Yes, Potential output is lower… that is old news.
Yes, potential output is lower than people thought, much lower.
I have been saying for almost a year that potential output is lower. (link 1, link 2) Commentators on Mark Thoma’s blog thought I was nuts. Mark Thoma himself did not agree with me. Mark Thoma now offers one explanation to his class that the cause could be hysteresis, where long periods of unemployment make the economy more sluggish. But Eric Morath contradicts that view…
“The finding backs an emerging view that the relatively weak recovery is due to more than just the deep recession. Economists appear to have not accurately projected the impact of a number of trends, including demographic shifts and changes in the number hours worked per week, that were taking shape even before the recession took hold.”
Even David Beckworth recently (January 17th) wrote about natural interest rates and concluded using the Finance-neutral method that the output gap was still large.
“We cannot directly observe the natural interest rate, but there is evidence of ongoing slack in the economy. And since slack–or a negative output gap–is a key determinant of the short-run natural interest rate, it is reasonable to believe the natural interest rate has been depressed over the past five years.”
Even Paul Krugman believed potential output was little changed from before the crisis…
“…potential output is defined as the highest level of output consistent with stable low inflation. If you want to claim that an economy has grown unsustainably above potential, you need to show me the accelerating inflation.” (link)
“potential GDP is a measure of how much the economy can produce, not of how much people want to spend.” (link)
Yet, he makes a mistake. True potential does depend on how much money people have to spend. If not, then why doesn’t Chinese firms sell more to their domestic population? Well, it’s because people in the US have more purchasing potential.
As for inflation, if production is healthier than how much people have to spend, inflation will be muted. We live in a world of under consumption from fallen labor share in advanced countries. Europe and the US are concerned about weakening inflation.
Krugman needs to acknowledge the weakness in his potential output concept. He would have been able to foresee the reality of a small output gap.
So we see top economists making a crucial mistake in determining the output gap. Now the risks of easy monetary policy will become quite apparent. As Mark Thoma offers a warning to his class from the 30:00 to 31:30 minute points in this video…
“If that is true (very small output gap), then they (the Fed) should back off the stimulus starting now.”
I based my calculations on labor share over a year ago and got it right. So this news about potential output being lower is not news to me.
I agree with you. In fact , I think you can make the case that we’re above potential , since we should have as a primary goal further deleveraging from the current high debt loads across the economy.
The only way to increase potential that doesn’t imply releveraging is to shift incomes to those who will use it to increase demand ,and away from those who hoard it or use it to speculate on assets. Increased labor share is one way to do it. More progressive taxation combined with , say , gov’t-funded universal health insurance , is another. A higher minimum wage is a move in the right direction , but won’t do much by itself.
A proper finance-neutral output gap must first establish the desired long-term economy-wide leverage ratio. We’re now above 240% debt/gdp ( using nonfinancial , public and private debt ) and I think we should be aiming for something around 150-180% , i.e. 50-60% each for the public , household , and business sectors. Since we’re no longer delevering towards that lower level , my “finance-neutral” output gap measure says we’re currently running above potential.
To get to 180% debt/gdp over time , assuming 5% ngdp growth , we’d need to average ~9% growth in new borrowing as a share of ngdp , but instead we’ve been running at ~11% , and we haven’t been hitting 5% ngdp growth , either.
We either need some kind of an incomes policy , or a debt jubilee , or some combination of the two. Otherwise , we’re doomed to stagnation or another destructive credit bubble blow-up.
So Edward, say the Fed increases IOR and/or greatly tapers QE.
What do you see happening?
It’s hard to imagine anything like a pretty picture…
Is this a “take your medicine now” approach?
Krugman’s position would be that “potential” has a specific definition within economics and , in that narrow sense , he’d be right. But he allows his belief in those definitions to blind him to the reality of the current situation. He thinks a properly-sized fiscal stimulus will boost us back into a sustainable , full-employment equilibrium. That equilibrium would last only as long as the stimulus lasts , but Krugman doesn’t see that , or won’t admit to it , at least , in spite of his supposed buy-in to Summer’s “secular stagnation” thesis.
Economists need to talk about supply potential vs demand potential , and which one of the two is the binding constraint at any given time. Right now , it’s demand , and you can make the case that it’s been demand for a very long time. When debt and asset prices rising faster than GDP ( unsustainably , by definition ) are necessary to sustain aggregate demand , it seems pretty clear to me which “potential” is binding.
I believe that if economists truly understood the beginning and then the end of the Great Depression then effective demand limit would already be widely accepted. (Debt and then increased personal income and rationing which led to personal savings.)
It is as though the rejection of the importance of effective demand (and labor share) was so important that the cause of the end of the Great Depression had to be muddled. (Subconsciously?)
Recognizing the source of our current problems will not bring instant relief.
It will mean a realization that the low interest rates and QE were irrelevant to a truly self sustaining recovery. They were just cosmetics applied to an ugly pig of an economy. Remove the cosmetics and you still have an ugly pig. And the cosmetics were not cheap. The cosmetics should have been applied liberally for the first 2 or 3 years and then withdrawn so as to understand what the economy was truly like. (Repeat 1937.)
The most important question is how to increase labor share. You either search out the primary cause of the lower labor share and deal with that or you apply a series of patches. (Raise the minimum wage, reduce the work week from 40 hours, realign the income tax rates or do all of those)
I believe that the Global Free Trade (GFT) religion has been a disaster which lowered labor share in this country. (We never should have allowed trade deficits to get this far out of control.) We need to deal with that immediately because the near future holds another problem for labor share. That is automation. Some want to confuse that with our labor share problems dating back over the last two decades and thus avoid dealing with GFT.
Yes, take the medicine now. But like Thoma says in that video link… economists are still debating the output gap and the side that says the output gap is still large is winning. But he also says that if inflation starts appearing, Yellen is very capable of tightening.
You make an excellent point about the stimulus being falsely seen as a remedy for a small output gap. “That equilibrium would last only as long as the stimulus lasts.”
As I see it, low labor share is a binding constraint. If you take away the stimulus, the economy falls back to the constraint.
Your words should be heard from the highest mountain tops to all the coasts. Your words have a deep vision.