The Primary & Huge Error of Macroeconomics… Potential Output
What is the primary error in macroeconomics? Potential output… and this error is huge. The measure of potential output is the foundation for many calculations.
- Natural real interest rate
- Natural level of unemployment
- Monetary policy
- Slack
If you get these wrong, there will be problems. Paul Krugman wrote an article for the IMF, Increasing Demand. He writes…
“First, we don’t really know how far below capacity we are operating… Nobody knows—”
How wrong has macroeconomics been? Well, I am going to compare the CBO projection of potential real GDP with my own calculation of potential from my Effective Demand research.
As real GDP declined back in 2008, the CBO was not adjusting their projection of potential (pink line). Whereas my calculation (dark red line) moved horizontal for 3 years. My calculation showed that potential real GDP dropped to a lower trend line… a lower “New Normal”.
The red arrowed lines show the discrepancy between my view of potential and the view of all major economists since the crisis. The discrepancy is huge and started early. The macroeconomic discourse has been based on this major error since the beginning… and the CBO downward revisions of potential have not cleared the error.
Assume for a second that my calculation of potential is correct. Then you realize that
- monetary policy has been misguided.
- imbalances have been building from erroneous policy for 5 years.
- Larry Summers’ projection of a negative natural real interest rate is misguided.
- secular stagnation is just dropping to a new trend line.
I will make two more comparisons of the CBO potential real GDP and the effective demand potential.
Volcker Recession
During the Volcker recession, real GDP dropped quite a bit. However, the potential real GDP from the effective demand research did not drop to a new lower normal. It followed parallel to the CBO projection… and then moved with real GDP after the recession. The economy had a normal recovery from the recession.
2001 Recession
In 2000, real GDP (yellow) started to flatten and fall. While the CBO was raising their projection of potential (pink), my effective demand potential (dark red) was beginning to flatten as well. Eventually all lines come back together in 2004.
But the important point is that potential real GDP gives a measure of slack in the economy (unused utilization of labor and capital). This measure of slack is critical for monetary policy. In 2000, the effective demand potential was showing that slack was increasing into a recessionary gap (real GDP less than potential). However, the CBO was still showing a high inflationary gap (real GDP more than potential). Greenspan saw the inflationary gap, saw inflation rising in 2000, expected more inflation and raised the Fed rate. The recessionary gap started to form months later. The effective demand potential said that he should not have raised the Fed rate like he did.
Carl Walsh wrote in 2001 for the Federal Reserve Bank of San Francisco in an article titled, The Science (and Art) of Monetary Policy...
“As the economy grew rapidly during the second half of the decade (1990’s), economists were uncertain whether real output was rising above potential, in which case interest rate hikes would be called for, or whether both actual and potential output were growing more rapidly, leaving the output gap stable.”
The ED potential GDP showed the latter; potential was rising leaving the output gap stable.
Conclusion
In my view, Volcker was not misled by the CBO’s projection of potential. Yet Greenspan in 2000 was misled… Now, the Fed and major economists have been hugely misled for 5 years by a CBO projection of potential that is much too high… Years from now, macroeconomics will look back and recognize this great error.
Note: The equation for Effective Demand potential real GDP…
ED Potential real GDP = real GDP – $3.4 trillion * (capacity utilization/(index of non-farm business labor share * 0.762) – 1)
Seems like you have a problem then. If we have been operating above potential for four years, where is the inflation? If interest rates are too low where is the boom? Is seems if anything, your chart demonstrates monetary policy has been just where it should be to keep real aligned with potential.
Lord,
Where is inflation? An inflationary gap does not have to be inflationary. That is just its name given from the 1970’s.
Inflation is low from the Fisher Effect. Here is a link to a past post.
http://angrybearblog.strategydemo.com/2014/05/dallas-fed-lays-an-important-foundation-for-fisher-effect.html
So while it seems that we do not have an inflationary gap because we do not have inflation, we have the conditions for low inflation from steady and low nominal rates…
The more the Fed or ECB holds nominal rates low, the more inflation stays low… right up to the top of the inflationary gap… and labor share has been dropping, whereas in the 70’s it was high. This lower effective demand creates a drag on prices.
