Paul Krugman is beginning to wax Smithian. Via Mark Thoma

How goes the state of the union? Well, the state of the economy remains terrible. … But there are reasons to think that we’re finally on the (slow) road to better times. And we wouldn’t be on that road if Mr. Obama had given in to Republican demands that he slash spending, or the Federal Reserve had given in to Republican demands that it tighten money.

Why am I letting a bit of optimism break through the clouds? Recent economic data have been a bit better… More important, there’s evidence that the two great problems at the root of our slump — the housing bust and excessive private debt — are finally easing. …

A couple of things.

This would actually be a great issue over which to flush out the relevant narrative. Paul sees housing prices and private debt overhang as the driving concern.

I tend to think that housing prices per se, don’t matter, land prices do and that the private debt overhang is not necessarily a big deal.

If we lived in a world without capital it would be. The only way to get the economy going again would be for natural borrowers to be able to meet the savings demand of natural savers. That can only happen if the debt overhang is reduced.

However, in a world with capital this need not be the case. Natural savers can switch from funding the consumption of natural borrowers to funding the capital investment. In an environment of stable land prices and rising population this is almost a no brainer because structures last a really long time relative to recessions and increasing population means that eventually they will be needed.

If the carrying costs are zero or negative then building is no brainer. The problem is that buildings are attached to land and when land declines in value it upsets the collateral backing a potential loan. This effectively increases the risk premium and means that real interests rates have to be very low or even negative to fund construction.

In any case, what I wanted to touch on here was how fast the recovery can proceed. Most people are still saying years to full employment and that would be my guess, but it is worth noting that the speed limit on the economy is extremely high. Here for example is the closing of the output gap post 1983

FRED Graph

From 7 percent to 1 percent in a little over a calendar year.

Now lets look at the output gap as it stands today

FRED Graph

So following a similar path we could close the output gap almost completely by the end of this year.

Will that happen. Given the stance of the Federal Reserve so far, I doubt it. However, its important to note that this is a choice. The Fed is deciding that the costs to closing the gap by Q1 2013 outweigh the benefits.

It is clearly and fully within their power to do so and they have done so before.

I’ll follow up on a couple posts on why this is utterly realistic on the ground. As a preview, we have the office space, we have the factory capacity, we have the roadway capacity, we have the electrical power generation in place. We have the storefronts. We have the cranes. We have the bulldozers All the things we need for GDP to increase GDP by 10% over the next year are in existence.

And, – and this is important – we have actual physical counts of these things. We need not speculate. We know how bulldozers there are in America. We know how many square feet of office space are for lease.

The pretense of knowledge is a lot less pretense-full when you have a 1 Terabyte portable Hard Drive and GIS mapping software.

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