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Weekly Economic Briefing

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Potential confusion

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Potential output, the maximum amount of goods and services that an economy can sustainably produce, is one of the most important concepts in macroeconomics. Economists describe an economy operating at and growing in line with its potential as being in balance, as it should show no tendency for the rate of price inflation to either rise or fall. For central bankers it is indispensable as a target and guiding post, helping to identify when the economy is operating below/above potential and policy needs to be loosened/tightened to close any output gap. It is also critical for governments needing to know how much of any excess budget deficit/surplus is structural and hence can only be eliminated through measures to increase/decrease tax revenue or reduce/increase government spending.

The potential slowdown... Has no single explanation

Unfortunately past, current and future potential output and its growth rate cannot be directly measured; they can only be inferred. To do this, some practitioners prefer purely statistical approaches that separate the path of output into a cyclical and trend component. Some use hybrid statistical filters that also make use of the Phillips Curve or Okun’s law relationships. Others use models based on production functions, which decompose trends in output into contributions from the accumulation of labour and capital, as well as the efficiency with which labour and capital are combined – total factor productivity. However, each has to be forecast into an uncertain future, and the latter is a residual representing the portion of output growth that cannot be explained by the other two. Unsurprisingly then, estimates of potential output, its growth rate and output gaps can vary significantly. As an example, the Congressional Budget Office, which relies on the production function approach, estimates that the US economy was operating 0.4% above its potential in 2007, OECD estimates based on a different production function put it at 2.5%, while a recent IMF paper (Alichi et al) based on a multivariate filter, proposes 1.2%. Muddying the waters further, especially for policymakers making decisions in real time, all of these models’ estimates of the growth rate of potential and the size of the output gap back in 2007 have been revised significantly over time. 

Non-specialists trying to wade through methodologies and estimates could be forgiven for giving up on the concept of potential altogether. Yet there are some facts that most economists can agree on. The first is that the country’s potential growth rate has been on a declining trend; the CBO, OECD and IMF estimates were on average all over 3% in the 1990s; between 2% and 3% in the 2000s; and between 1.5% and 2% in the 2010s (see Chart 2). The second is that there is no single reason for the potential growth slowdown; slower labour force growth due to population ageing, slower investment growth related to hysteresis following the financial crisis; and slower TFP growth related to the reduced diffusion of technological innovations all appear to have played a role (see Table 1). The third is that although potential growth is hard to forecast, it is unlikely to return to previous highs and a meaningful improvement on current rates will require the acceleration of structural reforms. The upshot: when Congress moves on from the fight about the role of government in the provision of healthcare, it has much work to do.

Jeremy Lawson, Chief Economist