You’ve Got Potential

NOTE: The Growth Economics Blog has moved sites. Click here to find this post at the new site.

A couple things I read this week, along with a frustrating parking-lot conversation with someone who asked me about the economy, got me thinking about how we talk about GDP. I think we can and should be a little more clear in economics about what we mean by “Potential GDP”. Obviously this term comes up a lot in discussions about the current state of most economies, as a lot of the policy discussion depends on how far (if at all) GDP is “below potential”.

There is a difference between “potential GDP” and what I guess we could call “potential potential GDP”. It may be easiest to start with an analogy to get these terms straight. Think of your health. Your regular level of health is your “potential health” – how you feel and how capable you are when you are not explicitly sick. Getting the flu would be like a recession, as you are clearly “below potential health”.

“Potential potential health” is different from your “potential health”. “Potential potential health” is your health if you starting working out regularly, stopped eating so many Christmas cookies, skipped that second beer, took the stairs, actually got up from your desk once in a while, did the stretches your therapist suggested, meditated daily, ate more vegetables and less bacon, etc. etc. “Potential potential health” is the best health you could possibly achieve given your genetics. “Potential health” is your non-sick state of health.

In terms of GDP, what do we have?

• Potential GDP: This is our non-recessionary level of GDP. We spend most of our time in this state, but it is not the best we can do. It is simply the typical level of GDP we have been achieving lately.
• Potential Potential GDP: This is the best possible level of GDP we could get given our current level of technology (which I would equate with your genetics). It is the GDP we could have if we eliminated market inefficiencies like information issues, and collusion, and regulatory capture, and rent-seeking, and externalities, etc. etc. Take all the Harberger triangles you can find and eliminate them, so to speak.

Why do I think we should distinguish these concepts? Because “potential GDP” gets confused very often with “potential potential GDP”. It is literally impossible to get GDP higher than “potential potential GDP”, and thus it is impossible to sustain a GDP higher than “potential potential GDP” for any period of time. “Potential potential GDP” is the budget constraint for the economy. We cannot possibly produce more than this.

But that is not true about “potential GDP”. It is *not* the short-run, medium-run, or long-run budget constraint for the economy. It is not something structurally fixed. But people treat it as such. They presume that any aberrations away from “potential GDP” must be offset over the long-run by equal and opposite aberrations. Booms (GDP above “potential GDP”) *must* be met by slumps (GDP below “potential GDP”). Similarly, slumps must eventually erase themselves. None of that is true, as “potential GDP” is not the budget constraint for the economy.

This matters for how one thinks about business cycles. We cannot uniquely decompose actual GDP into “potential GDP” and deviations from potential – in other words, into trend and cycle. Doing so presumes that the cyclical components “cancel out” over time. Econometrically, the methods used to separate trend and cycle *require* that the cycles cancel out around the trends. Roger Farmer’s recent post makes this point more clearly than I just did. As he says, by accepting the trend/cycle decomposition of GDP – i.e. by assuming that “potential GDP” is the budget constraint – business cycle economists have implicitly limited themselves to a small class of explanations for fluctuations.

Once you stop thinking of “potential GDP” as being necessarily a supply-side phenomenon, then failures of aggregate demand, or “animal spirits”, or self-fulfilling expectations can move around “potential GDP” as well. This is Farmer’s point about the economy having essentially an infinity of equilibrium GDP levels. We can get stuck at a new, lower level of GDP. There is nothing that necessitates that the economy move “back to potential”, as “potential GDP” is a fluid concept. There is also nothing necessary about recessions as some kind of economic retribution for booms. Stop. “Potential GDP” doesn’t work that way. If we can coordinate on a higher level of GDP, then great. We win – more cookies and Diet Coke for me. That isn’t some kind of cheat. It’s not “living beyond our means”. It’s just us finding a way to shift a little closer to the *real* limit, “potential potential GDP”.