Lord,
The negative output gap is an illusion, because everyone is told that there is still a lot of slack. So there must be a negative output gap.
But realize that the stock markets have been hitting records for months. Do you really think that the stock markets can continue hitting records all the way up to the potential that the CBO is projecting? Wait until the Fed sees fit to start normalizing monetary policy. Then you will see the economy normalize.
From: http://www.federalreserve.gov/newsevents/speech/yellen20140822a.htm
Extracted from Janet Yellen speech 22 August 2014 at Jackson Hole: “Over the past several years, wage inflation, as measured by several different indexes, has averaged about 2 percent, and there has been little evidence of any broad-based acceleration in either wages or compensation. Indeed, in real terms, wages have been about flat, growing less than labor productivity. ”
Total Household Debt seems to have stabilized, so it looks like consumers are no longer living on loans. Given that, I wouldn’t expect inflation, if wages won’t support it!
Someone has to purchase goods for more inflated prices. Who would that be?
I might have to argue with “primary.” Failure to see the bubble and crash – pretty basic.
As a matter of policy, it would have been/still is possible to execute a plan which would increase labor share. While most macroeconomists who would support it might not highlight “labor share” they would be right about the impact in closing the gap.
Another view of potential output is to simply look at the direction and focus of human energy in a system. By that standard, the US is operating far below potential right now, and also far below – and at the same time far above – optimal (a quite different measure.)
Imagine, for instance, an alien invasion. Human energy worldwide would immediately be mobilized and directed toward the important tasks opposing the invasion. Look at WWII and how British and American efforts were mobilized.
Right now, many Americans are running in place, working hard just to keep from falling behind, or dumping their energy into craziness or inconsequential activities — or letting their personal energy go to waste simply because no business can be bothered to hire them.
Low productivity in itself isn’t the worst problem. It’s the froth and stagnation, with a brimming ladle of shame-sauce, that’s poisoning the working world.
Noni
Noni Mausa wrote: “Look at WWII and how British and American efforts were mobilized.”
Of course you are right about that, but that effort in the US required a top income tax bracket of 94% and huge federal government deficits.
There is no political will to spend at anything remotely approaching those wartime levels. And we don’t require that high a percentage of the population to be employed to provide the US with consumer goods, even without imports.
Edward is looking at another problem. If you believe that we are way below Potential Output then you could over stimulate the economy and risk high inflation. (If conditions were normal.) So being able to discover the true Potential Output is important for the Fed.
But conditions are not normal. Consumers are carrying too much debt so they can not or will not borrow much more money, and their real incomes are stagnant. (Both in the aggregate.)
For now overstimulation is the least of our worries because consumers can not drive higher inflation anyway. And producers will not produce what they can not sell, so they do not need to invest in more capacity. So what would the source of the demand be that would cause inflation? If the answer is speculative bubbles, then those should be controlled by forcing bankers to use tougher underwriting standards. A speculating customer’s stock or commodity is very very poor collateral.
From: http://www.federalreserve.gov/newsevents/speech/yellen20140822a.htm
At Jackson Hole Janet Yellen said “First, the sluggish pace of nominal and real wage growth in recent years may reflect the phenomenon of “pent-up wage deflation.” The evidence suggests that many firms faced significant constraints in lowering compensation during the recession and the earlier part of the recovery because of “downward nominal wage rigidity”–namely, an inability or unwillingness on the part of firms to cut nominal wages. To the extent that firms faced limits in reducing real and nominal wages when the labor market was exceptionally weak, they may find that now they do not need to raise wages to attract qualified workers. As a result, wages might rise relatively slowly as the labor market strengthens. If pent-up wage deflation is holding down wage growth, the current very moderate wage growth could be a misleading signal of the degree of remaining slack. Further, wages could begin to rise at a noticeably more rapid pace once pent-up wage deflation has been absorbed.”
