The Silly Confusion over Potential GDP
As a small economist, my views are not seriously taken seriously. But still, if I turn out to be right, I will have bragging rights. So Paul Krugman wrote today about how the IMF way over-estimated the potential growth path of GDP. His post is titled, The Damage Done…
“That’s a huge shortfall. Yet the IMF believes that the output gap is only a couple of percentage points. If so, either there was a huge coincidence — a sudden, unanticipated drop off in potential growth that just happened to coincide with the financial crisis — or the crisis, and the poor macroeconomic management that followed, have done incredible damage.”
OK… so what happened? Was there an unanticipated drop off in potential growth or was there poor macroeconomic management?
I have never been confused over potential GDP. Mr. Krugman wants us to think that there was poor macroeconomic management. But there really was an unanticipated drop off.
Over a year ago, I saw potential GDP had started trending lower right away during the recession. Here is a graph of the CBO potential and my calculation of potential GDP (green line). (link to graph)
While the CBO and Federal Reserve continue to adjust downward their estimate of potential GDP, my line for potential GDP started trending lower right away. It flat-lined until 2010 and then settled into a stable lower growth path. I have never had to adjust my calculations of potential GDP. Real GDP keeps moving right along my potential GDP. The confusion by economists and central banks over potential GDP will end up being expensive. Hard to say that humbly as a small economist, but from what I see, the great economists still have something to learn.
Now was there mismanagement of the macroeconomy? This is the real question? Was the economy hurt somehow by some policy? Would real GDP have trended faster upward if we had done something “correctly”?
From what I see, economic growth has been on a normal path in this business cycle. So no, I do not see any real damage, Mr. Krugman. The economy is growing normally. Let me explain with the model for effective demand.
I only want to focus on the blue line, which shows how real GDP grows as more labor and capital is utilized. The blue line has a y-intercept of zero. (see post for explanation of model) Now ask yourself, as the business cycle goes through its expansion phase, would real GDP really tend to rise up that blue line on a straight trajectory? or would it take lots of different angles?
If real GDP tends to rise up that blue line on a regular basis, we could conclude that when real GDP moves up that blue line, the economy is expanding normally… and that there are no real shocks to normal growth.
Here are a series of graphs using real data for the model above. The blue lines that you see below have y-intercepts of zero. You will see that real GDP (the green lines) has always risen along this blue line during the expansion stage of previous business cycles. Then look at the last graph to see that real GDP in the current business cycle is once again rising normally.
And finally, the current data. You will see real GDP settle into its new trend by the middle of 2010 and began following the standard rise of the blue line. … And has been very close to the blue line ever since.
So when all the economists pull their hair out over how real GDP rises or falls from quarter to quarter, they look pretty silly. Real GDP is rising according to its standard path.
Real GDP has been growing on a very stable path in spite of policy mistakes that people may try to point out. However, the mistake of keeping interest rates low in hopes of growing the economy back to where it was before, has not hindered nor really helped growth. Low interest rates will be a problem when the business cycle starts ending earlier than economists think.
Sidenote: Look closely at the above graphs. The real instability at the end of a business cycle comes when real GDP begins to deviate to the upside of the blue line. Real GDP is currently staying on the blue line and rising normally. So relax everyone. The economy is behaving normally… and there is no apparent disaster from macro mismanagement. The economy simply adjusted to a new level very early on in the crisis and has been following that new level.
The real disaster is how great economists, like Mr. Krugman and many others, have gotten potential growth wrong from the beginning and continue to do so…
Are you arguing that had we invested in infrastructure to the amount the ASCE had called for, the economy would not be churning along at a much higher level by now?
Seems to me like the lack of such investment was a huge policy mistake that was a detriment to our economic growth.
Axt113 & Mike
The economy was due an adjustment. Do you think that the output level before the crisis was socially sustainable? It was built on bubble stimulus policies. Do you think that the higher output in China is sustainable with their bubble lending? Eventually the costs have to be paid or eaten.
I would want you to see in the last graph that real GDP made a smooth transition to a normal level. And once it settled into that level, the business cycle proceeded as normal employing labor and capital along the blue line. That has been the pattern for all business cycles before, except in the late 90’s when effective demand rose allowing productivity to raise real GDP vertically. That was a special case for a business cycle. The normal pattern is that once the business cycle settles into its level, it tends to stay close to that level.
I want to call the blue line in the graphs above an attractor state for the business cycle. I am not sure that is the best term, but let me go with it here.
You are saying that we could have shifted the real GDP line up above its “attractor state” blue line by infrastructure spending. I am making a case against that view…
According to the patterns above, all we would have done is move up the attractor state blue line faster. We have moved up the blue line faster in the past. We would have employed labor and capital faster along the attractor state line. That blue line would not have shifted up. The past patterns show us that the blue line only shifts up at the very end of the business cycle as effective demand puts a profit rate limit on the utilization of labor and capital.
So Yes, real GDP would have risen faster, but we would have hit the effective demand limit faster too. Thus you would have shortened the business cycle.
Now, if increased infrastructure spending would have somehow increased labor’s share, then you would have extended the business cycle as you shortened it.
However, past patterns show that effective demand also settles into an attractor state. It rarely shifts up during a business cycle.
So in all, I think your idea would have just shortened the business cycle.
Let’s realize that everyone acknowledges that we need to know more about how the business cycle works. And what I present above is not found in any books. It is my own personal work. Yet, it shows patterns that repeat.
One more thing to add… the current attractor state line points to $21.750 trillion at 100% utilization of labor and capital (the limit of the x-axis in the graphs). We have been employing labor and capital directly toward that constant level of productive capacity. Other business cycles moved toward lower yet also constant levels.
The previous cycle before the crisis had a productive capacity level of $16.7 trillion. The business cycle before the 2001 recession ended up heading toward a productive capacity of $14 trillion. So there was a 20% jump in productive capacity between those two business cycles.
The current jump from $16.7 to $21.7 trillion is a 30% jump.
So doesn’t it seem to you that the current jump in productive capacity is a nice hefty jump?
Productive capacity is not the problem with the economy. Economists continue to think that increasing production and stimulus is the answer.
No… the problem is low labor share resulting in low effective demand. The economy will seem sluggish and under-performing in terms of the utilization of labor and capital. For example, housing is slowing down because the rich are slowing down their purchases, and the middle and lower incomes are not strong enough. The key is to raise labor share. That is the only answer to the sluggishness of the economy.
Yet, labor share is in its own attractor state and will not budge until another recession can allow it to shift. Hopefully it will not shift down. So we will have to make sure it shifts up when that time comes.