Thinking about the US output gap

Via Marginal Revolution I noticed the argument that a drop in lifetime wealth may have reduced potential output, thereby implying that there is a smaller output gap (permanent loss in productive capacity).

Now, I share Scott Sumners concern about this view. It is true that a negative permanent wealth shock will in turn lead to lower consumption – but in of itself this does not imply that it leads to lower output, which is what GDP and potential GDP are measures of.

Tyler Cowen put up the best defence of it when he stated “Simplest response to Sumner and Yglesias is that we may have had a biased estimate of the previous trend, for bubble and TGS-related reasons.” [note, he improved the defence further in response to Krugman here], but I think we need to go a step further and ask “how could we have been past some long term potential output before”?  In truth we need an explanation that works for why potential rose and why it fell that uses the idea of wealth.

In order to understand why potential may have risen then fallen we need to ask what factors were influencing the expectations of individuals so that they supplied too much labour/invested in too much capital.  We can’t just say “they consumed more” because without the ability to produce we consume more by borrowing and importing – which leads to the increase in consumption and imports canceling out in GDP.  We need a reason why production, output, GDP, was higher.

For this we need to rely on expectations.  Start with the drop.  Suddenly wealth is lower – wealth is the stream of returns on an asset, in the aggregate sense it is the discounted sum of expected income/output that is expected in the economy.  A drop in wealth here suggests that peoples expectations of future potential output have fallen – for better or worse.  As a result, your expected return on investing is lower – whether that be in skills for work, or whether it be capital in your job.

On the other side, suddenly wealth expectations are higher.  Income now has a greater expected rate of return in the future, you are more willing to invest now.

There is a case to be made that, if the rate of return is higher now, you will be willing to invest in order to reap the benefit.  Furthermore, you would be willing to supply more labour in order to achieve the capital gain (a return) associated with those “higher house prices” in the future.

If your wealth expectations suddenly fall, you are not willing to invest as much in the future, as the expected real rate of return is lower.  You are not willing to work as much given that the return on savings will be lower.  As a result, “potential output” would have declined.

Note:  You could in turn read these the other way around, it depends on the magnitude of “income” and “substitution” effects from the change in the expected real rate of return in the economy.

Note 2:  This is an entirely supply based argument, as it is about potential output.  Potential output is the “supply” notion of the economy, while many of the other cyclical issues we discuss are “demand” based.

Sidenote

These shocks exist for any view of “potential output”.  And this doesn’t mean potential isn’t a useless concept – it just means that maybe there is a more solid variable we can use to tell us the same thing without the confusion.

Conveniently we measure the UNEMPLOYMENT RATE, and we have a relatively clear and fixed idea of what the natural rate of unemployment is.  As a result, the gap between these two is a lot more useful to look at when trying to ascertain whether we are below or above potential IMHO.

Update:  Scott Sumner discusses why this doesn’t make sense for the US.  However, I think it is a partially workable argument for NZ given the inflationary pressures we were experiencing, the high participation rate, and the amazingly low unemployment rate all prior to the crisis.