Tuesday, 9 March 2010

The Lost Decade through Pessoa’s bespectacled eyes

   Ever gloomy, ever versatile, Fernando Pessoa, the literary giant of the XXth century, has been summoned back from the dead for some after-life extra hours. The bored-office-clerk-turned-cultural-icon's name now serves as the acronym of the latest model of the Portuguese economy at the Bank of Portugal. As its authors state "PESSOA is a New-Keynesian DSGE model for a small open economy participating in a monetary union... with a rich fiscal policy setup" (more info here and here). Fittingly, as seen through Pessoa's eyes, Portugal's outlook is, well... kind of sad.
   In one of many interesting exercises, the authors kindly ask Pessoa to go through the following thought experiment: what would happen if, starting in 1999, the Portuguese economy went through ten years of abnormally low productivity? Gloomy Pessoa answers with a graph:
   The dismal performance of consumption, investment and hours, the deterioration of the net foreign asset position and the loss of competitiveness in tradable goods, all so familar from previous posts, show up with a vengeance in Pessoa's graph.
   But surely, you might object, this is way off. As bad as things are, we did not experience a great depression style 12% fall in GDP. Well, in that case, an ever resourceful Pessoa will tell you a thing or two about mitigating factors: think about the permanent (?) decrease in risk premia and the easing of credit conditions associated with the euro or the fiscal policy expansion-tightening cycle. Now add up these three factors - productivity, credit and pro-cyclical fiscal policy - and things start looking very familiar.
   More worringly, Pessoa's assumption of temporarily low productivity starts to sound a bit like wishful thinking. Now that the credit boom has ran its course and that fiscal policy has its hands tied, some mean reverting manna from heaven would indeed be great news. Otherwise the graph above will not be telling us the story of the last decade but that of the coming one.


  1. The experiment was based on an actual decrease of prodcutivity or from a decrease in the growth of productivity below the trend ?
    If it is the latter I think the model could explain quite well what has happened. Just add a positive financial shock and I guess we'll get something quite similar to what has happened since the mid 90's.

  2. Hi JP,

    The authors run the latter experiment you describe. Still, they (and me) think that 12% fall in output and consumption relative to 98 trend is a bit harsh. And like you suggest, they show that the easing of credit constraints and the early 2000s fiscal expansion could do the trick. The problem is that those mitigating effects are now largely gone. So either we go back to trend very soon or the relevant scenario starts being a permanent productivity loss. Check Chapter 2 of the first link above (large PDF) for more info or the second link for all the gory details of the model.

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