At parent-teacher conferences, did teachers ever tell your parents that your academic performance was well above your potential? Probably not! But many of us remember them being told that despite good grades we were not “performing up to potential.”
The implication that one also could perform above one’s potential seems counterintuitive, but an analogous idea enlightens election-year discussions of U.S. employment markets.
A brief macroeconomics review may help. People who took economics in college since 1960 may recall the term “output gap.” Presented in connection with Keynesian theory that called for adjusting taxes, government spending and the money supply to manage the economy, “output gap” referred to the observation that, at any particular time, actual production of goods and services can diverge from the level the economy could achieve.
The idea that an economy can produce at less than its potential seems commonsense. In a recession, factories run at less than capacity, construction firms don’t have contracts, and people are out of work. Of course, the economy is producing less than it might.
The Keynesian belief that an economy can also produce more than its potential makes less obvious sense. If factories and mills are churning out some level of production, that next level must be potentially possible, must it not? So, how can an economy have a gap where actual production of goods and services exceeds the economy’s potential?
The textbook answer is that “potentially possible” includes the small-print qualifier: “over the long run without accelerating inflation or motivating unjustified investments.’’ An analogy might be that one could rev the engine in a 1957 Chevy up to 5,000 rpm and hold it there for a few seconds or even minutes. But if you tried to drive to Los Angeles with the engine at that rpm level, it would blow apart before you cross the state line.
If you accept the premise that an economy can be racing along faster than is sustainable given certain constraints, then it is possible that more people will be working and the unemployment rate will be lower than is “potentially possible.’’ If employment numbers then fall, is it prudent to expand the money supply in an attempt to regain previous high levels? This is the crux of current debate.
Unemployment rates and job numbers are a key issue in the 2004 presidential race. John Kerry repeatedly notes that the number of jobs in the United States remains well below the level when George W. Bush was inaugurated. Despite good job growth this spring, the number of jobs in June 2004 languished some 1.2 million below January 2001.
Unless there is rapid growth, Bush will be the first president in more than 70 years to end a term with fewer jobs than when he started. Bush supporters emphasize improvement, however. The gap was more than 2 million just six months ago. Moreover, the average unemployment rate for Bush’s first term is lower than the average for 1992-1996 under Bill Clinton.
Even so, some economists note that the U.S. population and potential labor force have grown by several million during the past four years. Getting back to the same number of jobs as four years ago would mean that there were no new jobs for these millions of additional potential workers. To return to the same proportion of the adult population working that we had in 2000, we would have 5 million additional jobs — not just 1.2 million.
One may wonder why the unemployment rate is not higher if millions of people were added to the potential labor force. The answer is that the proportion of people 16 years of age and over who are working or looking for work has dropped. The extra bodies are counted as “out of the labor force,” not “unemployed.”
What then, if anything, should be done? University of California-Berkeley economist Brad DeLong argues in Tuesday’s Financial Times that “the Fed should go easy on interest rates.” DeLong and some other economists, mostly Keynesian, believe that the dangers of inflation or bubbles in real estate and financial markets are small compared to the continuing problem of employment well below where it might be.
Their argument, however, is highly dependent on the assumption that the employment levels reached in the late 1990s and continuing into 2000 were normal, readily achievable ones that could be sustained over the long run.
If, instead, those high levels occurred in a short-run situation where both output and employment were above “potential” levels, even the most devout Keynesians would have to concede that additional Fed laxness might be harmful.
The argument that continued monetary slack is necessary to add millions more jobs scares those of us who are skeptical about the wisdom of Keynesian micromanagement in general. Thankfully, it is doubtful that the men and women who sit on the Federal Open Market Committee will swallow the “below potential” argument hook, line and sinker.
© 2004 Edward Lotterman
Chanarambie Consulting, Inc.