'Financial sector origins of economic growth delusion'
|Date||6 September 2016|
|Time||13:00 - 14:30|
Since the financial crisis, there has been much discussion of hysteresis (reduced potential output levels) and even super hysteresis (weakened trend growth). Much of this literature has taken the pre-crisis behaviour of GDP as normal, and asked whether it is demand or supply shocks that driven recent outturns far from this level. In this paper, we use a simple model to explore the role that the financial sector may have had in boosting GDP above first best before the financial crisis. We show that the implicit subsidy from government guarantees artificially boosts investment and inflates wages. Allowing banks to also engage in proprietary trading magnifies the problem. Where capital is domestically-produced, the implicit subsidy is passed onto land and capital good prices, and still inflates wages. We find all of these effects and yet there is no effect on final goods inflation. Our analysis suggests an important role of the financial cycle, and therefore financial regulation, on estimates of potential output measures derived from time-series trends; analysts could be deluded by the artificial (and welfare reducing) boost to GDP that derives from financial incentives. Furthermore, in a phase where such incentives are corrected, artificially high real wages will generate increased unemployment during the transition to a normal of scaled back of bank lending (joint with Michael McMahon).