Potential output may not be sexy, but it is critical to an economy’s future performance. A supply-side concept, it is defined as the level of output consistent with stable inflation. Unfortunately, it all too often gets lost in the heated debate over the demand side of the economy. But potential output is central to a country’s long-term economic prospects and it’s sending out worrying signals at present.
A recent study by the IMF found that (across 10 advanced and six emerging market economies) in the aftermath of the financial crisis potential output fell. The financial crisis led to a decline in both the level of potential output and its growth rate.
The IMF showed that potential growth has declined by around one percentage point in the advanced economies and two percentage points in emerging markets. In the advanced economies, the IMF attributed the slowdown to reduced capital growth and demographic factors. In emerging markets, the pre (2000-07) versus post (2008-14) crisis slowdown was attributed entirely to reduced total factor productivity growth – the efficiency with which labour and capital are brought together in the production process.
The hard numbers show that potential growth in the advanced economies fell from around 2 per cent annually pre-crisis to 1.3 per cent over the 2008-14 period. The IMF projects potential output growth will rise to 1.6 per cent per annum over the 2015-20 period. Yes that’s an improvement, but it’s still well below pre-crisis growth. Two powerful competing forces are at play: first, a steady improvement in capital growth; second, a negative effect from demographics and employment growth.
For emerging markets there is a pronounced slowdown, but from a higher rate. The potential growth rate is projected by the IMF to decline from 6.5 per cent per annum over 2008-14 to 5.2 per cent over the 2015-20 period. Three effects are seen to combine together in emerging markets: an ageing population, capital constraints, and weaker total factor productivity growth.
While the eyes of financial markets are drawn towards Greece at present, they are missing a much more powerful influence on our standard of living over the coming decades. In the advanced economies, we need to accelerate potential output growth in order to: first, return potential output growth to pre-crisis performance; second, overcome the negative effects of an ageing population on long-term growth; and finally offset the weakening in emerging markets.
This is why the debate over austerity is so misleading. It focuses on the impact of tighter fiscal policy on the demand side. However, reducing the size of the state to 36 per cent of GDP by 2020 (in the UK) will have positive supply-side effects as resources are moved from the less productive public sector to the more productive private sector – i.e. there will be an improvement in total factor productivity growth.
Whether it’s the UK, Greece or China, raising potential output growth should be the primary focus of economic policy. The more you drive up the potential growth rate, the faster you can run these economies without igniting inflationary pressures. Policy-makers need to re-orient their mindset towards long-term aggregate supply and away from short-term aggregate demand.