lowered the path of GDP in all advanced countries. Further, the policy responses were not appropriate in that strong hysteresis effects of fiscal consolidation have likely led to a long term negative effect on output, particularly for Euro area countries. For their group of advanced economies, they contend that every 1% fiscal policy induced decline in GDP during 2010‐2011 has meant a 1% decline in potential output by 2015 and even more by 2021. Long recessions and slow recoveries lead to persistent short run dynamics that leave large effects on permanent output‐ in the aftermath of these recessions, these affects are seen both because of sustained unemployment of labor but also because of sustained drops in investment.

In conclusion, there is no such thing as a policy that simply stabilizes an economy, as all such policies also have implications for longer term growth and even potential output. Examining microeconomic developments, at the bank, firm or household level, and identifying reasons for sustained low output and growth (e.g. deleveraging, changed expectations, high rates of unrestructured loans), policy should maintain momentum for active restructuring and limiting the time that resources remain idle. The financial conditions of banks, households and corporations have real effects on current and future output because of the direct impact on consumption, investment (innovation and capital accumulation) and the labor market. A long period of depressed demand and output can raise long term unemployment rates while also lowering the labor force participation rate as workers become discouraged. Reforms facilitating redundancy may be anti‐productive in low growth contexts with fiscal consolidation (IMF 2016). Structural unemployment in the Eurozone countries is estimated to have increased. Recent research also concludes (IMF 2016) that the larger a country’s output gap, the more policy should prioritize growth in the short and long runs. While the IMF focusses on infrastructure investment and product market deregulation, this recipe holds for monetary and other structural policies/regulations. Finally, as countries consolidate, it is important to remember that the concept of fiscal space is not an immutable one. It is partly endogenous and partly can be influenced by policy (official creditors) and by market expectations.

**Lesson 12: Consider the windfall (in output and deficits) temporary in the presence of asset market booms.**

_<u>Unless potential output and structural fiscal balances are corrected for asset price booms, policy mistakes will be greater. While precision in applying these concepts is difficult, simple adjustments can be made. Fast and sustained increases in real government expenditures (and government size) should be a warning signal and extra revenues during asset market booms should be saved.</u>_ _<u>Potential output, structural fiscal balances and the design of policy.</u>_ The estimation of potential output, never an easy task, differs substantially across studies (and policy making units). However, in pre‐ crisis years, potential output estimates did not include an adjustment for the impact of (temporary) asset market led booms on current output. Kanda (2010), Athanasopoulou (2009), and Borio et al (2016) show how, after correcting for the impact of the financial cycle, the output gap preceding the financial crisis is much larger than without the correction. At the same time, structural fiscal balances were not really “structural” in the sense that revenue streams were not corrected either for the impact of asset market booms.<sup>81</sup> Borio (2010) estimates that in 2007, when the headline fiscal deficit was in slight surplus for Ireland, the properly adjusted structural balance was ‐7 % of potential GDP (and ‐13% in 2008). In 2007, the EC measured the output gap in Spain to be 2% of potential output. Borio et al (2013) estimate a “finance‐neutral” measure of potential output and find the positive output gap for Spain to have been 4‐ 5% of potential GDP in 2007. Using alternative methodology, but including financial factors, Alberola et al (2013) find the output gap to have been 6%. Conversely, after the crisis, the output gap was overestimated

> 81 IMF (Selected Issues, July 2014, CR 14/193); Kanda (2010).

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