World Economic Outlook - Growth and Institutions,
April 2003

Other issues of the World Economic Outlook

Research at the IMF

Transcripts of video presentations on the analytical chapters of the April 2003 World Economic Outlook
by Thomas Helbling, Luis Catão, Maitland MacFarlan and Xavier Debrun

Washington. D.C., April 3, 2003

Hello, my name is Thomas Helbling and I would like to present the essay on "The Real and Financial Effects of Bursting Asset Price Bubbles," which my colleague Marco Terrones and I prepared for this World Economic Outlook.

The essay is about the experience with sharp and prolonged declines in asset prices-that is, so-called asset price crashes or busts. An important dimension of the experience concerns the behavior of key macroeconomic and financial variables during such episodes.

The motivation for writing this essay was a number of seemingly unusual features of the recent equity price busts in industrial countries. For example, while many countries have experienced economic slowdowns in tandem with the dramatic declines in equity prices, the downturns appear not to have been especially severe when compared to other equity price busts in financial history.

To obtain a point of reference for comparisons, we analyzed a large number of asset price busts in industrial countries over the last four decades. We focused on busts in two important classes of assets, equities and housing. On this basis, we document typical features of equity and housing price busts and the concordant macroeconomic developments, including the following ones:

  • Equity price busts were almost twice as frequent as housing price busts. On average, an equity price bust occurred once every 13 years compared to once every twenty years in the case of a housing price bust. Both types of busts were typically synchronized across countries, that is, prices fell by large amounts in many countries at the same time.
  • As was to be expected, both equity and housing price busts were associated with output losses (relative to the prebust situation)I should add, reflecting primarily the adverse effects of the falling asset prices on consumption and investment. The output loss associated with the typical housing price bust of about 8 percent of GDP was twice as large as that associated with a typical equity price bust.
  • The more severe macroeconomic downturns that coincided with housing price busts reflect several factors, including larger wealth effects of changes in housing wealth on consumption, larger negative effects on the banking system, and greater negative price spillovers on the other asset class, that is, equities.
  • Output growth usually started to recover about nine quarters after the start of either an equity or a housing price bust.

Comparing the most recent wave of equity price busts in industrial countries against these typical features suggests that the declines in broad equity price indices have so far been similar to earlier episodes in terms of the magnitudes, the duration, and the cross-country synchronization. However, macroeconomic developments have differed from the typical postwar experience in important respects, including the following ones:

  • The decline in output growth after the bust began earlier and has been larger than usual in most countries, reflecting the relatively sharper falls in private fixed investment. These steeper investment declines in turn can be interpreted as corrections after the above-average growth in the preceding booms, which reflected the impetus from the rapidly rising equity prices at the time.
  • The growth of private consumption has been more buoyant than is typical in some countries, reflecting in part stronger than-usual housing prices.

The analysis in the essay suggests one important ray of hope for the outlook and one important risk. The ray of hope is that, in some countries, the timing of the recovery in output and private investment growth appears to be in line with typical patterns observed earlier. The risk is that housing price increases over the recent years in some industrial countries have exceeded the threshold for a boom, which raises concerns about possible busts in this asset class.

This is it! A more comprehensive discussion of these and other fascinating issues related to asset price busts is provided in the essay in this World Economic Outlook.

I hope you will enjoy reading it.

My name is Luis Catão and I would use this opportunity to briefly talk to you about the essay "Corporate Fragility and Investment: What's different about the Recent Bubble?," appearing in Chapter II of the April 2003 WEO.

The topic is certainly timely: corporations' financial excesses in the United States and around the world have made headlines until very recently. At the same time, corporate investment has been badly hit in both North America and in Europe over the past couple of years, so the links between corporate balance sheets and investment is something we should definitely care about right now. Indeed, this link has not escaped the attention of several observers, who have suggested that the exceptionally high levels of corporate debt and overinvestment in some sectors of the economy are dampening the recovery.

What this essay does is to look at these links more systematically and compare the experiences of the euro area and the United States in this regard. We do so by taking a longer term perspective. That is, we compare the financial excesses during the recent boom and bust in stock prices with similar episodes in the past, we highlight the differences, and analyze the implications for investment spending.