The assumption that there could be ‘pent-up wage deflation’ is a little scary. The fear of rapidly rising wages and the counteractive economic measures would be the quickest way to get us into DEFLATION. At a minimum it would postpone any recovery from the Great Recession.
Hey J, you know of course that the 90+% top marginal rate FOLLOWED, did not precede, WWII. What FDR, Churchill et al. unleashed was the basic energy underlying their nations, the brains, muscles and passions of their citizens, which does not need to pass through the commercial profit-and-loss system. And such a process could be unleashed again, with or without a confiscatory top marginal. It might take a massive threat or shared endeavor of some sort to break the current plutocrat system, but it is there to be tapped.
This is why I don’t think of the fat cats as “job creators,” but rather as “job preventers” or “job limiters.” They stand between goods and services on the one hand, and the people who want those things, on the other hand. Unless people’s efforts can be structured as a profit-stream, or unless people can afford to expend their effort for free, needed efforts are fenced off from needy recipients (“needy” only in the sense that it would suit both parties to provide and receive each others efforts.)
What sorts of tasks need WWII size efforts right now? How about the immediate and essential task of stepping smartly back from the brink of climate disaster? Anybody who doesn’t think that outranks WWII as a priority is sort of missing the point of human life on this planet.
Noni
I did this table a few years ago to illustrate the problem with the number brackets. But it also gives the top tax brackets:
Year__Tax Rate for $4000___Tax Rate for $25,000___Highest tax rate____For Income over___Number of Brackets
1925_________3%_________________12%______________________25%___________$100,000__________23
1932_________8%_________________18%______________________63%__________$1,000,000_________54
1934_________8%_________________21%______________________63%__________$1,000,000_________30
1936_________8%_________________21%______________________79%__________$5,000,000_________33
1940 _________8%________________31%______________________79%__________$5,000,000__________31
1941________17%_________________48%______________________81%__________$5,000,000_________32
1942________26%_________________58%______________________88%___________$200,000__________24
1944________29%_________________62%______________________94%___________$200,000__________24
1946________26%_________________59%______________________91%___________$200,000__________24
1951________27%_________________60%______________________91%___________$200,000__________24
1952________29%_________________66%______________________92%___________$200,000__________24
1954________26%_________________59%______________________91%___________$200,000__________24
1964________23.5%_______________53.5%_____________________77%___________$200,000__________26
1965________22%_________________50%______________________70%___________$100,000__________25
1971________21%_________________40%______________________70%___________$100,000__________25
1977________17%_________________40%______________________70%___________$102,000__________26
1979________16%_________________39%______________________70%___________$108,300__________17
1982________14%_________________35%______________________50%___________$41,500___________14
1983________13%_________________32%______________________50%___________$55,300___________14
1984________12%_________________30%______________________50%___________$81,800___________16
1985________12%_________________30%______________________50%___________$85,130___________16
1986________12%_________________26%______________________50%___________$88,270___________16
1987________15%_________________28%______________________38.5%_________$54,000____________5
1988________15%_________________28%______________________28%___________$17,850____________2
Note : The rates stayed the same between the years shown.
Rates from: http://www.taxfoundation.org/publications/show/151.html
The top tax bracket was 79% in 1936 and just kept going higher until it reached 94% top tax bracket in 1944. So high taxes helped pay for WWII.
Doing a nationwide project repairing or rebuilding roads and bridges would be a no brainer, paying dividends long into the future. In my area we have a double decker bridge for I-75 as it crosses the Ohio River. It was built about 1960 and is in good physical condition, but it is too small for today’s traffic load. They have eliminated the emergency lanes, so it is a safety hazard. But the federal government will NOT pay to replace this bridge. Everyone is saying that another bridge will be built beside it and there will have to be tolls. Tolls on a major interstate highway running from Michigan to Florida makes absolutely no sense to me.
The problem is that there is no bipartisan political will to do much more deficit spending or to increase taxes. Without bipartisan support this it is just something to argue over. The US Congress has been very good at arguing.