I don’t really know her, I only know her name, but she crawls under your skin, you’re never quite the same, and now I know, she’s got something you just can’t trust. It’s something mysterious, and now it seems I’m falling, falling for her. She seems to have an invisible touch yeah. She reaches in, grabs right hold of your heart. She seems to have an invisible touch yeah. It takes control and slowly tears you apart. When Phil Collins sang this song for Genesis in 1986, he was singing about a woman who he desires even though he feels there is something bad about her. Mainstream economists also have desires about certain concepts and theories – even though they simply don’t make any sense. One such theory is the idea of Potential GDP.
This concept, which is often referred to in the press as the speed limit on the economy is based on what economists call a “production possibilities frontier.” This is generally depicted as a boundary – like the end of the universe outside of which the economy cannot operate. As such, Potential GDP is a measurement of what a country’s gross domestic product would be if it were operating at full employment and utilizing all of its resources. The difference between country’s potential GDP and its real GDP is known as the “output gap,” and is due to inefficiencies in the economy caused by things like taxes, unemployment and regulations. The chart shows the Federal Reserve’s ex-post estimate of potential GDP and actual GDP. Interestingly, the economy often operates at above potential, suggesting that the calculation is – well – questionable.
The fact is that since GDP is supposed to be a measure of the production of an economy, the potential is really impossible to calculate since it is based on so many unknowable (what economists call exogenous) factors. Consider the standard growth model for an economy, which economists would describe as:
GDP = F(L, K, A, T)
In normal language, GDP is a function of the amount of labor (L), capital (K), learning (A) and technology (T). Based on this, the calculation of potential GDP should be simple, just put the aggregate amounts of each of these items into a formula and presto. Unfortunately, it is not all so simple since it is impossible to forecast any of these elements in a meaningful way. Let’s consider each separately.
Labor Supply: One of the few long term trends that forecasters really understand is demographic change. Since the number of people are alive today is known, it is fairly easy to predict tomorrow’s population. Also, since the current age of people is known, it is easy to calculate the labor force participation rate in the future. So in a closed system, economists can calculate the future labor force accurately. But the United States is not a closed system. Legal, and illegal immigration can greatly impact the labor supply, and immigration laws (for example restrictions on H1B visas) also have a tremendous impact. In reality, the changing political landscape and world economic conditions have a much larger effect on the labor supply than most economists will admit, making this estimate highly unreliable.
The Supply of Capital: Capital use, or more appropriately the intensity of capital use has a tremendous impact on productivity, which has a huge effect on potential GDP. Orthodox economists believe that capital intensity is a function of the labor supply and savings (in effect real interest rates). But again, the market is not closed, and capital can flow rapidly between economies. If productive uses for capital exist then capital will flow into an economy. But these productive uses are generally associated with technological change, something that is totally exogenous to the model.
Technology: Technology is much more than the toys, gadgets and gizmos produced by Apple and Samsung. Technology includes processes, systems, medicines, or anything that changes production functions in a given industry. Therefore, the advent of a process – the assembly line – was a greater technological change than any consumer i-device. Huge technological leaps have occurred randomly throughout history. These include the invention of printing, the creation of the nation-state, the harnessing of electricity, the rail road, artificial lighting, the containerization of shipping and digitization of information. None of these developments could have been easily predicted and many had detrimental economic effects initially. For example most American railroads went bankrupt after they were constructed, and the effects of digitization took nearly 20 years to show up in the economic statistics. Like the labor supply and the supply of capital technological change is often exogenous to the model.
Accumulated Learning: Economists call this human capital, which is a measure of what humans know. Unlike technology, which is something that enters into the model in current time, accumulated learning is a form of wealth. Since Edison invented incandescent light 100 years ago, productivity has soared since people can work at night. Knowing about electric light is a form of accumulated learning, as is the understanding of digitization, plastic, the assembly line, etc. It is impossible to calculate the value of accumulated learning, and most forecasters just assume that this is included in the general GDP trend line. But learning can change dramatically on a daily basis, and is really exogenous to the model. How can one predict how human understanding can change? How can one predict that a patent clerk can become a great physicist (Einstein), or for that matter how a Visigoth (Alaric I) can destroy the accumulated capital of ancient Rome. Individuals can have a huge impact on the level of Accumulated Learning making this calculation extremely variable and like the other factors is exogenous.
So a model that is supposed to tell the speed limit of the economy is based on four factors, each of which is random and comes from outside of the parameters of the model. This means that the concept of Potential GDP while theoretically sensible cannot be forecast in any meaningful way. Basing economic policy on the concept of the “output gap” is something mysterious and something you just can’t trust.