On Friday I invited readers to comment on the graph below, which comes from the Congressional Budget Office. I took the graph from Brad DeLong's The Long-run Cost of the Economic Downturn. This quote is from the CBO's latest Budget and Fiscal Outlook.
... under the fiscal policies embodied in current law, output is expected to remain below its potential (or maximum sustainable) level until 2017 (see figure below). By CBO’s estimates, in the fourth quarter of 2012, real (inflation-adjusted) GDP was about 5½ percent below its potential level. That gap was only modestly smaller than the gap between actual and potential GDP that existed at the end of the recession because the growth of output since then has been only slightly greater than the growth of potential output. With such a large gap between actual and potential GDP persisting for so long, CBO projects that the total loss of output, relative to the economy’s potential, between 2007 and 2017 will be equivalent to nearly half of the output that the United States produced last year.
I added some notes to the chart. The dashed black lines shows the future trajectory of GDP, which meets up with "potential" growth in 2017 according to the CBO. Note that there are two "potential" lines. The second is a downward revision of the first. The blue line appears to be an extrapolation of growth during the 2003-2006 period. The red line (the revision) appears to be an extrapolation of growth during the 2007-2008 period. The black line shows what actually happened.
This post is a follow-up to yesterday's When The Bad News Is Good, And The Good News Is Bad, which looked at current trends in "consumer" credit. I recommend that you read it if you haven't already done so.
Is there good reason to believe that real GDP will reach its "potential" in 2017? No, not unless Americans are willing to take on a huge amount of household debt in the next four years, as I will explain below.
On the other hand, there are several good reasons to believe GDP will continue to stumble along, or fall dramatically if government spending cuts are enacted. See my post The Disconnect Between GDP And Energy In The United States.
The first thing to note about the "potential" GDP graph is that both extrapolations are based on the Housing Bubble years. The original blue line extends the trend when the bubble was in full swing. The downwardly revised red line extends the trend when the bubble was collapsing but the meltdown had not yet occurred. (House prices reached their peak in mid-2006.)
It is important to understand in this context that the standard Keynesian view assumes that demand is demand, no matter where it comes from. Tim Iacono commented on this in Debt-to-GDP and Misdiagnosing a Bubble Economy’s Ills. Crucially, demand which is fueled by debt is taken to be the same as demand fueled by rising incomes. Simply put, debt doesn't matter.
A few economists seem to be catching on, but not nearly enough…
About a year ago, St. Louis Fed President James Bullard wondered whether too much faith was being placed in what models say economic growth should be but, as detailed in When Models Trump Common Sense, he was rebuffed by nearly the entire establishment (or at least “a small army of bloggers with PhDs in economics”).
Now, in a story at Project Syndicate, Raghuram Rajan, Professor of Finance at the University of Chicago Booth School of Business and the IMF’s youngest-ever chief economist tries to explain Why Stimulus Has Failed and, in doing so, questions whether the root cause of our current economic troubles is simply a lack of demand, casting himself as an Austrian sympathizer in the process:
What if the problem is the assumption that all demand is created equal? We know that pre-crisis demand was boosted by massive amounts of borrowing...
Put differently, the bust that follows years of a debt-fueled boom leaves behind an economy that supplies too much of the wrong kind of good relative to the changed demand...
The only sustainable solution is to allow the supply side to adjust to more normal and sustainable sources of demand … The worst thing that governments can do is to stand in the way by propping up unviable firms or by sustaining demand in unviable industries through easy credit.
For flirting with this heresy, Raghuram Rajan was promptly denounced.
Those of us not laboring under the burden of formal economic training are free to apply common sense to the recent economic history of the United States. Common sense tells us that demand was artificially inflated by the Housing Bubble, and promptly deflated after the bubble burst, just as we would expect. Case closed. Yet, the CBO seems to assume that some Housing Bubble-like event will lift growth up to "potential" by 2017.
The situation is even worse when we look at income. Doug Short gives us this excellent chart based on inflation-adjusted Census Bureau data.
Click to enlarge. From U.S. Household Incomes: A 44-year Perspective
Even a cursory glance at this graph should be sufficient to convince you that any future economic growth the United States achieves must be debt-based, unless a miracle reverses these well-established household income trends.
Needless to say, no miracle has been forthcoming. In fact, the latest data release from Emmanuel Saez of UC-Berkeley indicates that the astonishing disparity in the distribution of income is getting worse, not better.
From 2009 to 2011, average real income per family grew modestly by1.7% (Table 1 below) but the gains were very uneven. Top 1% incomes grew by 11.2% while bottom 99% incomes shrunk by 0.4%.
Hence, the top 1% captured 121% of the income gains in the first two years of the recovery.
From 2009 to 2010, top 1% grew fast and then stagnated from 2010 to 2011.Bottom 99% stagnated both from 2009 to 2010 and from 2010 to 2011
And that, my friends, is the final nail in the coffin for the U.S. reaching its "potential" in 2017.
As you know, I believe these economic growth fantasies are deeply rooted in Human Nature. However, one needn't resort to a "deep" argument to debunk them because there is plenty of readily accessible evidence which does the job very nicely.
The assumption that such fantasies are innate and elemental explains their ubiquity and persistence, despite overwhelming evidence to the contrary, and the CBO "potential" GDP growth scenario is an excellent case in point.