Bob Murphy continues his thought experiment
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.
There are at least a few important things to note
1) There is a clear aggregate demand story here. When the oil as discovered there was a positive wealth shock. Indeed, it would be recorded as such in the Flow of Funds report. When the oil was found not to be there there would be a negative wealth shock.
These can and do happen and are recorded. Here for example, is Total Assets of Households and Nonprofits over the last two business cycles.
You can see the asset value run-up from both the dot-com and housing bubbles and the tiny fall from dot-com and serious collapse from housing bust. So from the point of view of explaining the series of events through traditional AD-AS lense there is no problem.
Interestingly if you extend out the circa 1995 slope you run right into where we are now. But, that’s a story for another day.
2) The other issue is that potential GDP and maximum possible GDP are not the same. The BEA attempts to estimate sustainable GDP and it is possible to exceed that. That is the output gap can be negative.
As you can see the BEA estimated the economy to be running well above sustainable levels in the late 1990s and only slightly above sustainable levels in the mid-2000s.
3) Now why only slightly above in the mid-2000s. Wasn’t the housing bubble huge? In prices yes. In output, no.
Here is construction spending as a fraction of GDP over the same period
This is a theme I talk about it a lot so I can go into it more but the boom in housing construction was not actually that big. It peaked around 2005. It was offset by a decline weakness in commercial construction. That picked up in 2005 but was in decline by 2007. And public construction ran low right up until 2007.
Combine that with the fact that construction is not that big a part of the economy to begin with and the bubble wasn’t really that big.
It looks big in part because prices were so distorting and because single family suburban construction really was moving like gangbusters. That’s where a lot of us live but its not where all Americans live and its not where most Americans work. Urban and rural construction was in the dumpster.
There is a strong argument that this was classic crowding-out though I am not totally convinced. In any case the boom was small and nothing compared to the bust.