Karl Smith graciously gave an answer to my earlier request, asking for clarification of how government economists would handle a scenario in which “real GDP” had shot up 10% because of massive investment in oil drilling infrastructure. Specifically, when people discover next year that there’s no oil there after all, then obviously (other things equal) real GDP falls back to its previous level or even a bit lower.
So my question was, would the people working in the BEA or CBO or whatever, revise that earlier figure? Would they say, “Even though the companies spent $150 billion on all these newly produced drilling equipment, paving the roads, etc. etc., they spent that money erroneously. Had they known the real situation, they would not have spent that money.” ?
Karl doesn’t think they would do that (and neither do I). Here’s Karl:
The short answer is no. Real output in the year in question was 1.1 Trillion. Gross Domestic Product is our attempt to measure real output and it would reflect that.
I think there are a few important concepts related to Bob’s question. One is Net Domestic Product, which according to Bob’s description did not rise as fast as Gross Domestic Product and could possibly have fallen.
Net domestic production is Gross Domestic Production minus the Consumption of Fixed Capital.
Now in fairness to Bob’s point the consumption of fixed capital is measured using the perpetual inventory method. Key in this calculation is economic service life, which must be imputed based on historical measures. Yet, Bob is postulating a strong shift in economic service life.
This would not be picked up immediately in Net Domestic Product calculations but would be picked up as the series was revised over time.
Essentially the BEA must wait until the capital has actually worn out early before going back and saying that it was wearing out at a faster than average rate.
However, the oil in the ground in would not factor into any of these statistics at all.
This is GDP and its cousins are attempting to measure productive output and income. The oil was not produced by human beings. Instead it is a measure of wealth. It would be captured in the Federal Reserve’s Flow of Funds report. [Bold added.–RPM]
I am fine with everything Karl says in the above, meaning that I agree with him on how the BEA deploys standard national income accounting. However, especially with his offhand remark about the capital becoming “worn out,” I’m not sure Karl is really seeing where I’m going with this.
In this hypothetical scenario, potential GDP would have gone up 10% in one year. Then real GDP would have crashed 10% (or so) the next year. So if the CBO looked at output in the year that the drills etc. were being produced, they would have plotted a dotted line from that point to the right, and then wondered what the heck happened to Aggregate Demand in the subsequent year to make real GDP crash. After all, the economy would have had the same number of workers and machines.
In this scenario, there’s no “technology shock” or “resource shock” or anything like that. What happened is that people falsely valued goods produced in the boom year. The economy actually wasn’t capable of producing $1.1 trillion of real GDP that year. Yes, businessmen paid $150 billion for the infrastructure to be created and installed, and yes consumer prices in the economy didn’t shoot up to offset the rise in nominal GDP. But those businessmen paid too much for the equipment.
This is a crucial point. When Paul Krugman dealt with the claim that the US economy was in a bubble during the housing boom, and therefore we shouldn’t take output from those years as being the economy’s potential, he said:
Just a brief note: one thing that keeps appearing in comments is the notion that because we had a bubble, in which some people were borrowing too much, the economic growth of 2000-2007 wasn’t “real” — that it was all a figment of our imagination.
This is confusing demand with supply.
We really did produce all the goods and services counted in GDP; we were able to do that because we had willing workers, a sufficient capital stock, the right technology, and so on.
What is true is that some of the spending that created demand for those goods and services was debt-financed, and those debtors can’t continue to spend the way they did. But that doesn’t say that the capacity has somehow ceased to exist; it only says that if we want to keep the capacity in use, someone else has to spend instead. In other words, past growth wasn’t an illusion, or a fraud; but we need policies to sustain aggregate demand.
No no no, this won’t do. I can’t speak for all of the commenters of course, but some of them are probably thinking the way I am on this. We’re not conceding that the high “real GDP” figures from 2005 and 2006 were legitimate. They were partly fueled by people making purchases based on erroneous expectations of the value of the goods they were buying.
If my oil example isn’t doing it for you, try this: First, suppose that a great new musician comes along. He plays to sold-out crowds, and people think he’s amazing. He actually earns $1 billion touring the country in a single year; that’s just how awesome and entertaining he is.
Now, did he “really” add anything to the economy? I mean, he’s going around, buying cars and food and houses–tangible things–and yet the economy can’t physically produce more of that stuff. So surely he hasn’t increased real GDP…?
Yet that’s not right at all. The musician clearly did create a flow of new services. People enjoyed his performances, and they voluntarily paid the extraordinary ticket prices to see him. For the purposes of calculating real GDP, the musician “created” $1 billion worth of entertainment, just as surely as a farmer created food with a market value.
OK now change the scenario. Instead of people paying to see a musician, instead they believe that there is a fortune teller who’s always right. He tours the country, and ends up earning $1 billion for giving his services.
Next year, his predictions all turn out wrong. Nobody buys his services anymore.
Now we can quibble about whether that original $1 billion was “really” part of output or not, before everyone realized the guy was a fraud. I could go either way on that count.
What I want to focus on, is that if you do count it as part of real GDP, then when real GDP falls by $1 billion the next year, you can’t say, “Holy cow, what happened to Aggregate Demand! Why is there now this huge gap between actual and potential GDP? Don’t tell me output last year was illusory. People really did buy valuable goods and services last year.”
I hope I’ve made my point. My concern is that when the CBO gives us those nice pretty charts of potential GDP–which is a dotted line going up and to the right from the peak of calculated “real output” at the height of the boom–and then Krugman et al. complain about how much in forfeited output we are now suffering, that they are ignoring the possibility that official real output in 2006 or 2007 was indeed unsustainable. It was based on erroneous expectations. So we can either mark down that output, or we can say that potential GDP dropped sharply once reality set in, or we can go through and try to figure out how much of 2006-2007 “real output” was based on an illusion. But we can’t methodologically just rule it out from the get-go, the way Krugman does above.