle model with learning is developed to analyze the role of potential output pessimism and the `debt brake' in the EU recession since the 2007-08 financial crisis, allowing for policy makers' uncertainty in estimating potential output. The paper documents important evidence on policy makers' perceived evolution of potential output, output gap and structural balance for a number of EU countries since 2004 and shows the model quantitatively replicates the evidence. The model suggests that the Great Recession led to over-pessimism about potential output which largely amplified the initial adverse shocks and underestimation of structural balances which triggered excessive fiscal austerity. The mutual reinforcement between potential output pessimism and excessive fiscal austerity contributed significantly to the prolonged recession in the EU. The analysis suggests that placing a moderate weight to new data to form estimates of potential output minimizes real-time mis-measurement of output gap and that placing this weight to the data during the Great Recession period would have led to a less severe recession.