A Cottage Industry in Measuring Against “Potential” GDP

How do you get a number to look small? Compare it to a big number.

How do you get a number to look big? Don’t use a real number, use one that represents the “potential” value of that number – even if this “potential” value assumes the repeat of conditions that no one really wants repeated, such as successive and very destructive asset bubbles in the U.S. and/or global economy.

That’s what passes for conventional wisdom amongst the dismal set these days and its spreading into the mainstream financial media as there now seems to be a cottage industry in measuring things against “potential” GDP rather than the real thing, the latest example being this story at the Washington Post.

This graph shows total private fixed investment relative to the nation’s potential GDP, going back to 1949. (That’s how much the private sector is spending on both houses and commercial installations). After averaging 15.5 percent from 1949 to 2007, private investment fell as low as 10.6 percent in the economic collapse starting in 2008 (it was 12.2 percent at the end of 2012).

In other words, for the last few years private construction activity has been far below its historic norms. And so long as the private sector isn’t building houses and office buildings and factories, the government can build without crowding out private investment.

As it turns out, you don’t need to compare to “potential” GDP to make the case stated above.

A quick trip over to the vast data repository of the St. Louis Fed known as FRED (where it’s really pretty neat what you can do) produces about the same result using GDP or potential GDP. I guess the point here is that it’s become commonplace to compare things to our past bubble economy rather than the economy itself.