Potential Output

The recent debate between Bullard, Smith, Duy, our own Barkley Rosser, Krugman and others has been interesting and has caused me to reconsidered some of what I thought I knew on this topic.  In fact, this is the fourth time I have sat down to write a post; my first three are all deleted.

What I now think is this: the purpose of a potential output measure is to offer guidance to macropolicy.  Bluntly put, a sizeable output gap tells us we can and should use monetary and fiscal measures to boost demand; an output surplus tells us to cool it.  This is loosely associated with a notion of productive potential, in the sense that, as an economy approaches or exceeds this potential, extra demand is increasingly diverted into either price level increases, trade deficits or both.  In this sense, what we want from an estimate of potential GDP is that it performs adequately as a guide to demand management.

That said, is there a case that the collapse of the housing bubble in the last decade could lower the trajectory of potential GDP?  The answer, I think, is yes, possibly.  The reason is that potential output can well be altered by changes in the pattern of demand.  The extreme poster child for this is Eastern Europe post-1989: they had a capital stock poorly suited to producing internationally competitive goods, and the sudden opening of their economies precipitated a change in demand resulting in a collapse in potential output.  This is why their transitional slumps could not be cured solely by augmenting aggregate demand, for instance through fiscal deficits; the result would have been only some mix of more inflation and more trade deficits.

The deflation of the housing bubble may have revealed a similar mechanism.  Perhaps the mix of physical and human capital in our society was tilted toward a product mix (lots of suburban tract development) that will change under the new, post-bubble demand regime.  It is true that unemployment in construction is not elevated over that in other sectors, but that doesn’t answer the question of what level sectoral employment will rise to once aggregate demand shortfalls dissipate.  For this story to be statistically meaningful, however, two things need to be true.  First, the change in the pattern of demand has to be substantial and persistent: Americans must continue to demand less new housing for the foreseeable future.  This is not the same as saying, as Bullard has, that prices cannot resume their previous trajectory.  (We can experience a change in the price-quantity relationship.)  Second, our capital (physical and human) allocated to housing has to be on the clay rather than putty side of things, not just instantaneously, but over the span of many years.

Putting it this way makes the issue empirical.  You can embed these questions in various models (Solow, DSGE, your home brew), but whether the deflation of the housing bubble has caused a trajectory shift will come down to these two judgments.  Someone should look into this.