The potential rate of growth: two definitions.

The Economist (a British weekly) in its September 6 issue, p. 67, dances to the tune of the neoliberal piper as it, when defining potential growth’ implicitly uses neoclassical models which by assumption exclude the possibility of involuntary unemployment. Potential growth is supposed to be: ‘the speed at which the economy can expand while keeping inflation in check’. Wrong.

Following the lead of Harrod, 1939 and Domar, 1946 and defying Solow (who, to get rid of the expenditure flow consistentcy of the Harrod and Domar models, ruled out unemployment in his famous 1956 article about growth, in retrospect a textbook case of scientific retrogression!) we have to define ‘potential growth’ as ‘the speed at which the economy can and has to expand while keeping unemployment low’.  See about this also this recent article by Fazarri et al and this Slack wire blogpost about the article. Empirically, the German, Spanish, Irish and Greek experiences seem to be described much better by the Harrod/Domar ideas than by the Solow model, Germany since 1991 being affected by Domar style endemic deflationary forces.

In a practical sense the definition of The Economist, which does not take structural unemployment into account, would restrict potential Spanish and Greek growth to 3% a year, the Harrod and Domar insights however show that both countries can grow much, much faster for quite some time as unemployment is sky-high.

Of course, potential growth is not necessarily the same thing as sustainable growth. Which makes things complicated. But inflation is no serious restriction, at least not for Greece and Spain. One overlooked aspect of the Spanish bubble before 2008 is by the way that wage increases were relatively restricted (really, check the data, and unit labour cost increases in manufacturing were restricted, too) as these were mitigated by large increases in immigration as well as a fast increase in the participation rate of women.