Underestimating Economic Potential as a Justification for Inaction

The narrative about the 2008 financial crisis is about the notion that several economies were following an unsustainable path before the crisis started. We talk about excessive spending, exploding debt levels, bubbles in asset prices and the imbalances they create. These imbalances are the seed of the crisis. While the story sounds simple, it is not well understood by standard macroeconomic models and this has led in my view to excessive pessimism about growth and the recovery.

In macroeconomics, the notion of “growing too fast” or “producing too much” is normally captured by measures of potential output or the output gap. When GDP is above its potential (or the output gap is positive) we label that situation as unsustainable. But in reality, most times we only see this after the crisis. It is only when we are in the middle of the crisis or even out of it that we recalculate all the measures of potential output to argue that the pre-crisis level were unsustainable. A good example is Latvia, an economy that suffered a large loss in GDP and it is recovering from it. But a recent paper by Olivier Blanchard and co-authors at the IMF argues that the current level of output might not be too far from its potential because the 2007 level represented a level of GDP that was clearly above its potential (Krugman has provided some critical comments on that paper). [Update: Jeremie Cohen-Setton also provides a critical view on how potential output was calculated in the context of European countries].

What do our economic models tell us about producing above potential? Not much. Neoclassical models of the business cycle are characterized by fluctuations that are always optimal, so it is hard to talk about unsustainable growth. It is true that we can have shocks that produce adjustment that have a shape similar to what we see in the Latvian economy but it would require a lot of ad-hoc assumptions about the type of shocks that hit the Latvian economy to replicate those dynamics. Keynesian models do talk about situations where output is “too high” because prices or wages are stuck at a very low level but it is also very difficult to fit that story to the Latvian case and to justify the swing in output that we have seen.

Here is where I think the narrative of the years that preceded the financial crisis does not fit well into traditional macroeconomic models and has led us to excessive pessimism. To describe the pre-crisis years we are telling a story about economic behavior that is unsustainable which will trigger a future adjustment that will have negative consequences in the economy. We can think about a bubble in asset prices or real estate as an example of that behavior. But in this story it is unclear why this leads to the economy operating above potential. The economy has engaged in behavior that is unsustainable and leads to a crisis, that we all agree. But many make the mistake of establishing a one-to-one relationship between an unsustainable level of asset prices or consumption with a level of production that is too high. In an open economy consumption growth can be supported by imports and production abroad leading to a current account deficit (this fits well the narrative of countries like Latvia or Spain or even the US or the UK before the crisis). But in terms of the productive capacity of the economy it is unclear why we have gone in anyway above its maximum. Employment might be high but not “too high” and I cannot see how these dynamics can make productivity go above what is possible.

The way I see the story above is very different from the standard narrative. It is that the unfolding of the imbalances created before the crisis that lead to years of underproduction and a negative output gap. From a macroeconomic point of view maybe we never produced above potential. Or if we did, the magnitude was small. If we perform an ex-post statistical analysis of GDP and simply think about trends we will make the mistake of calling the pre-crisis years as years where we produced too much. If we do that, we are going to become very pessimistic and assume that potential is lower than what it is. In other words, we will make a cyclical downturn look like a structural problem. And alternative way to think about these events is to start with a framework that represents business cycles as asymmetric deviations from potential, which is seen as a maximum level of output. This is what I argued in this blog post. While I do not want to take that too literally (maybe there are times where production is slightly above potential), I think it is a much better representation of economic fluctuations than the notion of economies fluctuating around a trend. In my framework the goal is to minimize the time we spend producing below output and there is also a role to understand and avoid the imbalances that lead us into a crisis.

This is not just an academic debate. Using the wrong framework delivers the wrong recipe for economic policy and affects the lives of many. We have high levels of  unemployment, underused capacity, we are not investing at rates which are consistent with the levels one would expect to see but we still justify inaction by arguing that we are not too far from potential and worrying about inflation and the next bubble.

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