Is the U.S. economy suffering from a persistently large output gap after the Great Recession? Or has potential GDP fallen dramatically, thanks to the effects of the crisis, bad policy, prolonged high unemployment, or some combination of them all?
That’s the wonky way of restating my Sunday piece, which explores the question of why the economy keeps disappointing forecasters year after year – and whether we’re doomed for slow growth for the foreseeable future. In non-technical terms, potential GDP is what economists consider to be the long-term growth path for the economy. The output gap is how far below that projected path the economy is at the moment.
If potential GDP is running close to historical trends, that suggests we’ve still got a big output gap – and plenty of room for more fiscal and monetary stimulus to boost growth to narrow the gap and get us back on track. If potential GDP has fallen thanks to structural factors – such as unemployed workers’ skills atrophying, hampering their ability to do the jobs the economy needs done – then stimulus probably wouldn’t help much.
So what do we know about potential GDP? A few things.
1) It’s probably lower than we thought it would be before the recession.
Check out this chart, from the Cleveland Fed:
It shows how the Congressional Budget Office’s forecast of potential GDP has fallen since 2007.
2) There are multiple reasons for that decline. One has nothing to do with the recession: Economists have just tweaked how they measure and predict growth; those tweaks account for a chunk of the downward revision.
3) The housing boom tricked people into thinking the economy was on a higher-growth path than it is. You see this in how much a fall in investment accounts for the decline in potential GDP.
There was an unnaturally large amount of construction investment during the bubble. Now there’s an overhang of construction, and a lot less investment, and we’re adjusting our expectations accordingly.
4) It’s probably going to be a long time before we know just how much potential growth we’ve lost. That’s because potential GDP is, even for economists, a fairly mysterious thing to predict. “It’s not a forecast, but you can think about it like a forecast, because it’s a thing we don’t actually know,” says Michael T. Owyang, an economist at the St. Louis Fed. “We never observe it… in the process of that estimation, there is uncertainty.”
5) There remains much empirical evidence suggesting a high output gap, and room for more stimulus. Here’s UC-Berkeley economist Brad DeLong on the subject – citing his work suggesting the economy is in a place now where, strangely enough, efforts to reduce the budget deficit will actually make the deficit larger.