Realizing the truth of potential real GDP… but why take so long?
Paul Krugman mentions a “blockbuster” paper from the Fourteenth Jacques Polak Annual Research Conference. The paper is titled Aggregate Supply in the United States: Recent Developments and Implications for the Conduct of Monetary Policy. It was written by Dave Reifschneider, William L. Wascher and David Wilcox… all from the Federal Reserve Board.
The paper states the seriousness of high unemployment and a falling potential real GDP.
“Our point estimates suggest that, in combination, these developments — whose eventual magnitude was arguably apparent only in hindsight — shaved almost 7 percent off the level of potential output relative to its pre-crisis trend. That said, the uncertainty about this estimate is extremely high and the implications for future growth are quite uncertain.”
7% is a big drop. and I would argue that this was not “apparent only in hindsight”. I have been saying this for a while.
It is true that statisticians now have years of data since the crisis to crunch the true potential real GDP. Yet, I use a model that does not rely on years of data to crunch the knowledge. My model shows quickly in real time that potential real GDP started falling drastically during the crisis. And is back on a normal and stable but lower path.
What they find in the paper above has been readily visible with simpler model that does not rely on statistical analysis of data. The equation to determine potential real GDP is based on labor share for demand constraint, and the utilization rate of capital for supply dynamics.
Potential real GDP = real GDP – biz cycle amplitude constant * (capital utilization/effective labor share – 1)
This is one of the big problems in economics… The dependence on statistics instead of real time models.
My equation does not rely on years of statistical data, but on real time data such as real GDP, capacity utilization and labor share. Once you understand the dynamics there, you can track potential real GDP in real time.
When real GDP dropped big during the Volcker recession, the equation above showed that potential real GDP did not budge much downward. The realization was that the economy would recover back to its trend after the Volcker recession. But now the equation showed instantly that potential real GDP was dropping during the crisis. We could have known back in 2009 the seriousness of what the paper above is now bringing to light.
Economics needs more real time equations like the one I present above.
Here is the update for potential real GDP (green line) according to the equation above. Keep in mind this view of potential real GDP defines it as the center of the business cycle. Real GDP is the blue line. Effective demand is the red line.
If I take off 7% from the potential real GDP (green line) in this graph, the green line shifts downward. I multiply the potential real GDP line by 93%. Here is the graph.
You can now see that the previous trend to the left and the trend that I am now calculating match up (shown by purple line). Thus my simple equation confirms the finding in the “blockbuster” paper. But we could have known this years ago.
KISS… Keep it simple statisticians… and you will know these things faster.