Kingdom of the Netherlands—Netherlands: Selected Issues and Analytical Notes

Important issues of the Netherlands are discussed. Openness to trade has benefited the Netherlands before the crisis and has supported the recent recovery process. However, both financial openness and trade linkages have also been a transmission channel for the financial crisis. Synchronized fiscal tightening across Europe has important spillover effects for GDP growth. The improvement on the supply side of credit has contributed to a normalization of the credit market. However, the recent increase in the financial stress index indicates that the situation is still fragile.

Abstract

Important issues of the Netherlands are discussed. Openness to trade has benefited the Netherlands before the crisis and has supported the recent recovery process. However, both financial openness and trade linkages have also been a transmission channel for the financial crisis. Synchronized fiscal tightening across Europe has important spillover effects for GDP growth. The improvement on the supply side of credit has contributed to a normalization of the credit market. However, the recent increase in the financial stress index indicates that the situation is still fragile.

Analytical Note 5: Potential Output Estimates and Structural Policy1

A. Introduction

1. The Dutch economy has suffered a very severe downturn by its own historical standards and those of other countries. For the first time in two decades, the Netherlands experienced a recession: from the second quarter of 2008, quarterly growth was negative for five quarters, with a cumulative (peak-to-trough) loss of output of 5.4 percent of GDP.2 Positive growth has returned, but output remains well below its peak of mid 2009. To put it in perspective: if the economy were to grow from its trough in the middle of 2009 at its pre-crisis trend rate of 2.2 percent per year it would still need 10 quarters to merely reach the level of output attained in 2008 (i.e. the end of 2011).

2. An important factor bearing on the strength of the recovery is the potential growth rate. Given the depth and duration of the recession, it is imperative that the economy grow as quickly as possible. This will be more difficult if the economy has also suffered losses to potential output, such that the recovery is not simply a case of restoring demand but also taking appropriate supply side measures. The level of potential output will also have implications for appropriate monetary and fiscal policy.

3. History suggests that financial crises can damage potential output. Studies of recoveries of previous recessions arising from financial crises suggest that recoveries are slower, on average, than those following other types of recessions (IMF 2009a). This weakness can be attributed in part to permanent output losses, which imply that economies that experience financial crises suffer losses to productive potential (IMF2009b). Consequently, it is important to have a sense of whether the Dutch economy has experienced permanent losses to potential output.

4. Estimating the level of potential output is especially difficult in the aftermath of a major recession. Even in normal times, estimates of potential output are subject to considerable uncertainty. The obvious problem is that potential output is not directly measured, and has to be inferred from observable data. This is particularly complicated in the current situation. In particular, one must be careful when using methods that impose the answer by construction—for example, the popular practice of using two-sided moving averages to smooth through data can work well when business cycles are regular, but is associated with more uncertainty when the only available data are from the immediate aftermath of a recession, especially one as severe as the recent recession.

B. Estimates of Potential Output

5. This note discusses the results from three different estimates of potential output comparing a standard HP filter, a production function approach and a multivariate approach. While the HP filter is a univariate approach and uses only the information derived from output, the production function approach derives the output potential from capital, labor and TFP trend, which, in turn, are determined using an HP filter. The multivariate filter approach (MVF) instead models the joint behavior of output, unemployment, capacity utilization, inflation, and inflation expectations. The approach can be thought of as using a reduced form New Keynesian model, estimated on data for the Netherlands, to infer the levels of potential output and the NAIRU that would be consistent with these observations. The technical details of the model and its assumptions are presented in an appendix.

6. The estimates of the output gap following the crisis are large by normal standards, but not as severe as for other major advanced economies. The output gap is estimated to have been as large as -2 to -2.5 percent in 2009 (Figure 5-1). However, this gap is less than those for other advanced economies. Estimates in Benes et al. (2010), which apply the MVF approach to data from other major economies, range from -4 and -3½ percent for Germany and France to -4 and -7 percent for the U.K. and U.S., respectively.

Figure 5-1.
Figure 5-1.

Output Gap Estimates

(In percent of potential output)

Citation: IMF Staff Country Reports 2011, 143; 10.5089/9781455286645.002.A005

Source: IMF staff calculations.

7. The production function approach and the HP filter suggest a closing of the output gap by 2015. Both approaches imply a rather gradual closing of the output gap. The multivariate approach suggests a faster recovery and a closing by 2014. This is due to higher growth forecasts in the years 2011 and 2012 compared to the forecasts underlying the HP filter and the production function approach. The higher forecast is in turn a result of the estimation approach, which is based on past recessions and can thus not include additional forward looking information such as the consolidation efforts across most countries in the aftermath of this crisis or other factors which are likely to retard growth.