The main findings are:

  • Just like previous booms, the boom of the late 1990s boosted credit market conditions and made firms' balance sheets to look generally quite good. Buoyant credit markets and good-looking balance sheets then allowed firms to take on more debt at lower cost. In the U.S. for instance, average corporate bonds declined in their yields by over 350 basis points (in inflation adjusted terms) between 1991 and 1999. This led firms to borrow heavily and invest well ahead of demand. As a result, the debt of the non-farm non-financial corporate sector in the U.S. rose by 10 percentage points of GDP since the mid-1990s (peaking at 48 percent of GDP in 2001). In the euro area, the increase has even been more dramatic since the since the mid-1990s, increasing by some 18 percentage points to reach a whooping 74 percent of GDP in 2001. Such high levels of indebtedness have clearly increased the business sector vulnerability to a downturn in consumer spending and overall demand.
  • However, even though corporate financial indicators have deteriorated during the recent equity price bust, this has been on the whole less so than during the busts of the 1980s and the early 1990s. There are three main reasons for this
    First, while stock prices have fallen, they still are above pre-boom levels.
    Second, central banks have aggressively cut interest rates, helping shore up liquidity.
    Third, much of the stock market boom was concentrated on hardware and software information technology firms that relied more heavily on equity-rather than on debt-to finance their investments.
  • The big exception to this relatively benign scenario is corporate leverage (the ratio between debt and the value of the firm). Leverage remains high and especially so in Europe, as I mentioned before. Moreover, although data for the United States suggests that deleveraging began in 2002, there is no evidence that this happened in Europe, at least according to the most recent data available.
  • The essay also presents empirical evidence that high leverage dampens investment and this is clearly to be expected as creditors find it riskier to lend to heavily indebted corporations, what raises the cost of new borrowing and induces firms to postpone investment and use more of their cash flows to reduce their debts. Moreover, the analysis also shows that the effect of leverage on investment is asymmetric over the cycle, being stronger during busts than during booms. The essay also show that this effect is far stronger in Europe than in the United States.
  • A key implication is that, even though interest rates are currently at historical lows and corporate liquidity is relatively high, the effect of high leverage on investment is likely to predominate. This is particularly problematic in the current low inflation environment since inflation can no longer be counted upon to help reduce the real debt burden of the private sector. The essay therefore concludes that leverage should continue to weigh down on investment recovery for a while longer, and the more so in the euro area than in the U.S.

Thanks for your attention and we hope that you enjoy reading this WEO essay.

Hello, my name is Maitland MacFarlan. The latest edition of the World Economic Outlook contains a chapter looking at the impact of institutions on economic performance. This chapter was prepared by a team comprising Hali Edison, Nicola Spatafora, and me.

Why this interest in the subject of institutions? An immediate reason can be seen in this Figure, which relates per capita incomes in about 100 advanced and developing countries to their respective levels of institutional quality. There are enormous differences in per capita incomes around the globe-ranging from only about $100 a year in parts of sub-Saharan Africa to over $40,000 in some of the advanced economies. The figure shows clearly that these income disparities are closely related to differences in the quality of institutions. Institutions are measured here using a broad based indicator reflecting perceptions of such things as the degree of corruption in the country, the extent of political rights, regulatory burdens, and the rule of law.

We need to consider what is causing what, though. For example, stronger economic performance may lead to stronger institutions: for example, as incomes increase, countries probably find they need, and can afford, better institutions. After taking this into account in our empirical work, we find that institutions have a significant causal impact on economic performance. In particular, better institutions substantially increase the level and growth rate of GDP per capita, and lower the volatility of growth. These findings hold over a wide range of measures of institutional quality.

Based on these results, we illustrate in the chapter the significant gains that countries could realize if they were to strengthen the quality of their institutions. Look at this next figure, for example. It indicates the average improvement in incomes that could occur in two developing country regions if their institutional quality were to improve. For example, per capita incomes in sub-Saharan Africa could rise by 80 per cent on average (that is, from about $800 to over $1400 a year) if this region's institutions improved to the level of developing Asia. And incomes in developing Asia could roughly double if this region's institutions strengthened to around the average of all the countries in our sample.

We also find strong results for growth and the volatility of growth. For example, per capita growth in sub-Saharan Africa would be about 1 ¾ percentage points stronger each year if institutional quality in this region rose to around the all country average. This would imply annual growth of 2¼ percent rather than ½ a percent-a huge increase. And we find that the same improvement in institutions would cut the volatility of growth by about 16 percent.

Institutions, then, appear to play a crucial role in economic performance. But what about the impact of macroeconomic policies? We find that policies also affect economic performance, after taking into account the impact of institutions. For example, a country's level of financial development has a positive impact on growth; and the extent of exchange rate overvaluation, which often reflects broader macroeconomic imbalances, increases the volatility of growth.

On the whole, though, we and others have found that when institutional and policy terms are both included in assessments of economic performance, institutions tend to be the dominant influence. If we are considering cross-country differences in income levels, results like this are probably not surprising: these income differences may reflect the impact of policies conducted over centuries, but may not be strongly related to policies measured only over recent decades (as in our analysis). More generally, measures of institutional quality and of policies are often closely related. For example, the measures of institutions we use in our analysis-such as perceptions of government effectiveness-reflect both policy and institutional influences. This makes it difficult to identify the separate contributions of institutions and policies to economic outturns.

