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…