(Analysis) A paper [pdf], presented by employees of the Federal Reserve at an annual conference sponsored by the IMF, is getting deserved attention in various media outlets. This is important, if the analysis in the paper is ever going to contribute to policy-making here in the US. What the analysis shows is that there is a quantifiable loss of potential output in the US economy due to what is technically called “hysteresis”. In layman’s terms, this simply means that we are living poorer than we would otherwise be living if our economy had not experienced a period when resources like capital and labor were under-used.
The really pessimistic reading of the graph (left) is that the estimated loss of potential output has been cumulative through at least 2012. Each year, as economic resources were underutilized, the estimate of our economy’s potential to produce goods and services has declined. The silver lining in this dark cloud, so to speak, is that the estimates appear stable when comparing the estimate based on data in 2012 with the estimate based on data through 2013. The decline of economic potential is hopefully at an end, leaving only a gap with the pre-recessionary path to be filled over some time period in the future.
When this gap in potential output is filled should be of great concern to policymakers, as they have direct influence over this gap, through both fiscal and monetary policy. The sooner this gap is filled, the sooner we will be able to live in a world where our economy delivers goods and services commensurate with a better standard of living.