A new discussion paper by Florian Gerth and Keisuke Otsu, KDPE 1606, September 2016
Nearly a decade has passed since the onset of the Great Recession. However, European countries have shown very little recovery. Economists collectively agree that the financial market turmoil initiated by the subprime loan crisis in the US is the source of the Great Recession. However, there is little consensus about the propagation mechanism through which the initial shock led to a steep and persistent drop in key economic variables...
In order to shed light on this issue, this paper analyses the Great Recession in 29 European countries over the 2008Q1-2014Q4 period with the Business Cycle Accounting methodology á la Chari, Kehoe and McGrattan (2007). This method evaluates the importance of different distortions during the Great Recession within a Dynamic Stochastic General Equilibrium framework. These distortions, also called wedges, help us find the propagation mechanism of shocks driving the post-crisis slump in Europe.
The business cycle accounting method is conducted as follows. First, we define a model with time varying production efficiency, labor market distortions, investment market distortions, and government expenditure, which we define as efficiency, labor, investment and government wedges. Next, we use the data of output, consumption, investment and labor in order to elicit the wedges. Finally, we plug the computed wedge one-by-one into the model in order to assess the impact of each wedge on business cycles.
Business cycle accounting provides equivalence and accounting results. Equivalence results show that a wide class of macroeconomic models can be mapped into the prototype business cycle accounting model with wedges. The accounting results provide quantitative indication on which wedge has the highest explanatory power of the business cycle fluctuation. Together, the two results guide the researcher to understand the main forces that drive the business cycle episode of interest.
The key result is that the deterioration in the efficiency wedge is the most important channel in accounting for the post-crisis decline in European output. This is consistent with the literature that blames the misallocation effect of credit crunches for aggregate productivity loss. We further find that countries with rapid growth in non-performing loans experienced less deterioration in efficiency wedges. This is consistent with the literature that argues that evergreen loans to unproductive zombie firms deteriorates the firm entry-exit economic metabolism and reduces aggregate production efficiency in the economy.