Romanian policies brought potential growth from 6.6% to 0% in 3 years

A lot of times I have the feeling that the official data in Romania does not reflect the reality around us. I had this feeling last week when I wrote about the output gap and how the fact that it is negative until 2013 could mean that Romania has room to grow fast without inflationary pressures.  On the other hand my view has always been that bad economic policies in the last few years have had a negative effect on Romanian potential GDP.

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To remind you, the output gap is a concept that tries to identify if resources in the economy are fully utilized. It calculates a potential output and if the economy is below there are still resources that can be employed without increasing costs while being above resources are over-utilized increasing the risk of inflation. Of course productivity shock swould help the economy remain above potential for a long time without inflation but let’s keep things simple.

These concepts might not matter to you and I on a day-to-day business but they are used by our policy makers when they implement fiscal, monetary or economic policy. For example , this is how the government saw the evolution of real potential GDP growth in Romania before and after the crisis. The estimates are from the official Convergence Report.

2009

2010

2011

2012

2013

2014

Original

6.6

6.5

6.5

6.5

6.5

6

New

-4.7

0.6

1.2

3.5

4.2

4.6

Drivers and their contribution to potential real GDP growth. TFP = total factor productivity

Capital Labor TFP GDP
 2009  1,5  -1,2  -5,0  -4,7
 2010  0,8  0,0  -0,2  0,6
 2011  0,9  0,0  0,3  1,2
 2012  1,0  0,0  2,5  3,5
 2013  1,5  0,0  2,7  4,2
 2014  1,8  0,0  2,8  4,6

In April 2011 when this was released the Romanian government believed that potential GDP will be growing by 3.5% by 2012. Really fast recovery if you as me. However, looking at the drivers we find that potential GDP will be most impacted by higher productivity and capital with no impact from labor. To me the surprise comes from the big contribution of Total Factor Productivity to the potential GDP growth. Historically TFP has been the least contributor to potential GDP growth. Oh well, miracles do happen.

These estimates seem too optimistic for me, especially considering the policy response to the economic crisis. To test these estimates I am going to use the same econometric techniques used in the Convergence report : Hodrick-Prescott filter.

First, let’s look at the nominal GDP. After applying the HP filter we identify the nominal potential GDP – red line. As the graph below shows in nominal terms Romania is still below potential in 2011. Also, important to point out that the economic crisis has not damaged too much the very long term nominal potential GDP for Romania.

Source: INSE and Florin Citu estimates. Shaded areas show recessionary periods.

Let’s now look at the potential for real GDP growth which relates directly to the estimates from the Convergence Report. Here things look more interesting. The graph below shows that potential real GDP growth started to fall since 2007. It does show the same negative growth for 2009 and further in 2010 as the Convergence Report does. But for 2011 and beyond things are, or better said, could be different.

One major problem with this econometric technique is the so-called end-point problem. Basically the last value is very much influenced by our expectations of future economic growth. To solve this problem somewhat I used two different scenarios: the official one agreed with IMF (red line) and a more realistic one (green line) in which the economy does not grow in 2012. The estimates for potential real GDP growth are quite different as the graph shows.

Source: INSE and Florin Citu estimates.

What to take from this analysis? In my view it is hard to foresee all negative or positive shocks. That is why I do not see too much blame in not foreseeing the economic crisis. What is important for a policy maker is to create a flexible economy and to respond appropriately once the shock has been identified. For example if inflation increases by surprise the central bank should tighten monetary policy to bring inflation back to target within the policy horizon.

Thus looking at those estimates for potential GDP it is important for the policy makers to understand that how they respond to the crisis will increase or decrease the potential GDP growth. To put it bluntly Romania needs policies to foster economic growth in the following period: e.g.  functioning money market at all tenors, lower taxes, lower public debt and lower expenditures. Otherwise, 2012 will be another year with negative growth for potential GDP translating into further destruction of the Romanian wealth.

Finally, if the analysis above did not worry you the following picture should. As potential GDP growth is falling debt as percentage of GDP is doubling. This is not sustainable by any measure and needs to be addressed fast.

Source: INSE and Florin Citu estimates.

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