In my article previewing Janet Yellen’s first major meeting as chairwoman of the Federal Reserve, I focused on potential gross domestic product growth. Basically, if everything was great, how much would the economy be growing? The Congressional Budget Office (CBO), the preeminent authority in estimating potential GDP, had recently revised down its projections, putting the U.S. economy at about 7 percent below its capacity.
The CBO said it was revising down its estimates because of trends that predated the recession and began in the early 2000s. The cyclical effects of the Great Recession were not the principal causes behind this “new normal” of lower growth; instead, structural forces are limiting potential growth, so there’s no point in providing stimulus.
But is the CBO’s reasoning sound?
Maybe not, argues a paper released Wednesday titled “Fiscal Policy and Full Employment.” The paper — written by former Treasury secretary and National Economic Council head Larry Summers, along with economists Brad DeLong and Laurence Ball — calls for more stimulative fiscal policy to juice growth and close the output gap (the difference between potential GDP and actual GDP). In advocating for such stimulative policies, the authors questioned the CBO’s estimate of potential GDP, and they “remain skeptical of CBO’s view.”
The paper includes a chart, shown below.
The chart shows the evolution of the CBO’s estimates of real potential GDP for 2014. They have steadily been revised down since 2007. If the CBO truly thought that the slowdown predated the recession, DeLong et al argue, it should have front-loaded its revisions when it recognized the peak of the business cycle (shown by the red line in the chart). Instead, the bulk of the downward revisions came afterward.
The authors write, “This pattern appears contrary to the CBO claim that revisions are explained by slow growth before 2007 and the fact that 2007 was a cyclical peak.”
In other words, they are arguing that the cyclical weakness in the economy is the major force driving down estimates of potential GDP. It’s the recession! And if this is the case, it calls for more stimulative fiscal policy. This view — that hits to potential GDP can be reversed — is shared by other progressive-leaning economists, such as Jared Bernstein, who is leading the Full Employment Project for which the authors’ paper was presented.