Another “bitch”: Potential output

The previous “bitch” was inflation expectations. Now it´s alternative views on “potential” output – which many take into consideration in their formulation of expected inflation – that´s making the rounds in blogosphere debates. Greg Ip returns to the topic:

Where the supply and demand side explanations for the economy’s depressed state converge is when demand remains deficient for so long that its cyclical impact on potential becomes structural. Mr Fleischman and Mr Roberts reckon the single biggest contributor to the recent decline in potential growth is the fall in the labour force participation rate since 2007. Perhaps this has been largely demographic, in which case the loss of potential was inevitable and permanent. But it may reflect hysteresis: the tendency of someone who has been unemployed a long time to become unemployable and eventually quit the labour force altogether. Demand can have a powerful effect on labour supply. In a 1984 paper Larry Summers and Kim Clark found that the Second World War dramatically boosted women’s participation rates, and the boost persisted long after the war ended and the baby boom was working to push participation down. The opposite could now be occurring: with the long-term unemployed now such a large share of the jobless, we could be doing permanent damage to the economy’s productive potential.

I hope not. I recently looked back at the Congressional Budget Office’s estimates of potential around the 1991 and 2001 recessions. Both were followed by jobless recoveries. Three years after 1991 recession the CBO had revised down its estimates of potential by around 3%; but by 2000, it had more than revised back the difference. After the 2001 recession, the CBO actually revised potential up by 2% as productivity surged. This shows that, at least for those episodes, recession need not leave a permanent scar on the economy’s productive capacity.

“Potential” output is a “bitch” because as the last paragraph above indicates, it´s hard to get it “right”, especially in real time.

On the other hand, it´s much, much easier to “keep track” of the nominal spending path, something that monetary policy can control with some precision. And as the set of charts below show, problems – be it unemployment, inflation or even deflation – tend to come up shortly following a deviation of spending from trend. And as the size of that deviation increases and persists, the problems “compound”. In the recent “episode”, things became really bad, actually the worse since 1938. And the persistence is “shocking”. And this persistence could end up transforming a “cyclical” or “demand problem” into a more lasting and harder to reverse “structural problem”.

The periods illustrated comprise 1922-1950; 1957-1969; 1987-1990; 1990-2012

The first covers the “roaring 20s”, the “Great Depression, WWII and “Demobilization”. The second illustrates the “Golden Age” (as the 1960s became known). The third the heyday of the “Great Moderation” and the last well describes the monetary errors responsible for the “Great Recession” or, more aptly the “Lesser Depression”.

And next the inflation chart (on same scale) for the three post war periods:

And the next chart gives up a “red light” indicating the possibility of “structural” problems being “brewed” by the complete absence of “cojones” (stronger spanish word for “balls”) being shown by the Fed/FOMC!

HT Patricia Stefani

3 thoughts on “Another “bitch”: Potential output

  1. Pingback: When ‘mañana’ never comes | Fifth Estate

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