8. All model estimates imply some losses in potential growth itself. The production function estimates indicate that the crisis resulted in a substantial, albeit temporary, reduction in potential growth rates of nearly 2 percent (yoy). The multivariate approach suggests a somewhat lower drop of slightly above 1 percent (yoy). However, there is a considerable amount of uncertainty around this estimate, and the 95 percent confidence band includes a drop of the size suggested by the production function approach. Qualitatively, we can interpret the MVF estimates as saying that the economy appeared able to grow steadily at high rates, with inflation largely under control, up until the crisis hit. Although inflation has fallen during the recession period, it has not fallen by as much as would be needed to conclude that the output gap is as large as the fall in output.

9. Multivariate model estimates indicate that the labor market is close to equilibrium. In comparison with other economies, the estimated path for the NAIRU is only marginally affected, rising slightly above its very low pre crisis level (Figure 5-2).3 The unemployment rate has neither increased during the crisis period by much, nor to anything like the levels seen in a number of other advanced economies, nor has the unemployment gap been large by historical standards.

Figure 5-2.
Figure 5-2.

Estimated Output Gap, Potential Growth and NAIRU

Citation: IMF Staff Country Reports 2011, 143; 10.5089/9781455286645.002.A005

Source: IMF staff calculations

C. Prospects

10. The multivariate model-based estimates suggest that growth rates will stabilize around 1.7 percent (yoy). To some extent, this forecast is imposed by the model (the steady-state growth rate assumption is 1.8 percent), but it is also a result of the estimated dynamics from previous business cycles in the Netherlands, which imply rather gradual convergence back to equilibrium.4

11. This implies a permanent loss of output. Year-on-year potential output growth is estimated at 1 percent in 2010Q3 under the multivariate approach. Continued growth at the predicted rate would imply a permanent loss of output relative to the pre-crisis trend of 4.5 percent. Results from the production function approach indicate a higher potential output loss of 6.75 percent. Although, the Dutch economy will eventually recover to and surpass the level of output at its pre-crisis peak, a sustained period of higher growth would be needed to restore the level of output to that implied by extrapolating the pre-crisis trend. IMF research indicates that such a pattern is commonplace in the aftermath of financial crises.

12. This loss could be alleviated if growth rates exceed the recent historical average for a sustained period. Higher growth rates have happened before: for example, the Dutch economy recovered from previous business cycle lows in 1993 and 2003 to reach growth rate peaks of 5.2 percent and 4.6 percent, respectively. Two factors give grounds for cautious optimism that growth rates could rebound more strongly if demand was higher, and need not be limited by short-run potential growth constraints:

  • Growth analysis suggests no substantial damage to labor participation or capital intensity. One approach to inferring whether there has been long-term damage to productive capability is to look at a decomposition of output growth by factors. After financial crises, capital intensity, the employment rate, and labor productivity are typically permanently lower. Analysis of data up until the end of 2009 suggests that the decline in output since the peak at the end of 2008 was mainly accounted for by a substantial fall in labor productivity (Figure 4-3). Comparison with the downturns of 1992 and 2003 illustrates that the decline in productivity has been unusually severe. However, labor productivity growth has rebounded strongly, and there are some signs of growth in other factors. Hence, to the extent that there has been no substantial reduction in capital intensity or labor participation, there should be no long-term damage to productive capability.

  • Decomposing output by production sectors indicates that the financial sector did not grow excessively. The nature of the crisis is to put particular stress on the financial sector. In those economies in which the financial sector expanded much more rapidly than other production sectors, one could expect that a consequence of the shock would be to reduce total output as resources are redirected away from the financial sector to other sectors. Given costs of shifting and adjusting labor and capital, this process could constrain potential output for some time. Analysis of the share of value added from financial services in total value added indicates that the financial sector in the Netherlands is important, but not excessively sized in comparison with other advanced economies. Moreover, the share has stayed roughly constant during the period leading up to the crisis, indicating less vulnerability of potential output to reallocations away from financial services.

uA05fig01
Source: Eurostat, national authorities, and IMF staff calculations, *Iceland: 2000-2005; Portugal: 2000-2006

13. Higher growth will depend on favorable demand conditions. Although there are no obvious signs of permanent damage to growth rates, higher actual growth than currently experienced would depend on very favorable external and internal demand. It will be important, for example, not to damage growth momentum by excessive fiscal consolidation in the short term.

Figure 5-3.
Figure 5-3.

