Transitory shocks, persistent effects: towards better suited recovery policies after a financial crisis

The financial crisis that burst in 2007-2008 left permanent traces in most OECD countries. The fact that such transitory shocks can durably affect the GDP of a country calls into question the way recovery strategies are traditionally tackled. Indeed, economic policies are based on models that tend to assume dynamic stability and ignore sunk costs. More specifically, central banks and financial institutions currently use calculations that ignore the possibility of strong persistent damage to the productive potential of an economy, what is commonly called potential output. « Misinterpretation of the economic phenomena can mislead policy makers into thinking they should implement austerity measures, for instance, when really they shouldn’t », says Dr. Federico Bassi to press the importance of an alternative approach. His post-doctoral project aims thereby at creating a new method to measure the potential output of an economy, one which takes into account these large potential output losses. The second part of his research consists in designing a theoretical model allowing him to test the impact of various monetary, fiscal and financial markets’ regulatory policies on economic stability when permanent potential output losses are explicitly taken into account.

« The risk of a secular stagnation in Europe, characterized by low rates of growth, high rates of unemployment, growing inequalities and permanent losses of productive capacity, rises two main challenges », explains Dr. Federico Bassi. « First, an accurate analysis of the sources and consequences of this Great Recession and its systemic nature; second, the design of appropriate and successful fiscal, monetary and structural policies, particularly as regards to banks’ and financial institutions’ regulation ». The present project aims to take on these challenges by reevaluating the architecture of the models currently used by policy makers, particularly in regard to their calculation of potential output, a core concept of economic policy. To convey the importance of getting this measure right, the researcher explains: « The output gap is the gap between potential and actual output. Getting an accurate measure of potential output is fundamental, since the output gap is among the most important indicators for policy makers: a negative output gap triggers restrictive monetary policies in order to slow down the economy and avoid inflationary pressures; a positive gap triggers expansionary monetary policies in order to accelerate the economy and avoid deflationary pressures ».

Avoiding misinterpretation of economic phenomena

« I believe that the better way to reduce the risk of misinterpreting economic phenomena is not having a unique, good model but rather a variety of models, built on different assumptions, in order to compare the different results and be able to select the model that fits better with the current historical context », continues Bassi. He uses the example of Italy which has lost 20 % of its productive capacity since the financial crisis and where a lot of businesses have closed. « How can we design effective recovery policies if we take for granted that these businesses are going to reopen? We’re designing a method that is more flexible and that doesn’t assume that. » Once this is done, him and his team will move on to designing a new macro-economic model to try and simulate various policies.

Theoretical models are crucial tools in assessing complex phenomena and in trying to mitigate their adverse impacts. That is if they reflect reality faithfully… This project develops along this main concern. Recognising that « the existence of permanent effects after transitory shocks seems to be the norm rather than the exception », Bassi’s project naturally aims to adapt current methods to this newly recognised phenomena, broadening the spectre of how economic recovery is presently approached. At a time when economists are in need of better understanding the effects of different stabilisation policies and the effects of institutions on the business cycle, his findings hold great potential for highly-needed insight.