You Can't Trust the Usual Gauges on This Economy
You can tell a happy story with the headline numbers from last week's estimate of third-quarter GDP growth. But a closer reading is troubling.
A second consecutive quarter of 3 percent growth, especially when natural disasters had some negative impact on economic activity, is good news. As disaster-ravaged communities get back their feet, and we get a short-term boost from rebuilding efforts, we should see a strong fourth quarter as well.
It’s not smooth sailing ahead for the economy, however. When we look at the output gap -- a measure of the level of economic activity relative to the economy's potential -- we see how structurally damaged the economy has become thanks to the after-effects of the great recession. Dealing with it will require a policy approach we haven't needed in decades.
Potential GDP, a measure put out by the Congressional Budget Office, tries to approximate how fast the economy can grow without overheating or undershooting. It's a reasonable way to evaluate the pace of economic growth, so officials can decide whether the economy needs stimulus or cooling.
Prior to 2000, when labor-force participation and productivity growth were higher than they've been in recent years, potential GDP growth was almost always 3 percent or higher. Since the great recession in 2008, when we've seen sluggish growth in labor-force participation and productivity, it's been revised significantly downwards. Potential GDP growth for 2017 is estimated to be 1.6 percent, and forecasts don't call for it to go above 2 percent. This is why economists say that we can no longer expect the economy to grow sustainably faster than 2 percent.
When we get GDP readings of 3 percent when potential growth is estimated to be 1.6 percent, the concern is overheating. Dividing the level of GDP by the level of potential GDP we arrive at the estimated level of the output gap -- whether the economy is running above or below potential. And as of the third quarter, for the first time since the great recession, the economy is estimated to be running above the sustainable "potential GDP" rate. Going back 50 years, this condition has rarely lasted for more than a couple years before the economy fell back into recession.
This puts policymakers in a difficult spot. The estimate of potential GDP suggests the economy is running above potential. The unemployment rate, at 4.2 percent, is lower than what the Federal Reserve considers full employment. Financial conditions as seen via risk premiums in financial markets are very loose. All of this suggests a mix of fiscal and monetary policy should be biased toward slowing the economy, perhaps significantly, in 2018.
But for those indicators to point toward slowing, when other markers show such problems, reveals how damaged the economy has become during and after the recession. Labor-force participation, even adjusted for demographics, remains lower than it has been in the past, suggesting a lot of workers have left the labor force without any explanation that should comfort policymakers. Housing construction and activity remains well below any historical level considered normal. If a goal would be to get labor force participation and housing activity back to pre-recession levels, the implication is it would require significant economic overheating, which current policymakers are likely unwilling to tolerate.
The other possibility is that some of the data is bad. Perhaps the labor-force participation rate is a better measure of labor-force slack than the unemployment rate, and for whatever reason the way we capture the level of unemployment is misleading. The official unemployment rate is 4.2 percent, which comports with other evidence like employers' constant complaints of labor shortages.
So we're left with two possibilities. Perhaps "the economy is bad" -- already at its potential even while labor-force participation and housing activity are well below the levels we're used to historically. Or perhaps the data is bad, and we're stumbling in the dark as we try to estimate full employment and the economy's potential. Either way, changes in the economy as a result of the great recession are to blame.
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