European Commission sees permanent decline in euro area’s potential output

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Potential output is what you can produce with ‘everyone working’ in the broad sense, and productivity increasing as quickly as possible, unconstrained by policy.

The monetary system is always ready and able to be adjusted to allow this to happen.

It does help to have an administration that understands the monetary system, however.

Since that seems to be in short supply, yes, growth rates can very well be subdued for quite a while.

European Commission sees permanent decline in euro area’s potential output

As so often, it is best not to read the media coverage, but the original documents. The European Commission’s Quarterly Report on the Euro Area contains a rare bombshell – a special essay on the long implications of the financial crisis, which says that the crisis will cause long-term damage to the euro area, and turn its feeble long-term economic growth prospects into something altogether more sinister.

The financial crisis affects both component of productivity – capital accumulation through lower investment rates, and total factor productivity through the credit crunch – and this is likely to have a lasting negative long-term impact on potential output.

In the short run, the effect on potential output growth is a fall of 1.6% in 2007 to 0.7% in 2010. After the crisis, the potential output growth should grow again, but it may never reach its pre-crisis level again. On page 34 it says:
“In other words, the crisis will entail a permanent loss in the level of potential output. One of the factors that will shape the size of this loss is the speed at which the economy reverts to long-term trends. The slower the adjustment to long-term trends, the greater the final loss in potential output level compared with a pre-crisis expansion path. The risks that the adjustment process will be protracted appear unfortunately to be high due to the specific characteristics of the current crisis, including its duration, its global nature and underlying changes in risk behaviour.”


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