This is, as Krugman might say, a bit wonkish but quite important and fortunately the author, Alphaville's Matthew Klein, knows his stuff and can lay it out in terms that are very straightforward.
The belief in the ability to forecast potential output, especially comparisons of pre-financial-meltdown to post, is something that has puzzled me for years. Everyone who looks at this corner of macro knows the growth-of-GDP chart that extends, bottom left to top right almost monotonically with the step-change down in 2008.
The version Mr. Klein uses in this piece is especially handy in that it shows the lowering of the projected 'potential':
From FT Alphaville, July 21, 2017
Towards the end of 2000, at the peak of America’s irrational exuberance, staff economists at the Federal Reserve Board presented the following forecast:
Structural productivity is estimated to have risen 3.2 percent in 1999 and 3.5 percent this year and then to accelerate to 3.6 percent in 2001 and 3.7 percent in 2002. Accordingly, with the contribution of labor input assumed to be advancing at a steady rate, our projections for the rate of expansion in potential output move up from 4.3 percent last year and 4.6 percent this year to 4.7 percent next year and 4.8 percent in 2002.A few months later, the boffins at the Congressional Budget Office released their forecasts for 2002-2011. They were only slightly more conservative than the Fed, expecting the “potential output” of the private sector to grow at an annual average rate of 3.8 per cent and for the overall economy to expand at a yearly pace of 3.3 per cent:
There are only two ways to interpret these forecasts. Either economists were ridiculously optimistic at the beginning of the millennium or the US economy spent the first decade of the 2000s operating far below its “potential”.
Standard theory* suggests the first interpretation is closer to the truth: technocrats at the central bank and the budget office were deluded into believing the anomaly of the late 1990s would continue indefinitely.
Their error seemed plausible at the time because both institutions had spent the second half of the 1990s consistently under-estimating the economy’s ability to grow.
Back in 1996, for example, the CBO expected “potential output” would only grow at a yearly average rate of “about 2.1 percent” from 1997-2006. That was about a percentage point slower than what actually happened, and about two percentage points slower than the average growth rate in 1997-2000. Similarly, the Fed’s staff economists thought potential output had a “2 percent trend” back in 1996.
By the time they’d finally corrected their earlier errors the world had changed again and they were left looking as foolish as people buying the S&P at a Shiller earnings multiple in the 40s.
The lesson here isn’t necessarily that the CBO or the Fed are uniquely incompetent, but that long-term forecasts are hard.
It’s basically impossible to tell the difference between a sustained but ultimately temporary deviation from a trend and a change in the underlying trend. Like people everywhere, economists try to learn from their mistakes. Often, like the rest of us, they over-correct....MUCH MORE
