Potential GDP & Real GDP are “in phase”… another economic mystery revealed

Edward Lambert | November 13, 2013 9:05 am

US/Global Economics

Many economists say we still have a big output gap and that we will eventually return to the potential GDP trend from before the crisis. It is not a wise view. Let me reveal a mystery to explain.

The following graph shows annual % growth for real GDP and potential GDP (center of business cycle). The red and blue lines are 2-year moving averages. Each point on a line represents the annual growth rate for the previous 2 years by quarter. The mystery is that Potential GDP and real GDP were “out of phase” before the 1990’s, and “in phase” since 1990. What does this mean?

(quarterly data has been faded to show moving averages.)

Potential GDP represents the center of the business cycle. Real GDP rises and falls in relation to this center through business cycles. As everyone watches real GDP, it is also important to watch the center of the business cycle (red line). Why? Because real GDP oscillates around that center. If the center rises, real GDP will oscillate at a higher level of output. Likewise, if the center falls, real GDP oscillates at a lower level of output.

Before the 1980’s, when real GDP growth (blue line) slowed down below 1% growth during a contraction, the average productive potential of the economy (red line) would actually be growing at levels of 4% or more. Thus contractions were a time when underlying economic growth would increase. This momentum created during a downturn allowed the economy to bounce back quicker. Since 1990, when real GDP slows down, average productive potential also slows down at a similar rate. Now the economy recovers slowly.

As well… Before the 1980’s, when real GDP rose fast, the growth of the potential of the economy would slow down. The effect would be a counter-balancing that maintained a more “stable” trajectory of economic growth. Since the 1990’s, when real GDP grows faster, the average productive potential grows faster too. It’s a pro-cyclical process. The current dynamic leads to bubbles.

The idea is that real GDP growth feeds upon itself into increasing productive capacity of the economy. An atmosphere of bubbles appears. People think that growth creates growth and the cycle will continue up and up and up. So there is more pro-cyclical behavior at all levels. The tendency to fall into a bubble economy is much more likely.

In the graph above, you can see that in the 1990’s, the economy maintained a higher high than had previously been “experienced”. (subtle reference to Jimi Hendrix) But we also see the economy hitting a lower low than has ever been seen for many decades. There is no mystery about this effect. When two waves are in phase, the resultant amplitude is increased… in both directions, up and down. The basic idea is that when real GDP and its center move in phase, the economy will experience higher highs and lower lows.

The next graph shows the overall movement between real GDP and potential GDP. Real GDP (yellow line) and potential GDP (red line) twisted in a braided pattern being “out of phase” before the 1980’s. Together they moved on a fairly straight path. Then when the two went “in phase” after the 1991 recession, both lines curved and “bubbled” to a new height. They started to come down during the 2001 recession, but a change in 2002 and 2003 ignited the housing bubble which kept the two “in phase” lines inflated. Eventually the correction came in 2008 and real GDP and its average productive potential both fell “in phase“. The higher high became a lower low.

The trend line during the bubble years was unsustainable due to real GDP increasing “in phase” with its center potential. It is important then to realize… Center potential has since fallen “IN PHASE” with real GDP. They fell together because they have been moving together “in phase”. This makes all the difference in understanding the economy. Potential productive capacity phased down as real GDP phased down. (see red and blue lines in first graph)

Economists like Mark Thoma talk about returning to the previous trend line of potential GDP. I simply disagree.

Here is Mark Thoma’s assessment back in March of 2012… Has he changed his views?

“But this is a temporary, not a permanent situation. Eventually people will be put back to work, trucks in parking lots will be back on the road, factories will reopen — you get the picture — and productive capacity will grow as the economy recovers. I believe many people are treating what is ultimately a temporary fall in capacity as a permanent change, and they are making the wrong policy recommendations as a result.

“In fact, there’s no reason to think productive capacity can’t return to its long-run trend just as fast or faster than output can recover. If so, then it would be a mistake to do as many are doing presently and treat the blue short-run y* line as a constraint for policy, conclude that the gap is small and hence there’s nothing for policy to do. Capacity will recover…

“I drew the long-run line so there is a long-run decline in the trend of our productive capacity after the recession (i.e. a permanent shock). However, it’s hard to see because, consistent with my beliefs, I do not think the change in our long-run capacity to produce goods and services will be as negative as many others. So the effect is not large in the diagram”

To reach the former potential trend, the economy would have to generate another bubble dynamic raising “in phase” not only real GDP but also its center potential. Do we really want another bubble dynamic? Is it even possible? How long would the Fed even allow this before they were forced to cut back on QE?

Anyway… How did these lines get “in phase”? and Will they go back “out of phase” in the future?