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Macroeconomics and the financial cycle:
Hamlet without the Prince?
Claudio Borio
Did global imbalances cause the financial
Claudio Borio, Piti Disyatat
Measuring potential output: Eye on the
financial cycle
Claudio Borio, Piti Disyatat, Mikael Juselius, 9 April 2013
It is now generally accepted that financial factors can significantly influence output, sometimes
driving it away from sustainable levels. Yet, when it comes to assessing potential output the
maximum level of economic activity that can be sustained over time the influence of financial
conditions is generally neglected. This column argues that embedding information from
variables that proxy the financial cycle leads to estimates of potential output that are much
more precise and, above all, much more robust in real time. These estimates could help
improve policymaking.
No-one questions any longer the powerful
feedbacks between financial conditions and
the real economy. In recent years and in many
countries, credit and housing booms have
gone hand-in-hand with strong spending and
production. Similarly, during downturns,
deteriorating financial conditions have
weighed heavily on growth. Such linkages have challenged the long-standing
intellectual chasm between macroeconomics and finance. Efforts are underway to
bridge it. To a large extent, however, these efforts have neglected the concept and
measurement of potential output. This is surprising.
Potential output: From 'inflation-neutral' to 'finance-neutral'
From such a unified macro-finance perspective, prevailing views of potential output
have two shortcomings.
The first has to do with the concept. A defining feature of potential output is
sustainability. From at least Okun (1962) onwards, sustainability has generally been
defined exclusively in terms of inflation.
In Macroeconomics 101, it is the behaviour
of inflation that provides a key signal of unsustainability. But identifying sustainable
output with non-inflationary output is too restrictive. As the recent financial crisis has
powerfully reminded us, output may be on an unsustainable path even if inflation
remains low and stable: financial developments may be out of kilter.
The second shortcoming has to do with measurement. There is little doubt that
financial developments contain information about the cyclical component of output.
Variations in financial conditions are associated with, and in many instances drive,
fluctuations in economic activity. Ignoring them is bound to provide less accurate
estimates of potential output whenever this is measured by the non-cyclical
component of output fluctuations.
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Claudio Borio
Deputy Head of the Monetary
and Economic Department
and Director of Research and
Statistics, Bank for
International Settlements
Piti Disyatat
Head of Forecasting and
Macro Surveillance, Monetary
Policy Group, Bank of
Mikael Juselius
Economist in the Monetary
and Economics Department,
Bank for International
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Page 1 oI 6 Measuring potential output: Eye on the Iinancial cycle , vox
In a recent paper (Borio et al (2013)), we take a first step towards addressing these
shortcomings. Our approach fully recognises the critical role that financial factors may
play in the evolution of output, and in determining which of its paths are sustainable
and which are not.
More specifically, we rely on two variables that we have found in
other work to be the best proxies for the financial cycle: credit and property prices
(Drehmann et al (2012)). And we allow these variables to capture the cyclical
component of output at traditional business-cycle frequencies.
By operating at these frequencies, we arrive at a measure of potential output, and a
corresponding output gap, that are comparable to standard ones in economic
analysis and policy. But since it is the behaviour of financial variables, and not
inflation, that signals deviations of output from its potential, one can think of the
corresponding estimates as 'finance-neutral', as opposed to 'inflation-neutral',
measures of potential output.
Statistically, the novelty of the approach is that it incorporates economic information
very flexibly. In particular, we do not force the output gap to explain economic
variables, as is typically done in systems-based approaches and most prominently
through the inclusion of a Phillips curve (eg, the fully fledged production-function
approaches commonly used in policy institutions). Rather, we include the proxies for
the financial cycle as potential explanatory variables for the transitory, or cyclical,
fluctuations in output at the chosen frequencies. If the explanatory power of a given
variable is small, it will make little difference to the estimate of potential output. In
other words, the approach lets the data speak and, by so doing, avoids a common
source of misspecification. Moreover, it is simple and very transparent.
