1.4 Financial markets, investments and allocation efficiency

The textbook and mainstream macroeconomic approaches are mostly abstracted from the financial sector, as they assumed that apart from the occasional frictions or the temporary overstatement of external shocks and prolonged adjustment, their operation had no impact on the longer-term equilibrium path of the economies. Well-informed agents see through the financial and monetary veil, and they make their optimal decisions based on real considerations.

However, if it turns out that financial variables can steadily divert the allocation of resources from the sustainable path, it may happen that a longer adjustment will be necessary in the real economy as well, in order to reach the pre-crisis growth rate once again. Then the recovery from the financial crisis requires not only deleveraging, but also real economy adjustment, which is not only slow, but also expensive. It is enough to consider that due to the lax lending conditions before the crisis a large number of residential and other properties were built, which some private or corporate builders are unable to finance after the crisis. Due to the high degree of investment overhang only part of these can be sold, and even that at depressed prices. Such “misallocated” real assets cannot even be reconverted into other physical objects. In the new situation, most probably part of the machinery and equipment used in construction will also become redundant and difficult to exploit, and it is similarly difficult to convert these capital elements into cash. Finally, the headcount of the workforce employed in construction will be also too high due to the lower capacity requirement that can be sustained in the long run, and therefore the workforce must flow to such sectors the output of which is required permanently. This may as well entail the change of profession and geographical location, which is time consuming, and may also be accompanied by private and community costs. We could estimate the possible degree of economic policy error, if we knew the impact on potential growth of the deviation from the resource allocation ensuring an optimal growth path. Up to now only a few analyses have dealt with the empirical estimation of this, partly due to the estimation difficulties. 22 In part, this is also attributable to the prevailing paradigm, which assumed that the financial sector and nominal variables cannot have a secular real economic impact. These few analyses include the work of Cecchetti et al. and the BIS 2015 report, 23 in which they tried to estimate the impact of the sub-optimal allocation of the resources on growth. According to the fundamental assumption of the research strategy, the expansion of lending beyond a certain point diverts real economic resources to an increasing degree

towards industries in which productivity lags behind

the average. Thus, the credit boom may be regarded as an indicator of deterioration in economic efficiency. According to BIS, the deterioration of productivity, as interpreted above, was significant: had the growth rate of lending not exceeded the growth rate of 1994–2000, the productivity grow rate in 2004–2007 would have been higher on an annual average by 0.2 per cent in the USA, by 0.4 per cent in Italy, by 0.7 per cent in Spain and by 1 per cent in Ireland (Chart 1-9).

Based on the above, it can be seen that the cause of the lower growth potential is not that the economy is physically unable to generate higher output: it does have this capacity, but the utilisation of the resources in the given ratios and structures proved to be partially unsustainable in financial terms. With different resource and income allocation, it may also be possible to achieve or even exceed the precrisis growth potential. For example, if properties had been built only in a sustainable volume and as a result of a more even income distribution, and the indebtedness of home buyers had also remained at

22 In such research it must demonstrated how the growth would have developed on a path that did not materialise. That is, a counterfactual-type question must be answered. 23 Cecchetti and kharroubi (2015). See also the “Credit boom-induced resource misallocations stifle productivity” section in BIS (2015) pp. 50–51.

Chart 1-9 Productivity loss due to non-optimal allocation

0.0 IE ES DK IT SE FR US GB

–0.5

–1.0

–1.5

–2.0

Percentage point 2004–2007 2008–2013

Note: the chart by the BIS shows by how many percentage points labour productivity is smaller due to the suboptimal resource allocation resulted from the credit boo. Source: BIS (2015)

a sustainable level, then part of the real resources could have been utilised in areas other than home construction. Until the adjustment is completed both in the balance sheets and in the allocation of the real resources, we indeed should expect that the postcrisis growth potential will fall short of the pre-crisis level, but in theory it cannot be ruled out that it will once again reach it after a temporary period. The conclusion from these thoughts is that if economic policymakers assume, ignoring these considerations,

that the post-crisis growth potential is steadily

lower than that before the crisis and base their decisions on this assumption, they risk contributing

to the development of lower-than-possible growth

potential, as a kind of self-fulfilling prophecy.

In other words, the misallocation of resources was already typical before the crisis due to the credit boom and as a result, the potential output and the productivity of the economies fell short of the possible level, which could have been achieved by a close to optimal resource allocation. Thus, the conclusion is that in theory the pre-crisis productivity growth is not impossible to achieve. Naturally, the above does not mean that it will definitely materialise. It could be caused not only by the fault of economic policy by, for example, erroneously and steadily underestimating the economy’s potential growth. Similarly to the precrisis situation, the private sector may engage in both intratemporal (among industries and countries) and intertemporal (between the present and future consumption, due to excessive or insufficient investments) allocation errors in the future as well.