Sunday, March 31, 2013

Debt and Potential GDP

For Mom.

You will remember my recent four-part critique of Potential GDP:

1. Imagine That!, where I called PGDP an "imaginary" number.
2. The Myth of Jobless Recoveries, where I experimented with calculations.
3. The Myth of Robust Analysis, where I expressed some of my doubts, and
4. CBO’s Method for Estimating Potential Output, where I summarized the calculation of Potential Output.

Laurence Ball, one of the authors of the paper I challenged in part three of the series, shot me down by email. (I added part of his reply as an update to that post.)

Here's the thing. I don't know enough about all this stuff to question what he says, so I'm forced to accept that he's right and I'm wrong. I still think the "similarity" of the two lines on his graph is too good to be true. And I still think the similarity must arise from "circular" arithmetic, though Ball clearly understood my objection, and rejected it. But I can't develop these criticisms until I learn more.

The use of Potential Output in comparison to data other than unemployment is much less objectionable, because it avoids the apparent circularity. And if you allow me to think of Potential Output as the "best case scenario" for things that could have been, I think it becomes a useful tool. That's how I'm using it today.

Graph #1: NonFederal Debt as a Multiple of Federal (blue) and the Rate of Change of PGDP (red)

In the early years when the blue line is low, the red line is high. In the late years when the blue line is high, the red line is low.

In the early years when Non-Federal debt is low relative to Federal debt, Potential Output is high. In the late years when Non-Federal debt is high relative to Federal, Potential Output is low. You now know everything you need to know, to fix the global economy.

To get output up, you want Non-Federal debt low, relative to Federal debt.

If you want to know more about Non-Federal debt relative to Federal debt, refer to the posts in this series:

1. Debt Relatives, which shows preliminary comparisons;
2. Debt Relatives: Uncle Sam, where I look at the Federal debt relative;
3. Debt Relatives: The Cousins, a look at the Non-Federal debt relative.
4. Debt Relatives: The Rise and Fall of the Non-Federal Relative, a longer post where I examine the trends in more detail and present some thoughts on policy.

Two additional posts on the topic follow in sequence.

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