Opinion: Fears of Running the Economy Too Hot Ignore Race

President Joe Biden recently unveiled his $2.25 trillion American Jobs Plan that proposes investments in transportation, manufacturing, caregiving, and research and development, as well as universal access to safe drinking water and high-speed Internet. The policy wonks are scrambling to evaluate its economic effects, as well as the proposed increases in corporate tax rates to pay for it. Many are sounding the alarm about pushing gross domestic product past “potential output,” and that’s before Biden’s American Family Plan, the details of which are expected later this month.

After spending almost $6 trillion to fight the pandemic and bolster the economy, inflation hawks see anything that spurs a spike in demand as an existential risk. But be wary of arguments that wield “potential output” as a club. Its framework is discredited, and it is time for new tools and new thinking.

What is “potential output,” and why is it central to the debate over fiscal policy? Simply put, it is an estimate of how much gross domestic product the U.S. can produce given how much people want to work, the capital that businesses have and how effective these inputs are at making stuff, namely, productivity. The conventional thinking is that producing more than potential will “overheat” the economy, leading to much higher inflation.

The bottom-up approach for estimating potential output dates to the 1960s and, despite methodological refinements over time, has serious flaws. In times of great economic change, official estimates from the Congressional Budget Office can be subject to massive revisions. As I wrote in a policy brief recently, if the economy’s potential had grown as CBO expected in 2005, it would be higher by $4 trillion now, or about 20% of GDP.

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