the new normal: U.S. economy already nearing potential

The main argument that's been trotted against the "deficit scolds" is that Washington should wait until the U.S. economy has recovered.  When will it have recovered?  When it is approaching "full employment."

In economics, "full employment" is a rough synonym for "potential GDP" and it refers to the underlying productive capacity of the economy.  Potential GDP is the blue line in the graph below.  Although the U.S. emerged from the officially determined recession some time ago (indicated by grey shading), according to Keynesians a  large "recessionary gap" or shortfall in the aggregate demand for goods and services in the economy remains, as indicated by the gap between potential GDP and actual GDP (which is given in red):

Although there's no doubt about the red line, just where the blue line should be plotted is less than an exact science.  In this case, the blue line is plotted by the Congressional Budget Office or CBO, and what is of particular note here is that the CBO has been repeatedly shifting the line towards the right (i.e. towards the red line), as Brad DeLong has graphed, to the effect of steadily reducing the demand deficiency.  DeLong notes that the CBO has drawn down its potential GDP track by 8.5% since 2007, well in excess of the 2008-2009 contraction, which Dean Baker has pegged at 4%.  Here's a graph that has the potential GDP line coming very close to actual GDP:

This particular graph, which the President of the St Louis Federal Reserve, James Bullard, has been using, has come under a lot of attack by Keynesian economists because it challenges the hypothesis that there is currently a significant output gap.  The red dashed line here is generated by using a "Hodrick–Prescott filter," which is named after economists Robert J. Hodrick and Edward C. Prescott, who developed it to separate the "cyclical" element from the "trend" element.  Now an HP filter has various limitations, such as working with less information near its end point, but Mark Thoma takes issue with what it says in the middle: "the HP filter reveals a period of substantial above trend growth through the middle of 2008. This should be a red flag for Bullard. If he wants to argue that steady inflation now implies that growth is close to potential, he needs to explain why inflation wasn't skyrocketing in 2005. Or 2006. Or 2007."  One could start here by pointing to the fact that Paul Krugman has defended the use of data that uses a Hodrick–Prescott filter by arguing that a gap with potential GDP need not be defined exclusively by inflation.  Does Thoma believe that because the general consumer price index in Japan rose less than 4% between 1985 and 1989, the Japanese economy was not operating above potential despite real GDP soaring more than 20% during those four years?  Isn't there an obvious analogy between Japan's equity and commercial real estate bubble bursting in 1990 and the U.S. residential real estate bubble bursting in 2008?  Growth cannot always be below trend, meaning that unless Thoma is going to define a decade as the short term, he needs to acknowledge occasions where it has been above trend.

Notwithstanding his 2009 use of the IMF's HP filtered data, in July Krugman weighed in on the debate over Bullard's graph to note that back in 1998 he took issue with those who used a HP filter to conclude that Japan's economy was close to potential that year.  What Krugman doesn't tell you is that he took issue wrongly, claiming back then that "in retrospect it will seem clear that Japan's 1998 output gap was 8 percent or more... so that demand-side policies to close that gap are of very real importance."  In fact the OECD, which marked down Japan's potential growth to 1.6% in 1994 and forecast then that the estimated output gap for Japan in 1997 was, in Krugman's view, "remarkably small:  -  1.2  percent," has been vindicated.  According to the IMF's model (that would be the very same model Krugman used in 2009 to support his claim about the output gap in the U.S.) Japan's output gap for 1998 was less than two percent.  While Krugman argued that Japan was facing a prolonged slump in GDP growth below potential, the IMF correctly interpreted Japan’s lost decade as a slowdown in potential.  I might add here that the IMF also says that the U.S. had an "inflationary gap" (that is, a negative output gap) over 1% in 2005, 2006, and 2007.  Despite having wrongly prescribed aggressive "demand-side policies" for Japan in 1998, Krugman is currently pounding the drum for them to be applied in the U.S. in 2013.  

Ironically, Krugman exhibited a moment of worry in February 2008, noting that a HP filtered graph of productivity was flashing warning signs.  Productivity is a key component of potential GDP, meaning that he saw back then an explanatory factor for the U.S. economy's low growth that wasn't coming from the demand side.  Here is a graph of the year-over-year change in potential GDP as measured by the CBO:

Note the slump from 2000 to 2011.  The CBO optimistically believes the trend will reverse this decade, but if it doesn't, the CBO will continue to shrink its projected output gap by ratcheting down its potential GDP projections.

There are a variety of other metrics that one can point to that are inconsistent with the thesis that there is a large output gap, including the fact that inflation is running at 2%, pretty much right on the average since the late 1990s, the employment cost index (wages and benefits) is rising, and  U.S. capacity utilization has recovered to pre-crisis levels. 

But a Canadian now working for the St Louis Fed, David Andolfatto, makes a particularly compelling argument for deeming current U.S. unemployment structural as opposed to cyclical:

The Canadian unemployment rate is is blue, the U.S. rate in red.  Throughout the 80s and 90s, Canada's unemployment rate was consistently higher.  Although the Canadian unemployment rate rose around the 2001/2002 recession and again in 2008/2009, the rise was smaller than in the U.S., and Canada reformed its unemployment insurance program in the 90s, restricting benefits.  If it took Canada three decades to move in front of the U.S., why should we believe the U.S. will quickly reduce its unemployment to Canadian levels?  It's more likely that most of the "business cycle" adjustment has already occurred, such that remaining adjustment is subject to long term processes.

This brings us to yet another string of arguments, namely those advanced by Casey Mulligan.  Mulligan goes beyond the fact that the share of 25 to 54-year-old non-college educated men in the work force has trended down for decades to note how U.S. policy has encouraged non-participation in the labour force in recent years by easing eligibility rules for unemployment insurance, increasing the generosity of food stamps, etc:

The American Recovery and Reinvestment Act, popularly known as the stimulus, gave unemployment insurance recipients a weekly bonus, and offered to pay for the majority of their health insurance expenses. FDIC and Treasury reduced some “unaffordable” mortgage payments, which means that successful people need not apply. The list goes on and on.

The essential consequence for all of these is the same: a reduction in the reward to activities and efforts that raise incomes.

Dean Baker and Paul Krugman have occasionally taken issue with Mulligan, although Krugman frequently suggests that he considers Mulligan too much his inferior to engage.  At one point Krugman says "Mulligan and others keep emphasizing examples of individual groups that have managed to gain jobs by cutting wages or offering other attractions to would-be employers."  Why is this inconsistent with Keynes?  Because Keynes' was of the view that if you increased the skill level of all the unemployed in the economy in one swoop or reduced the wage cost to the employer of hiring them, this wouldn't reduce unemployment when there be an output gap because the problem is not with the supply of labour but on the demand side.  Krugman's reply is that a sub-group that reduces its unemployment says nothing about whether the whole group ("all unemployed in the economy") could realize the same success.  Everybody can't be an above-average potential hire, observes the Krugman.  I don't find this at all convincing, however.  Krugman ought to be be chastising Dean Baker instead of citing him if he were consistent.  Why?  Because Dean Baker's #1 policy prescription after the economy has returned to potential is a lower U.S. dollar.  I should think it would be obvious that not every country can depreciate its currency at the same time.  At issue here is the international competitiveness of the United States; if a particular group in the U.S. can take actions that improve its employability the Keynesians need to explain why it wouldn't work for the entire country to take a similar action.  

To be sure, I think Mulligan goes too far when he seems to suggest on occasion that the cause of the recession is to be found on the supply side.  But that's not the question at issue here on the doorstep of 2013.

UPDATE December 6:
Job vacancies continue to rise: