January 26, 2016
I was struck to see a news article reporting the estimate from Ireland’s central bank that the economy grew by 6.6 percent in 2015. The article reported that the economy is projected to grow 4.8 percent in 2016 and 4.4 percent in 2017. This is good news for the Irish economy since the country still has a long way to go to recover from its recession.
However what is even more striking is that this growth hugely exceeds what folks like the I.M.F. said was possible in Ireland. If we go back to the I.M.F.’s projections from 2013, they thought the country was 1.6 percent below the country’s potential GDP in 2012. It projected the economy would shrink by 0.3 percent in 2013, leaving the 2.6 percent below its potential GDP. This implies a potential growth rate of 0.7 percent annually.
As it turns out, Ireland’s economy grew by 1.4 percent in 2013 and 5.2 percent in 2014. If we add in the 6.6 percent growth in 2015, Ireland’s economy would now be almost 10 percent above the potential GDP that the I.M.F. projected for 2016. That would be the equivalent of the U.S. economy being $1.7 trillion above its potential level of output in 2016. Furthermore, Ireland’s growth is projected to exceed the potential projected back in 2013 by close to 4.0 percentage points in each of the next two years.
Naturally, we would expect a level of GDP far above potential and a growth rate that is also well above potential growth to lead to soaring inflation. That must explain why Ireland’s inflation rate has been 0.1 percent over the last year. (I know, it’s accelerating, the inflation rate had been negative.)
The reason for this Guinness-free trip to Ireland is to make a point about the widely used measures of potential GDP. They are worthless. They are generated mechanically based on current levels of output and the rate of inflation. If the inflation rate is not falling rapidly then we are close to potential GDP, end of story.
In this case, the I.M.F. appears to have been off by more than 15 percentage points, if we take the current growth estimates and assume hyper-inflation does not break out in Ireland in 2017. This should be a lesson for folks in the United States and elsewhere who are being told that our economy is now at or near its potential level of output. If we accept this view and it is wrong, we are throwing an incredible amount of potential output in the toilet.
And just to be clear, this is not a question of loving growth as an end in itself. This is about millions more people getting jobs. It’s about people in bad jobs who have the opportunity to get good jobs, or at least to get paid better wages in their bad jobs as the labor market improves. And, it is about governments having the resources they need to provide decent education, health care, and drinking water to their people.
This is a huge, huge deal. If the estimates of potential GDP are worthless, then we have reason to believe that we can expand the economy way beyond its current level of output. That should be a license to run very large budget deficits, but given the power of the deficit cult in Washington, that may not be politically feasible at the moment. But at the very least, we should be telling the Fed not to needlessly throw people out of work by raising interest rates.