Potential Output Straw Man
By Arnold Kling
Recently, bloggers have been talking about potential output or potential GDP. I find the discussion to be frequently misleading. For example, Mark Thoma quotes Tim Duy:
If we claim the economic potential of the nation has declined – that in aggregate, we can not make as much stuff as we did a few years ago…
But nobody claims that. The pessimists on potential output only claim that it is growing below some previous trend. They never claim that it has declined in absolute terms.
I do not blame Mark or Tim for making misleading statements on this topic. I think there is something inherently misleading about the concept of potential GDP. We talk about it as if we were living in a one-good world; however, in the real world there is heterogeneity of workers and and goods.
(PSST is most explicit about heterogeneity. The “representative agent” DSGE model is most explicit about ignoring heterogeneity. Other frameworks are somewhere in between.)
From a PSST perspective, employment and output decline when patterns of production become unsustainable in some sectors before new patterns have been established. This makes the concept of potential GDP untenable.
Let us say we are at full employment in 2007 and that we will return to full employment in 2015 (I am not predicting that, just using it as an example). What is potential GDP today? Is it the GDP we could have had by keeping everyone working exactly as they did in 2007? Or is it the GDP that we will produce in 2015, even though the production techniques, patterns of trade, and even some of the goods themselves have not all been discovered as of today?
The standard practice is to draw a straight line between GDP in 2007 and 2015, look at the current date relative to that line, and call that potential GDP. The problems with this are obvious. First, we do not know what GDP will be in 2015 (or whenever it is we might return to full employment.) Second, just because we draw a line between 2007 and 2015 does not meant that we belong on that line right now. The PSST story is that we are where we are because we constantly have to discover and tinker with the processes and patterns of specialization and trade that make the best use of resources.