One of the few ideas that has a broad consensus among economists is that macroeconomic stabilization policy should be conducted counter-cyclically, that is, in the opposite direction to the evolution of the economy.

 

If the economy is growing and shows signs of "good health", then macroeconomic policy (fiscal policy and monetary policy) should be restrictive. If the economy is struggling, then macroeconomic policy should stimulate growth by taking an expansionary stance.
There are two reasons for this counter-cyclical stance. The first is to try to make the inevitable cycles of industrialized economies (or developed, if you prefer) smoother, seeking to ensure stable and sustained growth. The second, which influences fiscal policy more directly, is to gain fiscal space in the good times that can be used when the cycle becomes unfavorable; basically the simple idea that we should have some reserve for rainy days.

 

This idea of always navigating against the wind becomes more consensual as a reaction to a way of making economic policy, common in the 1960s and 1970s, in which responses were marked by rapid changes in policy orientation and stance. To a negative reversal in the growth cycle was given a prompt and decisive response with all available instruments in particular by growing employment (through, essentially, fiscal policy); when growth showed perverse signs, particularly with high inflation, a restrictive policy was applied to control price growth. This Managed Economy drove economies like a drunk driver at high speed, making sharp turns and braking and very poorly controlled accelerations.

 

But if economists (at least those who accept market democracies as the best way to manage society) may agree on the general principle, the way it applies is subject of controversy and permanent discussion.

 

The controversy results from the fact that positioning in the cycle should not only be measured in terms of positive or negative variation of the product. Being true that it has been settled that the recession statement happens when there is a negative chain change in GDP in two consecutive quarters (the value of GDP in the quarter compared to GDP for the previous quarter), the normal state of an economy is not grow at a zero rate, remaining at the same level indefinitely.

 

It also seems generally accepted that economies grow on average at a rate determined by their potential, resulting from their capital stock (physical resources and equipment at the service of companies), of available workers (either in number or in skills and capabilities) and how such capital and these workers are used in a combined manner. The last variable of the equation, generally known as Total Factor Productivity (TFP), ends up capturing a part of this variability and is often seen as the measure of  economists' ignorance regarding the functioning of the economy. Being fair, it reflects economists' inability to properly measure in real time what is happening in the structure of the economy.

 

The result of the application of the equation that we have simply described is called potential product, that is, the pace at which economy should grow in the absence of cycles.

 

A similar reasoning can be applied to the assessment of the situation in the labor market. The "good" unemployment rate is not necessarily zero, being even admitted that there is a "natural" unemployment rate, higher than zero, and that is by comparison with this rate that one should appreciate the "health" of the labor market.

 

Macroeconomic stabilization policies would thus be guided by what is called output gap (distance from the GDP to its potential), by inflation (reflecting the instantaneous "temperature" of the economy) and by the deviation of the unemployment rate from its "natural" rate. That is, "sailing against the wind" ensures that the deviation of GDP growth from its natural (or potential) growth rate is not excessive (and here begins the debate on structural reforms that we will talk about at another time, as a way to increase that rate).

 

Unlike GDP, in which there are conventional and accepted forms of measurement by statistical authorities, the potential output can be estimated in several ways: from the application of statistical filters (simple or complex) to more sophisticated forms using econometric methods, of which the production function we describe is an example.

 

Because there is no conventional, generally accepted, way of measuring potential GDP this opens up ground for a relevant discussion, that can be sterilized with some ease, about how it is measured. The issue gains a particularly relevant dimension when the output gap is part of fiscal rules as is the case in the Euro Area (another subject that will surely come to this blog).

 

The essential issue that remains open is the great susceptibility of output gap estimates to revisions, often of significant magnitude. The techniques (statistics or econometric) available are very sensitive to the final values of the series used and this causes changes in variable statistics to lead to materially relevant changes in the estimates and projections of the gap. Moreover, the so-called variables observed are only so by convention: real GDP does not exist in nature, it corresponds to a theoretical framework that reacts slowly to changes in reality. The series of so-called variables observed are also regularly reviewed, by alteration of the convention or by correction of initial measurement errors.

 

If there are errors in estimates (observed or not), errors may occur in the formulation of stabilization policies: the consideration of a positive gap situation when the opposite is already happening, imposing a more restrictive policy when some accommodation was required (equivalent to convicting an innocent person); a negative gap, recommending a more accommodative policy, when the opposite was desirable (equivalent to freeing a culprit). Clearly, the most serious error is what happens when an economy that is, in fact, in difficulty is further constrained. An innocent is condemned!

 

However, there is broad consensus on the need to conduct stabilization policies using the measurement of cyclical position, even if the disagreement over the instruments for doing so is great.

 

To sail against the wind requires a special type of nautical equipment (triangular sails) and it took centuries before it was possible for the Portuguese to use the millennial techniques to transoceanic navigation. Surely the fruitful discussions about the techniques of measuring the growth potential of an economy will take effect and the recommendations based on them will improve on quality. Abandoning an instrument because it is not yet perfect can be a mistake with high costs.

 

Economy is changing rapidly and GDP and inflation (as we measure them now) are increasingly concepts that seem to have a greater divergence to a reality in which production and consumption are more and more distant from what was normal in the industrialized economies of the 20th century.

 

This is the drama of the social sciences (and to a large extent moral prescribers): in the natural sciences a mistake in theory does not alter the functioning of nature; in the social sciences a mistake in theory alters the functioning of society because at least it conditions the behavior of the human beings that constitute it.

 

The forecast of a particular economic fact is already an economic fact itself.