Many economists talk about a huge output gap and that we will return to the potential GDP trend from before the crisis. It is not a wise thought. A mystery needs to be revealed.
Potential GDP and real GDP were "out of phase" during the 1970's, then by 1990's they were "in phase". What does this mean?
This graph shows annual % growth for real GDP and potential GDP (center of business cycle). The red and blue lines are 2-year moving averages. Each point on a line represents the annual growth rate for the previous 2 years. The red and blue lines moved "out of phase" before the 1990's, and "in phase" since 1990. (quarterly data has been faded to show moving averages.)
Potential GDP represents the center of the business cycle. Real GDP rises and falls in relation to this center through business cycles. As everyone watches real GDP, it is also important to watch the center of the business cycle (red line). Why? Because real GDP oscillates around that center. If the center rises, real GDP will oscillate at a higher level of output. Likewise, if the center falls, real GDP oscillates at a lower level of output.
Before the 1980's, when real GDP growth (blue line) slowed down during a contraction, the average productive potential of the economy (red line) would grow faster. Thus contractions were a time when fundamental economic growth would increase. This allowed the economy to bounce back from recessions better. Since 1990, when real GDP slows down, average productive potential also slows down. Now the economy tends to recover slower.
The other side... Before the 1980's, when real GDP rose fast, the average potential of the economy would slow down. The effect would be a counter-balancing that maintained a more "stable" trajectory of economic growth. Since the 1990's, when real GDP grows faster, the average productive potential grows faster too. It's a pro-cyclical process. Now the effect leads to bubbles because there is no counter-balancing.
The idea is that real GDP growth feeds upon itself into increasing productive capacity of the economy. An atmosphere of bubbles appears. People think that growth creates growth and the cycle will continue up and up and up. So there is more pro-cyclical behavior at all levels. The tendency to fall into a bubble economy is much more likely.
In the graph above, you can see that in the 1990's, the economy maintained a higher high than had previously been "experienced". (subtle reference to Jimi Hendrix) But now we can see the economy hitting a lower low than has ever been seen for many decades. There is no mystery about this effect. There is a pro-cyclical bias to growth with the mentality of feeding off of the fury of increasing asset prices.
This graph shows the overall movement between real GDP and potential GDP. Real GDP (yellow line) and potential GDP (red line) twisted in a braided pattern before the 1980's. Then when the two went "in phase" after the 1991 recession, both lines "bubbled" up to a new height. They started to come down after the 2001 recession, but the housing bubble allowed the two lines to rise again "in phase". The crash came in 2008 when the real GDP and its average productive potential both fell "in phase". The higher high became a lower low.
When I hear economists talking about returning to the previous trend line of potential GDP saying that we still have a huge output gap, I have to roll my eyes. They don't realize that the trend line during the bubble years was due to real GDP increasing "in phase" with center potential. It is a false effect and one that can only be sustained by periodic crises for counter-balance. When two waves are in phase, the resultant amplitude is increased... in both directions, up and down. By wanting to return to the previous high, they insure another low like the one we have now.
The basic idea is that when they move in phase, the economy will experience higher highs and lower lows. The business cycle will have wider swings. This is not healthy. Personally, the economy works better in a democracy when the two are "out of phase".
Anyway, questions to ponder... How did this change take place? Will these two lines go back "out of phase" in the future?