Yes, potential output is lower than people thought, much lower.
I have been saying for almost a year that potential output is lower. (link 1, link 2) Commentators on Mark Thoma’s blog thought I was nuts. Mark Thoma himself did not agree with me. Mark Thoma now offers one explanation to his class that the cause could be hysteresis, where long periods of unemployment make the economy more sluggish. But Eric Morath contradicts that view…
“The finding backs an emerging view that the relatively weak recovery is due to more than just the deep recession. Economists appear to have not accurately projected the impact of a number of trends, including demographic shifts and changes in the number hours worked per week, that were taking shape even before the recession took hold.”
Even David Beckworth recently (January 17th) wrote about natural interest rates and concluded using the Finance-neutral method that the output gap was still large.
“We cannot directly observe the natural interest rate, but there is evidence of ongoing slack in the economy. And since slack–or a negative output gap–is a key determinant of the short-run natural interest rate, it is reasonable to believe the natural interest rate has been depressed over the past five years.”
Even Paul Krugman believed potential output was little changed from before the crisis…
“…potential output is defined as the highest level of output consistent with stable low inflation. If you want to claim that an economy has grown unsustainably above potential, you need to show me the accelerating inflation.” (link)
“potential GDP is a measure of how much the economy can produce, not of how much people want to spend.” (link)
Yet, he makes a mistake. True potential does depend on how much money people have to spend. If not, then why doesn’t Chinese firms sell more to their domestic population? Well, it’s because people in the US have more purchasing potential.
As for inflation, if production is healthier than how much people have to spend, inflation will be muted. We live in a world of under consumption from fallen labor share in advanced countries. Europe and the US are concerned about weakening inflation.
Krugman needs to acknowledge the weakness in his potential output concept. He would have been able to foresee the reality of a small output gap.
So we see top economists making a crucial mistake in determining the output gap. Now the risks of easy monetary policy will become quite apparent. As Mark Thoma offers a warning to his class from the 30:00 to 31:30 minute points in this video…
“If that is true (very small output gap), then they (the Fed) should back off the stimulus starting now.”
I based my calculations on labor share over a year ago and got it right. So this news about potential output being lower is not news to me.