Philadelphia Fed President Charles Plosser made this nice graph, showing how reduced views of potential GDP are closing the gap, not rises in actual GDP.
Obviously, it would help to go to his post and look at the graph. But potential GDP is perhaps my least favorite economic statistic. Keep in mind that potential GDP refers to real GDP, not nominal GDP.
How to define potential GDP? I think then when you come down to it, the definition is “what GDP would be if there were no shortfall of aggregate demand.” So I think that in order to buy into potential GDP, you have to be really committed to the AS-AD paradigm.
How is potential GDP arrived at? I think that the process involves taking a graph of the history of GDP and fitting trend lines in between the peaks, perhaps with some smoothing thrown in. Since we never know what the next peak of GDP will be, we pretty much never have a good idea of potential GDP in real time, only in retrospect.
When I think in terms of PSST, there is no analogue to potential GDP. Patterns of specialization and trade are always breaking and re-forming. When patterns break, unless the break is caused by war, disaster, or government policy, it is probably the economy’s way of freeing up resources that otherwise would remain misallocated. When new patterns form, it is only a good thing if the patterns are sustainable for a decent interval of time.
Here’s a way to think about potential GDP. Consider the rights to produce, which government bestows upon special interests and the like. Do those rights impact the size of the marketplace? Quite often, they do. An apt example is medical devices, which is something that average Joe – as far as I know – is still not allowed to contribute to the marketplace in many instances. Okay, maybe that would not be such a big deal, if taxation occurred on those who are bestowed the kinds of special production rights that limit participation. But if medical devices are not taxed, aggregate supply and aggregate demand are both negatively affected, and nominal GDP has to follow the political dynamics in this regard.
I think there is some truth to the animal spirits idea. The question is what percent is it compared to the Keynesians belief. As I say all the time, in this case with housing finance, the trend is the only thing we KNOW can’t keep going.
Btw, in the back of my mind, I subliminally knew this would be your least favorite statistic.
Doesn’t NGDPLT have a similar problem? Maybe you’ve commented extensively on this already…but then again, bloggers blog.
NGDPLT does not have the same problem. There is no such thing as potential-nominal anything. The market monetarists tend not to draw lines extending RGDP trends as if those extrapolations mean anything.
I don’t know:
http://en.wikipedia.org/wiki/Nominal_income_target#Level_Target
So if a recession pushes NGDP to 2% for one year, the bank should add the shortfall to the next year’s target to return the economy to trend growth.
I’m not going to say that doesn’t mean what you say.
That seems like an obvious, yet still very important point. Potential GDP cannot be observed, only inferred. The other underlying assumption is that GDP would grow monotonically to infinity if only we had effective Keynesian policy. In human affairs, things go wrong and projects which seemed profitable at the start prove in the end to be misguided. The patterns of trade must be unwound and reconstituted as PSST. On an individual level, when a worker’s livelihood is destroyed by technological change, he must find another, which may entail a job search, retraining or acceptance of a lower income. His potential GDP is lowered, whether or not someone else’s is increased.
A person’s happiness may turn to unhappiness when a spouse or a child dies, or when he is divorced. He has to go through a period of unhappiness until he can recover. Maybe he sees a psychiatrist who prescribes an anti-depressant so the unhappiness can be alleviated or turned to happiness. Or maybe he just has to be unhappy and work through it until things are better. Maybe that Keynesian stimulant delays the necessary painful correction and makes things worse in the long run.