Since the recession, a persistent gap between potential output and real economic growth is making some economists uneasy and creating debate. Potential output is essentially the nation’s economy at full throttle. It’s the hypothetical maximum level of production the economy could sustain given current resources and capacities. This figure combines the full capacity of the nation’s factories, offices, farms and mines, as well as an indicator of maximum employment.
The gap between potential output and the real economy is a strong predictor of GDP growth, so economists tend to keep close watch. A large gap reflects unused resources, and under normal circumstances, we would expect them to soon be put to productive use. For instance, new workers joining the labor force usually find jobs and newly-discovered iron deposits are eventually mined.
A great deal depends on potential output:
- Interest rates and inflation rise and fall with changes in potential output. When the economy is near full capacity, demand for resources outstrips supply, leading to unsustainable practices and spiraling prices.
- The amount of public debt our nation can sustain depends on the long-term rate of GDP growth. There is a limit to how far our national debt can rise in proportion to GDP without harming the economy.
- The tax base is proportional to some aspect of economic output—the potential output represents the growth potential for the tax base.
Although GDP has grown at a respectable 2.5 percent pace since the bottom of the recession, it remains 10 percent below its pre-bust trajectory—and shows no signs of rebounding soon. This stubborn underutilization has led some economists to question how much slack truly remains in the economy, speculating that the recession destroyed a significant chunk of the economy’s productive capacity.
But most mainstream economists doubt that we have lost 10 percent of potential output.
- The destruction of a tenth of the nation’s capacity would require an obvious cause—a catastrophic natural disaster, for instance.
- Historically, an unemployment rate above seven percent has been associated with a ten percent gap between GDP and the potential output.
- A rising stock market implies that investors believe there’s still plenty of room for growth.
Potential output was dented to some extent when the financial crisis wiped out massive amounts of capital and the damage may have been worse than widely believed. On the other hand, pre-recession projections of GDP growth were at least partly based on unrealistic assumptions about the housing market—perhaps it’s unfair to use them as a baseline for the economy’s true potential output. Time will tell whether this decline is temporary or here to stay, but remember, Fed policy can lessen the impact of the current economic cycle on future potential output.