Actual GDP, potential GDP and Keynesian ( or Keynesian-looking ) measures

Each economic crisis has its own characteristic features. When there is a major market correction or major market failure ( in this article, by market failure we will mean a situation where a market does not clear over an unusually large time compared to the recent historical norm in that market ), there is a possibility of spillover effects, both dynamical and psychological. The dynamical spillover effects are due to economic linkages between businesses and between sectors. They are largely unavoidable once there has been a contraction in some sector. The psychological spillover effects can be due to consumer sentiment or investment sentiment being depressed more than is warranted by the economic situation. To take an extreme example, bank failures in some banks may precipitate bank runs in many banks if paranoia takes a hold of the public, even though these bank runs do not constitute " rational behavior ". Another example is hoarding of cash by businesses because they have a sense that demand for their products will not pick up any time soon, even though there is nothing in the economic data to suggest this directly ( a case of businesses acting in a very risk-averse manner because they feel they don't have enough information to predict future demand accurately enough or to feel confident about future demand ).

It is a useful exercise to distinguish carefully between the spillover effects of a major market correction or a major market failure on banks and financial institutions on the one hand and on other businesses on the other hand. After all, banks and financial institutions play a major role ( and a different kind of role compared to other businesses ) in determining how the savings of a society are allocated and the kind of investments that take place. Sometimes, the bailing out of financial institutions and banks becomes necessary despite all the negative aspects like moral hazard associated with bailouts. If banks have a sudden cash flow problem, helping them out through monetary or fiscal measures may be the right thing to do. Otherwise, the credit flow in the economy may be squeezed far more than is justified by the original market correction or market failure that triggered the economic contraction. This is a case where the judicious use of monetary or fiscal measures can prevent the GDP from falling more than it needs to.

Psychological spillover effects can lead to a contraction of GDP beyond the necessary amount following a large market correction or market failure. Keynesian monetary or fiscal measures can help counter the psychological spillover effects. Dynamical spillover effects, on the other hand, can lead to a contraction, not just of actual GDP, but also of potential GDP ( for example, a significant amount of capital in a certain business or a certain sector of the economy may need to just wait for a long time for a market failure to be resolved or it may need modification before being re-used ). The latter ( dynamic spillover ) consists of cases where necessary dynamical corrections are experienced by the economy even after the most aggressive Keynesian measures.

by C. Jayant Praharaj ( send comments to cjpraharaj.blog@gmail.com )

What is the potential GDP of a quasi-capitalist economy during a deep and prolonged recession ?

How accurate are the potential GDP numbers ( or the differences between GDP and potential GDP ) being cited for prolonged and deep recessions in certain economies ? We are talking about economies with combinations of large private sectors and government welfare systems. The overall economic contraction is marked by businesses that have to lay people off or shut down due to declining profits. Is it possible that the potential GDP numbers being cited consist of overestimations because of, say, huge over-investment in particular sectors ( investment that wrongly anticipated demand levels by very large amounts ). This is one example where the potential GDP concept becomes murky. Have the corrections due to the capital associated with this over-investment been taken into account while calculating potential GDPs ? In other words, capital associated with unprofitable businesses can become a significant percentage of total capital during deep and prolonged recessions. This needs to be taken into account while calculating potential GDPs in quasi-capitalist economies. Since it is not easy to make unprofitable businesses profitable instantly in quasi-capitalist economies, the GDP at any time during a deep and prolonged recession is probably very close to the possible GDP at that time. Growth of GDP and potential GDP then becomes strongly dependent on the creation of new capital that is associated with profitable and sustainable businesses. Capital associated with unprofitable businesses may need to be modified or augmented or allowed to perish. Or one may have to wait for a long time before this capital becomes usable again. And the nominal value of capital associated with unprofitable businesses may have to be allowed to decrease significantly till it is priced correctly according to the pricing mechanisms available in quasi-capitalist economies. Large-scale market failures of the type we saw recently in the US and in Europe in the real estate sector can indicate a need for drastic decrease in the nominal value of existing capital in that sector and possibly in other sectors. That this revaluation takes very long and that the market takes many years to reach the right price levels and the right modification of capital or augmentation of capital or perishing of capital in that sector and in sectors where its spillover effects are felt means that it may be difficult to calculate what the actual potential GDP is in nominal terms. In real terms, capital that is expected to be idle for a long time ( no prospect of speedy re-use ) needs to be excluded from useful measures of potential GDP. Capital that needs costly modification before re-use needs to have the right value attached to it for potential GDP calculations. This may mean that for certain deep and long recessions, the GDP at any time may not be that far from actual potential GDP at that time ( where the effect of idle capital has not been overestimated ).

by C. Jayant Praharaj ( send comments to cjpraharaj.blog@gmail.com )