The Silly Confusion Over Potential GDP

As a small economist, my views are not seriously taken seriously. But still, if I turn out to be right, I will have bragging rights. So Paul Krugman wrote today about how the IMF way over-estimated the potential growth path of GDP. His post is titled, The Damage Done…

“That’s a huge shortfall.  Yet the IMF believes that the output gap is only a couple of percentage points. If so, either there was a huge coincidence — a sudden, unanticipated drop off in potential growth that just happened to coincide with the financial crisis — or the crisis, and the poor macroeconomic management that followed, have done incredible damage.”

OK… so what happened? Was there an unanticipated drop off in potential growth or was there poor macroeconomic management?

I have never been confused over potential GDP.  Mr. Krugman wants us to think that there was poor macroeconomic management. But there really was an unanticipated drop off.

Over a year ago, I saw potential GDP had started trending lower right away during the recession. Here is a graph of the CBO potential and my calculation of potential GDP (green line). (link to graph)

While the CBO and Federal Reserve continue to adjust downward their estimate of potential GDP, my line for potential GDP started trending lower right away. It flat-lined until 2010 and then settled into a stable lower growth path. I have never had to adjust my calculations of potential GDP. Real GDP keeps moving right along my potential GDP. The confusion by economists and central banks over potential GDP will end up being expensive. Hard to say that humbly as a small economist, but from what I see, the great economists still have something to learn.

Now was there mismanagement of the macroeconomy? This is the real question? Was the economy hurt somehow by some policy? Would real GDP have trended faster upward if we had done something “correctly”?

From what I see, economic growth has been on a normal path in this business cycle. So no, I do not see any real damage, Mr. Krugman. The economy is growing normally. Let me explain with the model for effective demand.