The guest commentary below was written by Dr. Daniel Thornton of D.L. Thornton Economics.
I have written elsewhere (e.g., Does Aggregate Supply Exist?) about concepts that are regularly used by macroeconomists and policymakers that don’t actually exist. “Why?” They are imprecisely defined, i.e., they are defined in a variety of ways. Furthermore, for any given definition, they cannot be measured at all or cannot be estimated with the accuracy required for accurate forecasting or making policy decisions. These concepts don’t have a real-world counterpart. In essence, they’re myths—“a popular belief or tradition that has grown up around something.”
In the case of potential output, the “something” is the concept of full employment, which is based on the simplistic idea that there is a limit to the quantity of goods and services (output) that the economy can produce. Such limits exist in economic models, where the structure of the economy is fixed and unchanging. But they need not exist in real economies that change continuously in a variety of ways. Technology and technological innovations create new products, change production processes, and increase efficiency.
What the Heck is 'Potential Output'?
Wars and natural disasters intervene with important consequences for the economies structure; ditto for discoveries of natural resources, globalization, and a variety of other things. When it comes to real-world economies, the one constant is change. But even if such a limit exists, our understanding of the complex interactions of the aggregate economy is such that economists would have no way of knowing whether a limit exists or how to quantify it if it does.
A commonly used measure of potential output produced by the Congressional Budget Office (CBO), shown in Figure 1 (the figure is taken from a Federal Reserve Bank of St. Louis Review article by Lawrence H. Summers, here, p. 94). The figure shows the CBO’s estimates of potential output annually from 2007 to 2016 along with actual output as of 2016.
For 2007, all of the CBO’s estimates are essentially the same and equal to actual output. However, as output declined with the onset of the 2007-2009 recession, the gap between actual output and potential output (the output gap) widened. The CBO responded by reducing its estimate of potential annually. The CBO eventually revised its estimate so that by 2016 the output gap was small. The output gap didn’t close because of strong output growth. It happened because the CBO estimate of potential was “too high.”
Living Up to Potential
This is not unusual. The same thing happened during the period from about 1995 to 2007. This is shown in Figure 2, which shows the CBO’s estimate of potential from 1948 to 2017. The annual updates are not presented as in Figure 1, but the upward rise in Figure 2 between about 1995 and 2007 was accomplished by the CBO annually ratcheting up its estimates of potential. Of course, the CBO has now reduced its estimate sufficiently that by 2017.Q3 the economy has once again achieved full employment. I can’t help myself: Hallelujah, the economy is once again living up to its potential! A little sarcasm is good for the soul or at least for the mind (just in case you don’t believe me, click on this link).
“Why did the CBO increase and then reduce its estimate of potential?” The CBO and others attributed the increase to an unexpected secular increase in productivity. The CBO has given four main reasons for the recent reductions in its estimate (here). But all of these reasons amount to the same thing—the structure of the economy changed. Just as I suggested, unpredictable changes in the economies’ structure change the output limit.
If such changes happen frequently, saying the economy’s limit is constantly changing or saying that the economy has no such limit amount to the same thing. In any event, because of frequent revisions of potential output due to persistent changes in actual output and the methods economists used to estimate potential output essentially guarantees that eventually, estimates of potential output will be nothing more than a non-linear trend of historical output.
Revise, Revise, Revise!
Figure 2 also shows a quadratic trend in output based on actual output from 1948.Q1 to 1994.Q4 and extrapolated to 2017.Q3. For the first 46 years of the period, the simple trend measure and the CBO’s measure are nearly identical. However, beginning in about 1995, output increased dramatically above the quadratic trend measure only to return to the trend measure at the recession’s end. Since then, output has remained very close to the trend measure. Both measures suggest that output is essentially at its potential by 2017. The CBO accomplishes this by dramatically increasing its estimates of potential starting in about 1995 and then reducing its estimate of potential after 2007. For the quadratic trend measure, this happens because of the lengthy but ultimately temporary increase in output comes to an end with the onset of the recession.
