PSST vs. Potential GDP
By Arnold Kling
The AS-AD paradigm includes a concept called potential GDP. Mainstream macroeconomists sort of force-feed macroeconomic history into AS-AD by talking about “cyclically-adjusted productivity” when they talk about AS and “trend-adjusted GDP” when they talk about AD.
Consider the following types of events:
1. Capital deepening (adding to the per-worker stock of physical, human, or social capital)
2. Technical innovation
3. Opening up new trading opportunities
In AS-AD, these are all supply-side phenomena that increase potential GDP. When GDP differs from potential, that is by definition a demand-side phenomenon.
WIth the paradigm of Patterns of Sustainable Specialization and Trade, we do not make such a distinction. Things like (1)-(3) are going on all the time. The consequences for employment depend on how resources move from declining to expanding industries. Three possibilties:
(E) Excessive Expectations. Resources move too quickly to what are perceived as expanding sectors. Think of the Internet Bubble, or perhaps the 1928-29 boom in electric utilities. People over-estimate the speed with which new industries can attain profitability, and investors in these industries over-estimate their wealth.
(D) Displacement Downturn. Resources move out of what are perceived as declining sectors before new sectors can absorb them. (The human and physical capital in declining sectors in fact may not have productive value in the new industries. As Tyler Cowen would put it, Zero Marginal Product.) People perceive the wealth decline in displaced sectors before they can realize the gains in new sectors. Alex Tabarrok points me to a literature on this, exemplified by Greenwood and Jovanovic.
(G) Goldilocks Growth. Resources move effortlessly and synchronously from declining sectors to expanding sectors. For example, within telecom in the 1990s, we lost jobs related to land lines and gained jobs related to cellular, and it all seemed to go pretty smoothly.
To illustrate the three possibilities, take Ricardo’s classic comparative advantage story. Imagine that we are just about to open up trade between England and Portugal. Ultimately, this is going to cause British labor and capital to shift out of wine and into cloth. If the British clothing industry becomes irrationally exuberant, it may expand too quickly, resulting in the (E) mode. Conversely, if the wine industry is wiped out by imports before its workers can be redeployed into cloth, we have (D). If adjustment is frictionless, we get (G).
I think that the question of how we can have (D) and not (G) is a difficult one. But that is where PSST wants to take the issue.