Actual GDP, meet Potential GDP

August 6th, 2015 at 8:17 am

I recently posted a “letter to the Fed” wherein I questioned the rationale for raising interest rates given a variety of economic developments that I argued offer no compelling reasons to tap the brakes on growth.

Here’s a point I made in that post, regarding GDP growth: “the current economy is like a slow runner who still hasn’t caught up to a goal line that’s moving closer as she runs towards it.”

Someone reasonably asked me what the h-e-double-hockey-sticks I was talking about. So let me try to unpack that bit of econ word salad. It’s all in the figure below.


Source: BEA, CBO

To underline what this is all about, you only need to wrap your head around two concepts. The first one is simple: real GDP, just the good old value of the goods and services that comprise the U.S. economy, currently around $17 trillion in today’s dollars.

The second one is a bit more obscure but very important. So-called “potential GDP” is what the value of the economy would be if it were firing on all cylinders, meaning all available resources were being utilized in producing the national product.

Consider a runner who sprained her ankle. Her actual speed, reduced by the injury, is analogous to GDP in a recession or weak recovery. Her potential speed is how fast she can run when she’s healthy.

OK—almost there, but one more important point to consider. Depending on the severity of her sprain, her potential speed could be reduced even when she’s fully recovered—the injury could have done permanent, or at least, lasting damage.

It’s the same thing with the macroeconomy. If the depth and length of the downturn is such that resources—people, machines, “animal spirits”—deteriorate more than they would have otherwise, that can lower the potential growth rate.

The analogy breaks down a bit here because benign factors, like the aging of the workforce can also lower potential. Moreover, the CBO assigns most of the reduced potential to “reassessed trends,” just a more pessimistic outlook re hours worked and productivity that they believe predated the Great Recession. Instead of spraining her ankle, our econo-runner could just be getting older and slower. That’s certainly been my personal experience.

At any rate, that’s what happened to the U.S. economy in recent years. My own view is that the weaker trends grow out of some less benign developments, like the deleveraging from the housing bubble, austere fiscal policy, stagnant earnings, and high inequality. Either way, the potential growth rate of GDP has slowed considerably.

Back to the picture. The top line shows the path of potential GDP that we thought prevailed back in 2007. Based on estimates of labor force and productivity growth at the time, if you asked a standard-issue macroeconomist back then where real GDP would be today, this is the line she would have showed you.

The next line shows the results of same exercise, but eight years later. By 2015, analysts had significantly marked down GDP growth, based on the fact that the labor force had contracted more than they thought back in 2007 and productivity growth was slower.

That’s bad in the sense that slower growth means less income relative to the higher 2007 potential, but here’s the punchline: six years into this recovery, actual GDP still hasn’t caught up to potential, even while potential has declined.

Before you go to the political place–Obama’s lousy recovery!–it’s important to note that the length of time it takes actual GDP to catch up with potential has been growing in recent decades. Our recoveries have become more L-shaped than V-shaped, an interesting change that’s a story for another day. (Also, Obama gets a big asterisk on this issue as Congress has consistently blocked his economic plans since 2010.)

At any rate, if you think of “actual” rejoining “potential” as a simple goal of a recovery, we’ve been running slow enough that we haven’t crossed the goal line yet, even as the goal line has been moving towards us. My letter to Yellen and co. explores the policy implications of that realization: it’s hard to look at the picture and see a strong rationale for brake tapping.

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2 comments in reply to "Actual GDP, meet Potential GDP"

  1. Veddiculture says:

    or they overestimate inflation and underestimate actual GDP. Sorry, but with the tech revolution, I don’t trust inflation data. IMO, it is to low on the industrial side, lower than the likely higher consumer price inflation is.

    I suspect RGDP is already above the blue line and inbetween the lines.

  2. Peter K. says:

    I would go to a political place. The Republicans forced unprecedented fiscal austerity on the economy. Remember the sequester? According to Menzie Chinn, the difference between the Bush recovery and the “Obama” recovery, is that Bush had some military Keynesianism.