Production Factors Around Output Peaks

Citation: IMF Staff Country Reports 2011, 143; 10.5089/9781455286645.002.A005

Source: National authorities and IMF staff calculations

D. Policies to Promote Growth

14. In the absence of strong population growth, policies will be needed to encourage greater work effort, capital intensity, and productivity. Trend population growth is low and declining. Over the past ten years, growth in working age population has averaged only just over 0.3 percent per annum. Population projections from Statistics Netherlands imply that this rate will decline further, to reach zero by 2038. Moreover, the population is aging, and the growth rate for those 65 years and older will be positive and substantially greater than the working age population growth rate for a sustained period. Consequently, the ratio of those of working age to those older than 65 years is projected to shrink from 4:1 to 2:1 within a generation. This has severe implications for output and the sustainability of social policies.

uA05fig02

ALMP spending

(percent of GDP, in 2008)

Citation: IMF Staff Country Reports 2011, 143; 10.5089/9781455286645.002.A005

uA05fig03

Labor force participation of the elderly

(55-64 years, in 2009)

Citation: IMF Staff Country Reports 2011, 143; 10.5089/9781455286645.002.A005

uA05fig04

Hours worked per week total employment

(in 2009)

Citation: IMF Staff Country Reports 2011, 143; 10.5089/9781455286645.002.A005

Source: OECD

15. Encouraging women to work longer hours and increasing participation of the elderly could enhance growth and reduce the costs of an aging population. The average participation rate of those aged 55–64 is relatively low by international standards. The estimated effective average retirement age is almost 4 years below the statutory retirement age of 65 years. Increasing the minimum age for early retirement and introducing steeper penalties to the replacement rate for early retirement could form an important element in reforming the pension system to encourage longer work lives and boosting output growth in light of the demographic developments.5 While the authorities are committed to increase the official retirement age, it is equally, if not more, important to raise the effective retirement age. The authority’s decision to maintain the subsidy system to firms that employ the elderly is one potential step.

16. Non-work income support is relatively high and potentially discourages a quick re-employment. Unemployment benefits in the Netherlands are among the most generous in advanced economies. Long-term unemployment benefits play a key role in the transmission of shocks on aggregate unemployment to long term unemployment. A disproportionately higher share of the recently unemployed could remain without work in the long term in the absence of a better incentive scheme to return to the work force. Thus there is a strong case to reduce the fraction of income which is replaced by the unemployment benefits. This would free up resources which could be redirected into training programs and other employment incentive measures for which Dutch spending is currently very low. De Mello and Padoan (2010) find from simulations that a reduction of the replacement rate by 10 percentage points can increase GDP per capita by 3 percent.

uA05fig05

Gross domestic expendittures on R&D

(percent of GDP, in 2008)

Citation: IMF Staff Country Reports 2011, 143; 10.5089/9781455286645.002.A005

uA05fig06

Total researcher

(per 1,000 labor force, in 2008)

Citation: IMF Staff Country Reports 2011, 143; 10.5089/9781455286645.002.A005

Source: OECD

17. To enhance productivity, research and development (R&D) should be fostered more rigorously. Gross domestic expenditure on R&D is fairly modest. This is partly due to lower public R&D investment but also to lower direct or indirect public funding of business R&D. The low R&D figures are mirrored in a low share of researchers relative to the labor force. More funding for R&D could not only increase productivity through innovation but also contribute to improved incentives for higher education by stimulating demand for highly skilled workers. Empirical evidence on R&D spending shows a clear positive effect on output. For example, a study by Guellec and van Pottelsberge (2001) find that an increase of 1 percent in business R&D generates an increase of 0.13 percent in growth while an increase of 1 percent in public R&D generates 0.17 percent in productivity growth.

18. Both productivity and working hours are negatively affected by traffic congestion. The Netherlands is one of the most densely populated regions in Europe and traffic is expected to increase further. Highly congested regions suffer output losses due to the lost value of time in traffic jams as well as potential effects on health (OECD 2010). While estimates of the total cost of congestion vary widely (0.2–4.2 percent of GDP) depending on the definition of the congestion cost and the exact method employed, the Netherlands features generally among the countries with highest costs. The large network of roads in the Netherlands is not sufficient due to the elevated population density and the transit character of the country. High congestion is also the result of the preference for passenger car transportation as opposed to public transportation. More investment in roads, while needed, could also have adverse effects unless complementary steps to promote public transport are undertaken. It potentially shifts demand from rail to road transportation as long as no parallel pricing of road traffic is introduced. While the authorities intend to increase investment in roads, implementation of a road pricing scheme has been postponed. A pricing scheme that reflects the social cost of private road transportation and opening up the transportation sector to more competition could provide a way to tilt incentives toward the use of public transport by increasing the opportunity cost of private transportation.

Table 5-1.

Summary of Impact of Relevant Structural Policy Reforms on Growth

article image
Source: OECD.

Appendix: Details of the Multivariate Model of Potential Output

The approach of the multivariate model of potential output is to treat the unobserved levels of potential output (Yt¯), the NAIRU (Ut¯), and equilibrium capacity utilization (Ct¯) as latent variables. After specifying a system of economic relationships between observed output, unemployment, capacity utilization, inflation, and long-term inflation expectations, the parameters of the system and the latent variables can be simultaneously estimated using maximum likelihood and the Kalman filter.1

There are four main economic relationships. First, an inflation equation relates the level and the change in the output gap to observed annual inflation, π4:

π4t=π4t1+βyt+Ω(ytyt1)+εtπ4

where y is the output gap and επ4 denotes shocks to inflation expectations. A simple random walk extracts inflation expectation shocks from observed inflation expectations, π4LTE:

π4tLTE=π4t1LTE+εtπ4LTE

The (unobserved) unemployment gap, u, is related to the output gap by an Okun’s law relationship:

ut=ɸ1ut1+ɸ2yt+εtu

where εu is the shock term. Finally, the capacity utilization gap, c, is also related to the output gap:

ct=k1ct1+k2yt+εtc

Given these economic relationships, identification of the gaps is accomplished by relating the gaps to the levels of actual output, unemployment, capacity utilization, and inflation. This is done by estimating equilibrium, or potential, levels for each of output, unemployment, and capacity utilization. The respective laws of motion for the potential output, unemployment, capacity utilization are as follows:

Y¯t=Y¯t1θ(U¯tU¯t1)(1θ)(U¯tU¯t20)19+GtY¯4+εtY¯U¯t=U¯t1+GtU¯ω100yt1λ(U¯t1Uss)+εtU¯C¯t=C¯t1+GtC¯+εtU¯

where, in each equation, the G term is a damped autoregressive process, meaning that the trend rate of change itself is stochastic. The system is completed by the three measurement equations which are given by the definitions of the (log) output, unemployment, and capacity utilization gaps

yt=YtY¯tut=UtU¯tct=CtC¯t

The following assumptions are made about steady-state levels:

Table A1:

Steady-State Calibration Values

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After estimation on Netherlands data, the values of the dynamic parameters are:

Table A2:

Estimated Parameter Values

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References

  • Arpaia, Alfonso, Kamil Dybczak, and Fabiana Pierini, 2009, “Assessing the short-term impact of pension reforms on older workers’ participation rates in the EU: a diff-in-diff approach”, Economic Papers 385, September 2009, European Commission.

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  • Benes, Jaromir, Kevin Clinton, Roberto Garcia-Saltos, Marianne Johnson, Douglas Laxton, Petar Manchev, and Troy Matheson, 2010, “The global financial crisis and its implications for potential output,” manuscript (Washington: International Monetary Fund).

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  • De Mello, Luiz, and Pier C. Padoan, 2010, “Promoting potential growth: The role of structural reforms”, OECD Economic Department Working Papers, No. 793.

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  • Euwals, Rob, Daniel van Vuuren, and Ronald Wolthoff (2010) “Early retirement behavior in the Netherlands: Evidence from a policy reform”, De Economist, 158:209–236

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  • Guellec, Dominique, and Bruno van Pottelsberge de la Potterie, 2001, “R&D and Productivity Growth: Panel Data Analysis of 16 OECD Countries”, OECD Science, Technology and Industry Working Papers, 2001/3,

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  • International Monetary Fund, 2009a, “From recession to recovery: how soon and how strong,” Chapter 3 in the World Economic Outlook (April) (Washington: International Monetary Fund).

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  • International Monetary Fund, 2009b, “What’s the damage? Medium-term output dynamics after financial crises,” Chapter 4 in the World Economic Outlook (October) (Washington: International Monetary Fund).

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  • Organization for Economic Cooperation and Development, 2010, “Economic Survey of the Netherlands”, Paris.

1

Prepared by Alasdair Scott and Sebastian Weber.

2

Quarterly real GDP growth has been negative on several occasions during the previous two decades, but never for two successive quarters, which is often used as a criterion for identifying classical recessions.

3

This result is neither driven solely by nor very sensitive to assumptions about the steady-state NAIRU, which was assumed to 4 percent, a value that could be considered high given that unemployment peaked at 4½ percent during the previous cycle.

4

See the parameter estimates in Table A2 of the Appendix. The values for the ρ and the τ parameters imply near-unit root behavior for the output gap and output gap trend growth.

5

Euwals et. al. (2010) find positive effects on the participation of the elderly of reforms aimed at discouraging early retirement as implemented in the Netherlands in the 90s. Arpia et. al (2009) find similar effects and a marked impact on the participation of women aged 55-59 in a sample of EMU countries. De Mello and Padoan (2010) find from simulation exercises that an increase in the retirement age by one year increases GDP per capita by 0.3 percent.

1

In practice, Bayesian methods are used to aid the estimation.

Kingdom of Netherlands: Netherlands: Selected Issues and Analytical Notes
Author: International Monetary Fund