Answer to an Economics Puzzle

Economist columnist Greg Ip poses three questions about the recent behavior of the U.S. economy:

1) Why is GDP growing so slowly?

Since the recession ended, growth has averaged 2.5%, roughly around its pre-recession trend-rate, which means no progress closing the massive gap between actual and potential output that opened over the course of the recession.

2) Why is unemployment falling more quickly than the modest GDP growth would imply? [yes, falling unemployment is a good thing, but the article is analytical, not prescriptive]

In a six month period when GDP has probably grown roughly 2.5%, annualised, unemployment has fallen at a rate fast enough to justify 5.1% growth.

3) Why hasn't inflation fallen further?

Models that prevail in most forecasting shops would have projected much lower inflation given the size and persistence of the output gap than has actually occurred.

Greg Ip concludes that there is one explanation that fits all the facts [emphasis added]:

both the level and growth rate of American potential output is much lower than we think.

A discussion about potential output may seem arcane, but the subject is dear to the heart of economists. During a recession actual output, or GDP, falls well short of its theoretical potential, i.e., when the economy's resources are fully utilized.

The silver lining about recessions is that recoveries should be quick and nearly inflation-free. Idle plant and labor can readily be put to use without price increases, hence the conundra of (1)--the economy should be growing faster than 2.5% during its current phase, and (3) -- inflation should be 1 to 1.5%, not its current 1.9%.

The unemployment puzzle concerns the relationship between GDP growth and unemployment, which has held fairly steady over the past quarter century. People are going back to work at higher rates than 2.5% growth would have predicted in the past.

Greg Ip's explanation--that potential output is growing slowly, if at all--makes sense to this non-economist. "Potential" GDP doesn't grow on its own or even sit there waiting for demand to catch up. Capital and labor erode: airplanes parked in the desert can't really fly again, nor can laborers--think injured NFL quarterbacks--resume work at 100% without a lot of expense or re-education.

Just keeping the economy's potential where it's at is more costly than ever.

(Related subject: Tyler Cowen's Great Stagnation discussed how 20th century America picked the low-hanging fruit of free land, technological breakthroughs, and education of an intelligent, but unskilled populace to trigger an unparalleled era of prosperity. Expanding potential output has become much more expensive as well.)