Arnold Kling  

PSST vs. Potential GDP

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The AS-AD paradigm includes a concept called potential GDP. Mainstream macroeconomists sort of force-feed macroeconomic history into AS-AD by talking about "cyclically-adjusted productivity" when they talk about AS and "trend-adjusted GDP" when they talk about AD.

Consider the following types of events:

1. Capital deepening (adding to the per-worker stock of physical, human, or social capital)
2. Technical innovation
3. Opening up new trading opportunities

In AS-AD, these are all supply-side phenomena that increase potential GDP. When GDP differs from potential, that is by definition a demand-side phenomenon.

WIth the paradigm of Patterns of Sustainable Specialization and Trade, we do not make such a distinction. Things like (1)-(3) are going on all the time. The consequences for employment depend on how resources move from declining to expanding industries. Three possibilties:

(E) Excessive Expectations. Resources move too quickly to what are perceived as expanding sectors. Think of the Internet Bubble, or perhaps the 1928-29 boom in electric utilities. People over-estimate the speed with which new industries can attain profitability, and investors in these industries over-estimate their wealth.

(D) Displacement Downturn. Resources move out of what are perceived as declining sectors before new sectors can absorb them. (The human and physical capital in declining sectors in fact may not have productive value in the new industries. As Tyler Cowen would put it, Zero Marginal Product.) People perceive the wealth decline in displaced sectors before they can realize the gains in new sectors. Alex Tabarrok points me to a literature on this, exemplified by Greenwood and Jovanovic.

(G) Goldilocks Growth. Resources move effortlessly and synchronously from declining sectors to expanding sectors. For example, within telecom in the 1990s, we lost jobs related to land lines and gained jobs related to cellular, and it all seemed to go pretty smoothly.

To illustrate the three possibilities, take Ricardo's classic comparative advantage story. Imagine that we are just about to open up trade between England and Portugal. Ultimately, this is going to cause British labor and capital to shift out of wine and into cloth. If the British clothing industry becomes irrationally exuberant, it may expand too quickly, resulting in the (E) mode. Conversely, if the wine industry is wiped out by imports before its workers can be redeployed into cloth, we have (D). If adjustment is frictionless, we get (G).

I think that the question of how we can have (D) and not (G) is a difficult one. But that is where PSST wants to take the issue.

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CATEGORIES: Macroeconomics

COMMENTS (5 to date)
david writes:

To quote Sumner quoting Andy Harless:

"It’s not structural, and it wouldn’t matter if it was" ... [Harless:] structural unemployment is pretty much the same deal as an oil shock; it’s a reduction in aggregate supply. In both cases, employment eventually readjusts. [...] In both cases, the adjustment happens faster if monetary policy accommodates: because there is more incentive to retrain and relocate workers; or because product prices rise more quickly.

(E), (D), and (G) work just fine in AS-AD; your distinctive contention would that monetary adjustment is unable to grease (or, inversely, impede) structural adjustment, added to an assertion that the recalculation problem is too difficult for the market to readily solve even given enough grease. The New Keynesians/quasi-monetarists suppress the latter by invoking market efficiency, of course.

Harrison Searles writes:

I think that a key difference between the Displacement Downturn and Goldilocks Growth would be incentives and especially the effectiveness of relative prices.

If there are incentives exogenous from the economy (e.g. government policy) that encourage growth in a sector then a gradual recoordination of resources from this sector when it otherwise would have become unprofitable will not occur. Instead, it is likely that there will be a sudden crash resulting in a displacement downturn as entrepreneurs suddenly realize that many of their plans for the future are unviable. A mass realization of the unprofitability of a single sector seems to be a perfect recipe for the D-scenario.

Relative prices act similarly and are perhaps even more important because they are the mechanisms by which entrepreneurs will know what sectors of the economy to move into. It is only by a decline of the comparative profitability of producing cloth rather than wine in Great Britain, something that is communicated by relative prices, that entrepreneurs there will invest in the cloth-industry. If these price signals for whatever reason do not work well, then this coordination will not be possible and so the G-scenario unlikely.

Andy writes:

Stop posting so much! I'm still trying to get caught up on your other macro posts.

Daniel Kuehn writes:

David makes the same point I have on here before - PSST is fine, I just don't see it as of necessity oppositional to AS-AD insights. I think when I wrote that in the comments, you concured - although I could be wrong. My concern is that just because the coordination and stability of these patterns are essential for growth, it doesn't seem to follow that their discoordination offers the best explanation for recessions.

Bill Woolsey writes:


You are confusing the concept of potential income with the claim that it is always on a constant growth path.

Or, at least, that seems to me what you are saying.

Claiming you have a new paradigm where potential income can fall because of resource reallocation adds nothing to the assertion that real income is never below potential income. Much less does it help make sense of your trully odd notion that money expenditures always passively adjust so that they equal potential income at whatever price level happens to exist.

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