RESTORING THE ART OF COMPROMISE

The Output Gap – The Economics Debate du Jour

In Tyler on March 20, 2012 at 2:30 pm

“Du Jour” may be the wrong description of this debate, as it has been ongoing for some time.

The Free Exchange blogger, from one of the posts I linked this morning, writes:

I still find the demand-side explanations for the depressed state of the economy more convincing and my base case is that the economy will outperform the 2% to 2.5% consensus this year, resolving some of these puzzles in the process. But the longer the contradictions persist, the more we owe to ourselves to consider the alternative.

That quote is important to keep in mind throughout the debate since the person who sparked this iteration of the conversation isn’t necessarily espousing his own argument. Nevertheless, the debate continues.

So what is this debate about? The graph below really highlights differential in question.

20120319-071057.jpg

This is depicting actual nominal GDP (the line with the giant dip around 2008) and potential GDP (put into nominal form for comparison). The graph is a version what was posted by Felix Salmon here, only I used a smaller timeline.

The proposition being debated here is:

Potential GDP represents assumptions of future growth that cannot be substantiated as recent growth was due to an unsustainable bubble that has now ended.

Follow the jump to read more about this debate.

At the crux of the discussion surrounding potential GDP is the concept of a bubble. Few would argue that there was not a housing bubble of some sort in the mid-2000s, that there was not a dot com bubble in the late 1990s, or that bubbles preceding earlier recession did not exist. The debate lies in the implications of those bubbles for growth. Because the economy was riding a wave of housing in the naughts, was there a false sense of employment in 3-4% of the population that otherwise would not have been there or would those employees simply have spread out across other sectors without the boom in housing?

Many arguing in favor of the proposition are particular swayed by the presence of leverage in the overall economy over time. Felix Salmon expresses this sentiment, saying:

There’s a whole narrative in this chart [referring to the chart below]. From 1970 through the beginning of the crisis in 2008, GDP grew at a pretty steady pace. But the amount of debt required to generate that output just got bigger and bigger — the rate of growth of the credit market was much faster than the rate of growth of GDP. In 1970, GDP was $1 trillion while the credit market was $1.6 trillion: a ratio of 1.6 to 1. By 2000, when GDP reached $10 trillion, the credit market had grown to $28.1 trillion: a ratio of 2.8 to 1. And by mid-2008, when GDP was $14.4 trillion, the credit market was $53.6 trillion. That’s a ratio of 3.7 to 1.

20120319-132558.jpg

Karl Smith, representing the opposition to the proposition, is not as swayed by the debt increase. He uses the following chart and the description below it to support his argument.

20120319-133520.jpg

The second run-up was of course the housing bubble. A small portion of this went into the increased production of single-family houses, though at the expense of mutli-family and manufactured housing. However, most of it went into the price of land. Which meant that some of it was simply a wealth transfer between Americans.

When all is said and done it seems most likely, to me at least, that growth will experience an extended short-run lag from the level of deleveraging that is moving through the economy. It mostly started in the private sector and is moving through the municipal and state government levels as well. Federal debt will likely decline more slowly by virtue of the federal governments unique debt carrying abilities; this will help relieve some of the stress on the growth trend. However, it seems entirely plausible, if not probable, that the growth trend will return fairly close to previous trends. While sector and industry will continue with their busts, I see no reason to think that this most recent expansion and contraction cycle would be any different than those before it (including the Great Depression and the depression of the 1890s) in a post-contraction growth sense.

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