The estimates: Much more precise and robust in real time
Of course, the proof of the pudding is in the eating. And this particular pudding
happens to taste quite nice. We illustrate this in the case of the US, although in the
paper we also apply the procedure to the UK and Spain, for which the findings are
similar. The results are striking.
For one, credit and property prices have significant explanatory power: their inclusion
greatly improves the statistical precision of the estimates. Figure 1 compares the 95%
confidence bands for the output gap derived from our approach (right-hand panel)
with those associated with the output gap resulting from a very common statistical
technique based only on output itself, the so-called Hodrick-Prescott (HP) filter (left-
hand panel).
Our procedure roughly halves the size of the error bands. Moreover,
these bands are likely to be considerably smaller than those for fully fledged
production function approaches, which rely on many assumptions about economic
relationships and on several HP trends for key variables.
Figure 1. US: Finance-neutral output gaps statistical precision (as a percentage of
potential output)
Source: Authors calculations.
More importantly, our procedure yields output gaps that are much more robust in real
time. In other words, history does not get heavily rewritten as time unfolds: the output
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Page 2 oI 6 Measuring potential output: Eye on the Iinancial cycle , vox
gap estimated based on information available today (the 'real-time' estimate) is not
very different from that estimated a few years later, when more information is
available ('ex post'). This is shown in Figure 2, which compares real-time estimates
with those based on the full sample of data.
Figure 2. US output gaps: Full sample and real-time estimates (as a percentage of
potential output)
Sources: IMF; OECD, Economic Outlook; authors calculations.
The difference between our approach and traditional ones is immediately apparent.
The HP filter gap and the full-fledged approaches of the OECD and IMF a
representative sample of current approaches did not detect that output was above
sustainable levels during the boom that preceded the financial crisis. In fact, the
corresponding real-time estimates indicated that the economy was running below, or
at most close to, potential. Only after the crisis did they recognise, albeit to varying
degrees, that output had been above its potential, sustainable level. By contrast, the
finance-neutral measure sees this all along (bottom right-hand panel). And it hardly
gets revised as time unfolds.
Why the difference? It reflects how the approaches deal with what is technically
known as the 'end-point' problem. Statistical filters typically have a hard time
measuring trends accurately because they are very sensitive to the latest
observations. As long as the financial variables soak up the cyclical fluctuations, and
do so reliably, they can obviate this problem. This is precisely what is happening
A word of caution, though. The finance-neutral estimates shown in the graphs are
illustrative. For simplicity, they refer to the linear version of our approach. This version
does not allow for the possibility that, as other evidence suggests, the distorting
impact of the financial booms increases with their size (eg, Borio and Drehmann
2009). Allowing for this possibility, which we think is more realistic, yields output gaps
that are considerably larger during the boom and smaller during the bust.
Policy application: the case of cyclically adjusted budget
For policymakers tasked with keeping the economy on an even keel, large revisions
as time unfolds are daunting. Based on traditional methods, policymakers would have
completely missed that output was on an unsustainable path ahead of the financial
Page 3 oI 6 Measuring potential output: Eye on the Iinancial cycle , vox
crisis. Had they relied on finance-neutral potential output measures, they would have
been in a better position to assess potential vulnerabilities and to take remedial
We illustrate this for fiscal policy although the point applies also to monetary policy.
Consider cyclically adjusted government budget balances. Because tax revenues
tend to be low and expenditures high during booms, and vice versa, taking into
account the state of the economy gives a better indication of the underlying stance of
fiscal policy and health of the public accounts. Given that financial booms can flatter
the fiscal accounts, neglecting the financial cycle can make assessments unreliable.
The recent experiences of Spain and Ireland are quite telling (eg, Benetrix and Lane
2011). The fiscal accounts looked strong during the financial boom: debt-to-GDP
ratios were low and falling and fiscal surpluses prevailed. And yet, following the bust
and the banking crises, sovereign crises broke out.
The finance-neutral output gap measures help correct for the flattering effect of
financial booms.
Consider, again, the US. Figure 3 shows the actual fiscal balances
(red line, right-hand scale) together with the real-time cyclical adjustments based on
the HP filter, production function and the finance-neutral potential output measures
(bars, left-hand scale). In this context, a difference of more than half a percentage
point of GDP is generally regarded as economically significant. During the financial
boom that preceded the financial crisis, cyclical adjustments based on the HP filter
and production function approaches were small and sometimes even positive. By
contrast, those based on the finance-neutral measure were persistently negative,
generally above 0.5 percentage points and often in the order of one percentage point,
if not larger. Clearly, underlying fiscal positions were substantially weaker than the
headline figures suggested.
Figure 3. US: Budget balances and cyclical adjustments (as a percentage of output)
As a percentage of GDP.
Cyclical correction of the unadjusted
budget balance implied by the different output gap estimates. In
percentage points.
Sources: OECD, Economic Outlook; national data; authors calculations.
Financial developments are an integral part of cyclical output swings. Our findings
reflect this simple fact. Assessments of sustainable output that ignore financial factors
are fundamentally incomplete.
Authors note: The views expressed are those of the authors and do not necessarily
represent those of the Bank for International Settlements or the Bank of Thailand.
Benetrix, A and P Lane (2011): "Financial cycles and fiscal cycles," mimeo, Trinity
College Dublin.
Page 4 of 6 Measuring potential output: Eye on the financial cycle | vox
orio an P isyatat 2011 : lo al im alances an the Iinancial crisis: in or no
lin or ing Papers o. 3 6 May.
orio P isyatat an M uselius 2013 : ethin ing potential output: Em e ing
inIormation a out the Iinancial cycle or ing Papers o. 0 e ruary.
orio an M rehmann 2009 : ss essing the ris oI an ing crises revisite
BIS Quarterly Review March pp 29 6.
ong on 200 : wo concepts oI the output gap World Economics vol 9 no 1
pp 1 .
rehmann M orio an sats aronis 2012 : haracterising the Iinancial cycle:
on t los e sight oI the me ium term or ing Papers no 3 0 une.
Mish in 200 : Estimating potential output peech elivere at the onIerence
on Price Measurement Ior Monetary Policy e eral eserve an oI allas May 2
200 .
un 1962 : Potential P its measurement an signiIicance owles
oun ation ale niversity.
1 ee Ior instance ong on 200 an Mish in 200 Ior useIul iscussions oI the
2 n reIlection there are several reasons Ior this . nusually strong Iinancial ooms
are li ely to coinci e with positive supply si e shoc s. Economic expans ions may
themselves temporarily wea en supply constraints eg in ucing increases in la our
supply an the capital stoc . inancial ooms oIten go han -in-han with a ten ency
Ior the currency to appreciate as omestic assets ecome more attractive an capital
Ilows surge this in turn puts ownwar pressure on prices. n unsustaina ility may
have to o more with sectoral mis allocation oI resources than with overall capacity
constraints eg unsustaina le expansion oI the construction sector .
3 hese Iactors can give rise to what elsewhere we have terme the excess
elasticity oI the Iinancial system orio an isyatat 2011 . ust li e a piece oI
ru er that stretches too Iar an eventually snaps the selI-reinIorcing interaction
etween cre it creation ass et prices an the real economy can lea to a uil -up oI
Iinancial im alances that eventually erails economic activity.
echnically the graph reIers to a ynamic P Iilter which allows Ior autocorrelation
in the output gap.
Moreover as we argue in the paper we suspect that our current proce ure oes
not a e uately capture these non-linearities. oing so woul li ely re uce the
estimate oI the output gap in the ust Iurther.
6 hat sai they o so only partially. hey capture the impact oI output eing a ove
potential ut they ignore compositional eIIects the Iact that Iinancial ooms are
revenue-rich an the uil -up oI contingent lia ilities to a ress the su se uent ust.
Topics: inancial mar ets nternational Iinance
Macroeconomics an the Iinancial cycle: amlet without the Prince
Page 5 of 6 Measuring potential output: Eye on the financial cycle | vox
Claudio Borio
Did global imbalances cause the financial crisis?
Claudio Borio, Piti Disyatat
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Page 6 of 6 Measuring potential output: Eye on the financial cycle | vox