How should countries go about improving their institutions? The chapter notes some broad principles that may help to guide the reform process. In particular, all successful market based economies need institutions that will protect property rights, uphold the rule of law, provide appropriate regulation of markets, support macroeconomic stabilization, and promote social cohesion and stability. We also note though that, when it comes to the details of reform, there are likely to be strong country specific elements coming into play. For that reason, if countries try to adopt institutional arrangements that have worked well elsewhere, they also need to be prepared to modify these arrangements to suit local circumstances.

We also point to several mechanisms that may support institutional reforms. Greater competition including through greater openness to foreign trade-can help to reduce the power of vested interests, who may tend to resist reform. The scope for corruption and poor policy choices may be reduced if information flows and transparency are improved, particularly the transparency of public decision-making. The use of external "anchors", including multinational agreements and constraints, has also proved effective in some cases: for examples, the EU accession process has encouraged institutional reform in central and eastern Europe, and WTO membership has contributed to reform efforts in China and elsewhere. An overriding requirement, though, is the need for a strong domestic commitment to institutional reform efforts. Mechanisms such as competition, transparency, and external anchors may help, but there is unlikely to be a substitute for sound domestic leadership in the key reforms needed to underpin better economic performance.

I hope you enjoy the chapter.

Hello, my name is Xavier Debrun and I want to talk to you about the chapter I wrote for the latest issue of the World Economic Outlook. The chapter is entitled: "Unemployment and Labor Market Institutions: Why Reforms Pay Off"

What is the chapter about? Well, over the last 20 years, unemployment rates differed markedly across industrial countries. Some, like the United States, maintained reasonably low average rates of unemployment; others like the United Kingdom, the Netherlands and Ireland witnessed steep increases in the early 1980s followed by a downward trend; but a third group in which we find large euro area economies like France, Germany, Italy and Spain, have been experiencing high and remarkably persistent unemployment rates since the mid-1980s. Many observers have long argued that labor market dysfunctions were at least partly responsible for these developments. If true, then high unemployment countries should correct those dysfunctions through reforms, that is, through changes in the institutions affecting labor relations. Yet, economists and policymakers still debate on the actual contribution of labor institutions to the persistence of high unemployment and, thereby on the potential benefits from reforms. This chapter provides a summary of the current debate as well as new evidence on the linkages between labor market institutions and unemployment.

So, does high unemployment really originate in flawed institutions? I address this issue using an extensive database covering 20 OECD countries since the early 1960s. Such a wide coverage is essential because critics of the case for labor reforms point out that European unemployment was low in the 1960s and the 1970s in spite of institutions broadly similar to the ones they have today. The same skeptics also underscore the satisfactory performance of countries with apparently rigid labor markets such as Denmark, Sweden and Norway. A comprehensive statistical analysis nevertheless provides robust evidence that labor market institutions are indeed an important determinant of unemployment.

Now, which are these institutions contributing to high unemployment? The study focuses on a number of usual suspects. First, generous unemployment insurance increases unemployment because incentives to actively look for a job are weakened. Second, strict employment protection tends to increase unemployment because firms are reluctant to create jobs they might find too costly to eliminate if needed. Third, high labor taxation also increases unemployment because of its direct effect on labor costs. Finally, other institutions directly affecting competition in the labor market, such as high rates of unionization and coordinated wage bargaining schemes, may also engender unemployment.

Now you might ask: if things are so straightforward, what keeps the debate going? Well, I have to admit that the effects of labor institutions on unemployment hardly appear to the naked eye. The main reason is that each country has a unique institutional framework characterized by a specific combination of employment protection, unemployment benefits, labor tax policy, unionization and so on. It is therefore necessary to investigate the possibility that the relationship between unemployment and, say labor taxes, might depend on other elements of the institutional framework: unionization for example. These interactions among institutions indeed appear to be critical, bearing important implications for the design of labor market reforms. First, the most effective mix of reforms depends on the existing institutional framework and is therefore country-specific.

In other words, there is no one size-fits-all medicine to cure high unemployment. Second, comprehensive reforms exploiting possible complementarities between the various measures are preferable to isolated actions. Finally, what do we know about the potential gains from reforms? Here, I relied on a variety of simulations performed with my empirical model as well as with the IMF new Global Economy Model. I found that a convergence of euro area labor institutions to those in the United States might lead to a reduction in unemployment rates by about 3 percentage points and bring about output gains of more than 5 percent. So, the evidence suggests that reforms do indeed pay off.

I hope you will enjoy reading this chapter.