Both measures suggest that the period from about 1995 to 2007 output was very different from the first 46 years and the eight years since the recession ended. But the stories they tell about the economy are very different. The difference is most easily seen by looking at the two measures of the output gap, shown in Figure 3. The two gap measures are very similar up to about the mid-1990s and remarkably similar up to 1984.Q4. The commonly cyclical pattern is due to the cyclical behavior of actual output. However, the two measures are very different after 1995. The CBO’s measure suggests that the economy has been below its “potential” since the end of the 1981-1982 recession. Indeed, there were only two brief periods when output was above potential during this entire period. In contrast, the quadratic trend measure suggests that the economy has been above trend since the mid-1980s and way above trend during the period from 1995 to 2007.
The Great Moderation
Economists have dubbed the period since about 1984 to 2007 as the Great Moderation—a period of strong, steady economic growth punctuated by two mild and short recessions. Even a casual look at the economy’s performance during this period is grossly at odds with the interpretation suggested by the CBO’s measure. One is tempted to scream, “How can an economy be below potential for nearly all of the last 50 Years?” But, of course, I wouldn’t do that. Just in case you think I’m picking on the CBO or only the CBO’s estimates look like this, see Laubach and Willians, Figure 8, page 26.
“But wait. I thought that economic growth has only been about 2%, way below most estimates of the economies’ potential growth rate that is said to be 3% or higher. So does this mean that the economy’s growth potential is 2%, not 3%? Of course not, if potential output doesn’t exist, then neither does the growth rate of potential output. What I know that output returned to its 1949 - 1995 trend path when the recession ended. I also know that 1995-2007 period was characterized by a variety of things that could have caused output to be unusually high during the period, as suggested by the trend-gap measure.
Specifically, advances in technology and technological innovations, the launching of the World Wide Web (1991), a marked increase in productivity, the widespread use of securitization and other financial innovations, the growth of finance generally, globalization, making homeownership a national priority, a marked decline in lending standards (especially for residential real estate lending), and lax oversight of the mortgage market and other financial markets. The period was marked by two mild and short recessions, one of which was the consequence of excessive speculation which resulted in the dot.com bubble. It ended with the bursting of the house-price bubble.
I know that the growth rate of output has trended down steadily since 1948 (see Economic Growth, Figure 1). The trend rate as of 2017 is about 2%. I also know that with the exception of the period from about 1995 to about 2007, the growth rate of productivity declined fairly steadily since 1948 (see Economic Growth, Figure 7). The downward trend in output growth and productivity may be symptomatic of an economy evolving into what Walt Whitman Rostow called the “Age of Mass Consumption”—the last stage of Rostow’s five stages of economic growth. Indeed, some economists believe that Japan, the U.K and most, if not all, of Western Europe, have evolved to this stage. If the U.S. has as well, 2 percent growth or slightly higher may be the best we are likely to do.
Conclusions
Potential output is a concept. It can’t be defined, let alone measured. It may exist in economic models, but it need not exist in real-world economies. Even if it does, economists lack the knowledge to identify it and measure it in a way that is helpful for making important policy decisions. Consequently, potential output should not be used in discussions of real economies. It is disingenuous to say that we need more stimulative monetary or fiscal policy because output is below potential or because the economy is growing below its potential growth rate. A science based on myths rather than facts cannot progress. It’s time to tell the king that he’s running around in the buff—it’s not a pretty sight.
Finally, I don’t want to leave the reader with the impression that my analysis invalidates basic economic principles. It does not. Basic economic principles are based on axioms of human behavior. The myths that have evolved in macroeconomics and monetary theory are not. They are based on simplistic ideas about how the economy behaves.
EDITOR'S NOTE
This is a Hedgeye Guest Contributor piece written by Dr. Daniel Thornton. During his 33-year career at the St. Louis Fed, Thornton served as vice president and economic advisor. He currently runs D.L. Thornton Economics, an economic research consultancy. This piece does not necessarily reflect the opinion of Hedgeye.
