How can I justify that potential real GDP has actually fallen so low?
I look at this graph...
The red line is real GDP. The green line is how I calculate potential real GDP. You can see that potential real GDP has fallen below real GDP lately. Is it crazy to think that?
The white line is Effective demand. The yellow line is an exponential curve.
The growth of real GDP should have followed a normal exponential type curve. But from 1995 to 2008, the economy inflated way over the "natural" growth path. There were 12 years of a bubble economy. An economy based on false asset values and debt. The economy was not real, not natural. Excess Effective demand was being manufactured.
Then in 2008 the bubble burst in a big way and the economy came back to reality. The potential real GDP line came back to where it should have been all those years.
I look at 1995 to 2001 when the bubble grew. I see Effective demand growing to unusual heights above the exponential curve. Then the high Effective demand was maintained until 2008 by the housing bubble. The difference between the exponential curve and potential real GDP was the false economy. Then in the crisis Effective demand exploded upward as utilization rates of labor and capital fell.
Effective demand is more than how much money people have to spend. It is also a measure of profit potential. The income of people can support the dynamics of increasing production. Which means that profit rates have an upside. Businesses can grow to together and share profits. There is an overall incentive to produce more. However, when Effective demand starts to constrain output like it is currently, businesses have to compete more for profit share.
Effective demand was highly inflated throughout the bubble years. The era of "you can have it all" has come to an end. Now we see that Effective demand is coming back to reality too. Effective demand is settling the economy into a lower normal, which looks to be the true normal according to the graph above.
Was it inevitable for the natural rate of unemployment to rise? No... It only rose because labor share of income fell with the bursting of the bubble. If effective labor share was still around 78%, there would be plenty of Effective demand left over to allow unemployment to go down to 6%.
So we are back to reality with Effective demand and potential real GDP returning to the exponential curve. All we need to do now is raise effective labor share and the unemployed will get back to work.
Update: The equation for the exponential curve is...
f(x) = $3.9 trillion + 6.4 billion * x1.4 ... Points in curve are from left, x = 1, 2, 3, 4, etc.