Behind the Slowdown of Potential GDP
The current level of real GDP is 11.4 percent below the forecast that the Congressional Budget Office (CBO) made back in 2007, before the beginning of the crisis. One reason for the lower-than-expected output is that the recovery has been slow and the economy is still producing much less than its potential output level—the level that could be reached if all available capital and labor were being used at a high rate. The other reason is that the level of potential output itself is now estimated by the CBO to be lower. This downward revision accounts for a little more than 50 percent of the gap between the current level of real GDP and the pre-crisis forecast. Forecasts of future potential output have been revised downward as well, and this will have long-lasting implications for economic activity. The CBO now expects future potential GDP to be lower by about 7 percent relative to its pre-crisis path. Since actual output is expected to converge to its potential over time, the long-run path of real GDP is now expected to be lower by about 7 percent as well.
The potential growth rates for the years 2004 through 2016 were all revised downward, with particularly sizeable revisions for the years 2008 through 2015. The long-run growth rate of potential GDP was revised down as well, but by a smaller amount. This pattern suggests that one factor behind the near-term revisions was the occurrence of the 2007 crisis. The ensuing recession damaged the supply side of the economy, temporarily reduced the potential growth rate and permanently shifted the future path of potential output downward. [update 2/13/13: The CBO estimated that the recession and the ensuing economic weakness will lower potential output by about 1.5 percent in 2022 (see An Update to the Budget and Economic Outlook: Fiscal Years 2012 to 2022, Box 2-2, page 40-41). The remainder of the revision is mainly the result of a reassessment of long-term trends.] [This paragraph has been modified to reflect the conclusions of the CBO report.]
It is quite typical to see potential GDP slowing down after the economy enters a recession. This is because investment generally falls during an economic contraction, which slows down capital accumulation and reduces the growth rate of potential GDP. In the most recent downturn, however, the drop in investment has been exceptionally large and persistent, and this has caused potential GDP to decelerate more and for longer than is typical (see “A Return to Lower Levels of Investment Activity”).
In an accounting sense, there are three determinants of potential GDP—the capital stock, potential hours worked, and potential multifactor productivity—and changes in any one could be behind the slowdown of potential GDP. The growth rates of potential hours and potential productivity have remained stable since 2006, so they have hardly contributed to the slowdown. The contribution of capital services, however, has decreased significantly since 2008, and almost entirely accounts for the subsequent slowdown of potential GDP. It also accounts for a temporary snapback of potential output growth that is forecasted to occur from 2016 to 2020. This forecasted snapback, however, will not be enough to compensate for the current decline and to bring back potential GDP to its pre-crisis path.
This evidence points to the drop in investment and the resulting slowdown of capital accumulation as factors behind the loss of potential GDP. [Modified 2/13/13.] Capital growth dropped from rates consistently above 2.5 percent before the recession to rates below 1 percent after the economy bottomed out. This decline was larger and more extended than was typical in past business cycles. The smaller stock of capital will have long-lasting consequences, permanently lowering the future path of capital, potential GDP, and actual GDP relative to their pre-crisis paths.