A Question About Potential GDP

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A Question About Potential GDP

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1Bretzky1
Modifié : Jan 19, 2013, 9:21pm

One of the arguments that is made to support the federal government's stimulus program--in fact, I think it's the primary argument--is that the financial crisis caused households and businesses to deleverage, which in turn caused the private consumption (C) and gross investment (I) components of GDP to shrink (mostly C). This reduction in C and I caused a reduction in actual GDP, which opened an output gap between actual GDP and potential GDP.

That being the case, there were only three ways that the output gap could be closed: 1) decrease imports (M), 2) increase exports (X), and 3) increase government spending (G). In order for the first two ways to be used to close the gap by themselves would require massive government intervention largely in contravention of our treaty obligations under the WTO and are, anyway, not amenable to the rapid response that the economy required. Therefore, what we were left with was a program of dialing up government spending to plug the gap. And this spending was best done through borrowing so as to maximize the immediate effect.

My question is: how is potential GDP calculated, and are there any published comparisons between previous potential GDP calculations and actual GDP.

The use of the stimulus was premised on the idea that G could be used to temporarily fill the hole left by decreasing C and I, and that eventually those two components would return to their pre-crisis levels. But this assumes that the per capita pre-crisis levels of C and I were sustainable relative to pre-crisis per capita income. One of the major causes of the crisis, however, is that households and businesses (primarily those in the financial sector) were living beyond their means in a debt-fueled state of overconsumption. Wouldn't it make sense, then, for the lower ratios of per capita C and I to per capita income to stick and not go back up to their pre-crisis ratios? Should we even want them to return to their pre-crisis levels?

Let's face it, per capita C was as high as it was in the pre-crisis years in part because the government was undertaxing the population relative to its expenditures. We were already heading for a day of reckoning with an overdue tax bill that has only gotten more massive because of the stimulus program.

2quartzite
Jan 20, 2013, 1:08am

Potential GDP is based on productive capacity and much is usable vs how much is being used. High unemployment means that labor resources are being under used and industrial capacity utilization attempts to measure how much of 'capital' in the form of factories and infrastructure are being used, and and commercial occupancy look at how much of commercial real estate is being used. Lower capacity utilization rates and higher vacancies, also point to the gap between actual and potential GDP. These gaps are the result of low demand for the use of these resources and the things they produce. Both consumption and investment contribute to demand. When the private sector is reducing r demand, it can make sense for the government to help increase demand through its own additional consumption and investment or providing funds to those with a propensity to consume. These increases in demand will employ the he underused capacity/labor and boost GDP closer to potential which in turn can stimulate enough demand demand to overcome of the slump allowing government to ease back again.

3Bretzky1
Modifié : Jan 20, 2013, 1:27am

These increases in demand will employ the he underused capacity/labor and boost GDP closer to potential which in turn can stimulate enough demand demand to overcome of the slump allowing government to ease back again.

Right, that's the theory. But what if the potential GDP calculations are incorrect because the productive capacity of the economy has been overbuilt relative to a sustainable level of production?

Do you know of any studies that have been done regarding the correctness of the potential GDP calculations, especially in light of the bursting of the debt bubble that occurred in 2007-2009?

My gut feeling is that the only way that the government will be able to scale back its spending and have GDP not contract at a near exact amount is to substitute exports and net investment for private consumption, which would likely require a rather hefty drop in the value of the dollar, which itself would cause a large decrease in the American standard of living. Of course, one would have thought that a major correction in the value of the dollar would have already occurred, but that hasn't happened because foreign governments with deep pockets that depend on the US market for the health of their own export sectors have kept the dollar from falling overly much and wealthy foreign investors are still plowing money into US government debt as a safe haven from the difficult global economic situation.

The more that I look into this situation, the more I come to the conclusion that the US economy is nothing more than a giant Jinga tower just waiting for someone to pull out the wrong piece.

4quartzite
Jan 20, 2013, 1:34am

I am aware that some have suggested that potential GDP h was reduced by the crisis, but I think those claims are weak. What does 'overbuilt relative to a sustainable level of production' mean? Do you also think population is oversized compared to sustainable rate of production?

There is growing evidence that the growth of inequality and the subsequent concentration of wealth and stagnation of iii incomes at most levels is the biggest thing holding back demand and a return to full GDP. If that is true then policies that help reduce inequality and redistribute wealth will indeed help restore balance and growth.

5Bretzky1
Jan 20, 2013, 11:58am

What does 'overbuilt relative to a sustainable level of production' mean?

By that I mean that the productive capacity of the economy was artificially high because it was based, in part, upon an unsustainable per capita debt burden. That is to say that US production of goods and services prior to the crisis were fueled in part by a consumer and business debt level that could not be paid off given then per capita levels of income; and that had consumer and business debt been maintained at a sustainable level relative to income, then potential GDP would not have gone as high as it did prior to the crisis. In other words, a not insignificant portion of the economy's productive capacity went idle after the crash not because of slack in the economy, but because we simply don't have the means (or, perhaps, the inclination) to consume as much as we did before the crisis.

There is growing evidence that the growth of inequality and the subsequent concentration of wealth and stagnation of iii incomes at most levels is the biggest thing holding back demand and a return to full GDP.

If there was wealth laying idle in the hands of the wealthy, I could see how transferring it to those down the income ladder would provide a kickstart to the economy; but is that really the case.

Perhaps a better use of the stimulus would have been to pay off about $5000 to $6000 worth of debt for each household. That is, perhaps they should have transferred about $800 billion of consumer debt to the government. That would have freed up quite a bit of disposable income that households have been spending on servicing the interest on their debts. Not only would that have benefited the consumer, but it would have been an extra fillip to the effort to sure up the balance sheets of financial institutions. Plus we would have (hopefully) avoided all the wasted pork that has been thrown into the stimulus packages over the years.

6Carnophile
Modifié : Jan 20, 2013, 12:12pm

The Congressional Budget Office has a short, non-technical explanation of potential GDP here:

www.cbo.gov/sites/default/files/cbofiles/ftpdocs/51xx/doc5191/03-16-gdp.pdf

7quartzite
Jan 20, 2013, 10:50pm

Well I see Stiglitz made the case about inequality stalling recovery and that Krugman disputes this notion.

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