One of the many statistics that economists pore over for clues to future economic performance is potential output, also known as potential gross domestic product. This is a measure not of what the economy is doing, but what it could be doing: an estimate of the maximum amount of GDP the economy can achieve over a sustained period if it’s operating at close to full employment, using all its resources. Any lower, and the economy isn’t working up to its potential. Any higher, and it runs a greater risk of inflation. To help guide policy, economists forecast the output gap—the difference between potential and actual GDP—for years into the future.
On Feb. 28, the Congressional Budget Office revised an estimate for potential GDP for 2017 that it had made in 2007. The new estimate is 7.3 percent lower than the original forecast. This downward revision wipes out $1.5 trillion of potential output, according to Andrew Fieldhouse, fellow at the Century Foundation, a think tank. So instead of forecasting a potential GDP of almost $20.7 trillion, the CBO predicts potential output closer to $19.2 trillion. For years economists have been expecting too much from the economy.
Decline in the potential output of the U.S. economy in 2017
That matters because the size of the output gap can influence policy. A large gap leaves too many people unemployed and tempts policymakers to try fiscal or monetary stimulus. Closing a smaller gap is harder, because it increases the risk of overshooting on stimulus and sparking inflation. It’s even more difficult to raise potential GDP. Education can increase productivity, but that takes years. Technological revolutions can boost potential; those, however, are rare.
The CBO didn’t just revise potential GDP down. Usually the agency assumes the economy will eventually realize its potential within a decade. This time, though the CBO sees the output gap narrowing, it doesn’t project the economy ever reaching even the new, lower potential GDP. That’s unusual, says Barry Bosworth, senior fellow at the Brookings Institution and an economist who worked on price controls in the Carter administration. “The assumption has always been that the U.S. economy will gain back what was lost in a recession. Academics are coming to the realization that this time is different and that those losses appear permanent and cannot be regained.” The lower potential growth indicates to many economists that the recession did permanent damage to the economy.
In its report, the CBO noted that damage from a housing and financial bust endures longer than the effects of an ordinary recession. Some workers have left the job market altogether. Others are trained for the wrong professions, leading the CBO to raise its estimate of the “natural unemployment rate” from 5.0 percent to 5.5 percent.
Yet two-thirds of the revision in potential GDP comes from trends under way before 2007 but not apparent until after the financial crisis. By far the largest of these is the size of the potential labor force, which is not as big as the CBO had thought—the smaller the workforce, the smaller the potential putput. And those who remain in the workforce are deciding to work fewer hours. In a speech last September, James Stock, a member of the president’s Council of Economic Advisers, argued that the economy was performing close to its potential. But that potential, he said, had dropped since the 1990s, in part because women were beginning to match men’s long-term decline in labor participation. Puzzling to many economists is that young people have been dropping out of the workforce, too.
The CBO’s downward revision feeds the debate over stimulus. Now that the output gap has narrowed, Douglas Holtz-Eakin, an economic policy adviser to former President George W. Bush and ex-director of the CBO, says less fiscal and monetary stimulus is needed. “When you think about tapering and pulling back from quantitative easing,” says Holtz-Eakin, “this shows that we’re closer than we thought.” The Fed should continue the pace of its taper, he says, since there isn’t as much slack in the economy as previously believed.
“The left side of the political spectrum now has a harder time making the case for fiscal stimulus,” says Neil Dutta, U.S. economist at Renaissance Macro Research. “It’s hard to argue there’s a lot of slack in the economy when you can drain the unemployment rate by three percentage points with just 2 percent GDP growth.” The CBO declined comment, but in a speech last week to the National Association of Business Economics, Doug Elmendorf, the agency’s director, stressed that the revisions focused on long-term trends. For the present, he said, “considerable slack remains.” The CBO’s own data show this as a current output gap of $754 billion.
Jared Bernstein, now of the Center on Budget and Policy Priorities and formerly Vice President Joe Biden’s chief economist, says the big reason for lower potential growth is the austerity measures put in place by Congress. “This deceleration in potential growth is not the outcome of benign forces,” he says. “This is the result of serious mistakes. They’ve thrown a wrench in the engine, and they’re now saying, ‘Well look, the car isn’t capable of going as fast as it used to, so let’s not fix it.’ ”
If Bernstein’s right, though, these mistakes have reduced potential growth by no more than 0.7 percent, the total impact the CBO attributes to all changes in federal tax and spending policies. Potential output has dropped in the U.S., and most of the problem comes from trends Washington hasn’t even begun to fight about.