In Potential Mistakes (Wonkish), Paul Krugman wrote “It is important to have an idea of how much the economy could and should be producing, and also of how low unemployment could and should go.

Much of the rest of the post is indeed “wonkish”, complete with charts.

Taking “wonkishness” at least an order of magnitude higher, Edward Lambert writing for the Effective Demand blog actually attempts to determine True Potential Real GDP by looking at previous recessions.

Here is chart number 6 in an 8 chart series.

I am not going to bother explaining the chart, nor do I think anyone should spend any time studying it. Rather, let’s discuss Lambert’s two-paragraph conclusion.

The global economy has been made unstable by low interest rates. I have my doubts that the economy can push against the effective demand limit like it did from 2006 through 2007. The Fed raised rates during that time to control a bit of inflation. Yet, this time around, if the Fed tries to regulate the economy in any way, the global reaction will be tremendous.

Like Paul Krugman says, it is important to know what the economy is really capable of producing in order to set appropriate fiscal and monetary policy. And if my analysis above is correct, monetary policy is based on a false notion of potential real GDP. This is too dangerous to get wrong. The global economy is hanging in the balance.

emphasis mine

Measuring Real Potential GDP

I have no issues with the first paragraph above. The Fed (central banks in general) certainly have made the global economy unstable in recent years, blowing repetitive bubbles of increasing magnitude.

However, I strongly disagree with Krugman and Lambert regarding the importance of figuring out real potential GDP.

For starters, GDP is a blatantly distorted number.

By definition, government spending adds to GDP, no matter how useless the spending. If the government paid people to spit at the moon it would add to GDP. Paying people to dig holes and others to fill them (as many Keynesian economists have proposed) is equally ridiculous. As a more practical example, GDP would rise by the same amount if government spent $100,000 or $20 billion to build a bridge.

To compute “real GDP” one needs to take “nominal GDP” then factor in a measure of inflation. However, there is no accurate way to measure inflation. Sure, one could use the CPI, but the CPI does not contain a measure of housing prices or any other asset bubbles. And look at the mess the Fed made by ignoring housing prices between 2003 and 2005.

I have written about housing and the CPI numerous times. Here are my latest two posts.

The first problem with measuring price inflation is there is no true representative basket of goods and services. Even if there was a representative basket, the basket changes over time and also changes by demographics.

The second problem is price inflation is often a lagging effect of prior monetary inflation.

The third problem is all widely used measures of inflation ignore asset bubbles.

More Moving Targets

Lambert takes a look at prior recessions to determine “potential”. But what if potential changes over time due to demographics and other factors?

Economist Point of View

It’s important to predict the “potential” of a moving target, of a very distorted number. To make the number “real” it must be adjusted for inflation even though inflation cannot accurately be measured and asset bubbles are ignored. 

Finally, there is an implied assumption that politicians and the central banks will do something intelligent with the number once they have it.

Mish Point of View

Even if there is a “potential Real GDP”, it is a moving target that cannot be measured in any reasonable time. Constant GDP revisions and asset bubble implosions are proof enough.

If by some miracle, economists did stumble on the correct number, the odds of Congressional bodies and central banks doing something intelligent with the number is zero. And we’ve certainly proven that over and over again haven’t we?

Choice #1: Let a group of central planners divine the future in a field of moving targets and things that cannot be measured at all, complete with constant revisions to input data, with the expectation the Fed and legislative bodies will do something sensible with the centrally planned number once they have it.

Choice #2: Let the free market adjust itself.

Uncertainty Principle

For further discussion, here’s a recap of the Fed Uncertainty Principle written April 3, 2008 before the Bernanke Fed started slashing rates in the Global Financial Crisis.

Fed Uncertainty Principle:The fed, by its very existence, has completely distorted the market via self reinforcing observer/participant feedback loops. Thus, it is fatally flawed logic to suggest the Fed is simply following the market, therefore the market is to blame for the Fed’s actions. There would not be a Fed in a free market, and by implication there would not be observer/participant feedback loops either.

Corollary Number One:
The Fed has no idea where interest rates should be. Only a free market does. The Fed will be disingenuous about what it knows (nothing of use) and doesn’t know (much more than it wants to admit), particularly in times of economic stress.

Corollary Number Two: The government/quasi-government body most responsible for creating this mess (the Fed), will attempt a big power grab, purportedly to fix whatever problems it creates. The bigger the mess it creates, the more power it will attempt to grab. Over time this leads to dangerously concentrated power into the hands of those who have already proven they do not know what they are doing.

Corollary Number Three:
Don’t expect the Fed to learn from past mistakes. Instead, expect the Fed to repeat them with bigger and bigger doses of exactly what created the initial problem.

Corollary Number Four:
The Fed simply does not care whether its actions are illegal or not. The Fed is operating under the principle that it’s easier to get forgiveness than permission. And forgiveness is just another means to the desired power grab it is seeking.

Rather than wasting time and energy in foolish attempts to divine what is impossible to accurately predict, I propose getting rid of the Fed and all the wonkish analysis, then stepping back, doing nothing, and let the free market economy work as it should.

Mike “Mish” Shedlock