One thing that should be remembered is that the trend line extrapolated from 1984-2007 implies that the output gap as of 2015Q4 is …-18%...I want to stress that estimating potential GDP and the output gap is a difficult task.It is a difficult task and perhaps the CBO estimate of the gap is understating it. But to pretend the potential GDP would continue to grow by some akin to 3.4% from 2000 to 2015 is just absurd. Well it seems this crowd has “updated” their trend line analysis. J. W. Mason writes:
This alternative measure gives a very similar estimate for the output gap as simply looking at the pre-2008 forecasts or extrapolating from the pre-2008 trend. “Our estimates imply that U.S. output remains almost 10 percentage points below potential output, leaving ample room for policymakers to close the gap through demand-side policies if they so chose to.”The ‘alternative measure’ comes from an interesting new paper:
The fact that most of the persistent declines in output since the Great Recession have parlayed into equivalent declines in measures of potential output is commonly interpreted as implying that output will not return to previous trends. Using a variety of estimates of potential output for the U.S. and other countries, we show that these estimates respond gradually not only to supply-side shocks but also respond to demand shocks that have only transitory effects on output. Observing a revision in measures of potential output therefore says little about whether concurrent changes in actual output are likely to be permanent or not. In contrast, some structural VAR methodologies can avoid these shortcomings, even in real-time. This approach points toward a more limited decline in potential output following the Great Recession.While it is true that this new paper suggests that the output gap may be as large as 10%, Mason’s back flip is not justified for two reasons. First of all, the authors of this new paper are very critical of any crude trend line analysis. But more importantly – notice how the Gerald Friedman crowd substantially changed its tune on what trend line they should be using. Alas – the level of intellectual dishonesty in defense of what Gerald Friedman wrote a year and a half ago may be worse than the original paper.