Reality of Potential GDP Sinking In

A new paper came out this month from the Board of Governors of the Federal Reserve System talking about how Potential Output is lowered after recessions. (link) They make a case that potential output is lower than people think and that the economy adjusts too slowly to that reality.

At the end of the paper, they call out to economists to figure out how this happens.

“As a profession, we may need to rethink how we adjust potential output and growth forecasts around recessions.”

Keep in mind that potential GDP is critical to having a correct monetary policy. This is an important topic.

Even Paul Krugman wrote an article for the IMF, Increasing Demand

“First, we don’t really know how far below capacity we are operating… Nobody knows—”

Maybe I do… Two and a half years ago I wrote that potential output had fallen to a new lower trend level, much lower than the CBO was projecting. (link) I based this view on my model of effective demand. That post was linked from Mark Thoma’s economistsview blog. Some commenters at his blog thought I was crazy and asked Mark to never link to me again.

In the post I wrote…

“What does it mean that potential real GDP could fall so harshly? Many economists can’t fathom a fall in potential real GDP. They think that it represents the natural potential of the economy using its full resources of labor and capital. They think that the economy will simply return to that level as labor and capital are re-utilized. But this is where the principles of Effective Demand come in and explain the situation. A lower effective labor share has locked the utilization rates of labor and capital into lower levels. The economy won’t be able to utilize labor and capital to the extent that it needs to in order to return to the historic potential trend.”

I posted another article about potential output one year ago. (link) In the post, I compared the changes to potential output around 3 recessions. I showed how potential GDP did not change much after the Volcker recession. I showed how potential output around the 2001 recession was different from what the CBO was projecting. I again showed how potential output had fallen after the 2008 recession. Thus, my model was able to discern how potential output changed around different recessions.

This ability to discern changes in potential output has apparently eluded economists, but my model can discern those changes.

I concluded that article by saying…

“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.”

Now just a year later, the Board of Governors of the Federal Reserve System have a new paper where they at least recognize that potential GDP can significantly change around a recession. Yet, apparently they still don’t have a model to discern those changes.  Well, I have one to offer…

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