Studying Growth in the Modern Classical Approach: Theoretical and Empirical Implications for the Analysis of Potential Output

Abstract

The main characteristics of the modern classical approach to growth are studied with particular reference to the notion of ‘potential output’. In contrast to mainstream approaches, which consider potential output to be exogenous and supply-determined, it is here regarded as endogenous and path-dependent. A tentative analysis is carried out of the implications of such a conception in empirical research, with special reference to the effects of the crisis on potential growth. Mainstream estimation methods (especially those used by international institutions) are shown to be deeply influenced by theory, but also to provide dubious and puzzling results. Very different empirical results and policy implications may be obtained from the standpoint of the alternative theoretical framework provided by the modern classical approach. On this basis, the paper proposes that the long-term policy target should be set in terms of the rate of unemployment rather than potential output or potential growth.

Keywords:

• Sraffian economics
• GDP time series
• Estimation models
• Economic growth
• Europe

JEL Codes:

• B51
• E17
• E66
• O40
• O52

Acknowledgements

Comments and criticisms by the editors of the symposium and an anonymous referee are gratefully acknowledged.

Disclosure statement

No potential conflict of interest was reported by the author.

Notes

¹The main argument had already been outlined in two previous works in Italian (Garegnani 1962, 1964–65).

²This conception of normal utilization is compatible with Kurz's (1986) definition of normal capacity utilization as the cost-minimizing technique, provided cost minimization contains a ‘strategic’ element having to do with the firms’ desire not to lose market share to their competitors.

³This is the basis for criticizing the Cambridge theory of distribution and the other ‘Keynesian’ approaches that postulate rigidity of long-run output with respect to changes in demand. See Vianello (1985), Ciccone (1986), Garegnani (1992) and Park (1997).

⁴Some neo-Kaleckian growth models maintain that the possibility of variation of utilization destroys the trade-off. See, for example, Rowthorn (1981) and Amadeo (1986) and the critiques of these models by Committeri (1986), Ciccone (1987), Vianello (1989), Park (1995), Trezzini (2011) and Cesaratto (2012).

⁵Although not explicitly referring to supermultiplier models, Eatwell (2012) shares the idea that the ‘normal’ output that characterizes normal long-period positions entails not only adjustment of output to demand, but also full adjustment of capacity.

⁶See Sraffa (1960, p. 78). As noted above, dominant techniques prevail in the flow of gross investment but not necessarily in the whole stock of capital. Similarly to what is maintained here, Parrinello (2014) suggests that existing fixed capital be treated as a means of production of different quality relative to the machines installed through the flow of gross investment.

⁷Relevant to this point is Kaldor's description of the process of ‘circular and cumulative causation’ in which higher exports lead to higher manufacturing output, which via increasing returns leads to lower costs, which in turn further stimulate exports (see Kaldor 1981).

⁸Such ‘supply-side policies’ have, of course, nothing whatsoever to do with the conventional insistence on the need for deregulation and flexibilization of the labour market, but are rather to be interpreted as industrial policies.

⁹This section draws in part upon Palumbo (2013).

¹⁰The analytical bases for identifying the non-inflationary rate of unemployment as the equilibrium one are to be found, even before Friedman's critique and reinterpretation of the Phillips curve, in Lipsey's (1960) attempt at explaining Phillips's relation in terms of disequilibria in the labour market. The matter is explored in Palumbo (2010).

¹¹Some NAIRU models postulate a role for demand policies in influencing the equilibrium rate of unemployment by taking account of hysteresis effects; see below.

¹²Applied literature frequently relies on the New Keynesian Dynamic Stochastic General Equilibrium (NK-DSGE) models, which combine New Classical and New Keynesian characteristics. These models follow Real Business Cycle theory in adopting an intertemporal general equilibrium framework in a stochastic environment to model the macroeconomy. But they modify the strong conclusion of RBC models as regards continuous equilibrium by assuming nominal or real rigidities and market inefficiencies, which result in transitory non-optimal fluctuations.

¹³The ‘cyclically adjusted budget balance’ corresponds to potential output, while the ‘structural budget balance’ is the former corrected for one-off measures.

¹⁴The long-run Phillips curve is assumed to be vertical, while a short-period relationship is postulated to exist between output gaps and inflation changes.

¹⁵With the widely used Hodrick and Prescott (1997) filter, for example, the estimated trend strictly depends on the arbitrary value assigned to the weighing parameter, which determines both its variability over time and its greater or lesser adherence to the series of actual output (Billmeier 2009, p. 404).

¹⁶Solow (2000), for example, points out that the increase in average unemployment in the 1990s in most European countries seems to have been accompanied by an increase rather than a decrease in labour flexibility due to policy measures. Such difficulties in identifying an empirical counterpart to the theoretical concept of NAIRU have induced some authors to introduce into their models the notion of hysteresis, according to which the actual rate of unemployment influences the equilibrium unemployment rate; hysteresis will be discussed below.

¹⁷The approach assumes that potential capital coincides with the actual capital input; potential labour is obtained from the filtered series of the actual labour force corrected with the NAIRU; potential total factor productivity is obtained by applying a statistical filter to the TFP series calculated as the residual of the regression of actual output on actual inputs. In other words, a fictitious productivity factor, the TFP, is defined, which in fact expresses the unexplained residual of actual output growth that cannot be accounted for by actual capital and employment growth, and then capital, trend employment and trend TFP are used to derive potential output.

¹⁸The OECD provides estimates of the NAIRU, while the European Commission currently estimates the NAWRU (Non-Accelerating Wage Rate of Unemployment). The difference between the two concepts can be ignored here, since they both purport to identify the supposedly unique equilibrium rate of unemployment compatible with constant inflation and constant wage growth.

¹⁹See the Ameco dataset of the European Commission at http://ec.europa.eu/economy_finance/ameco/. In both countries the estimated figures for 2014 are above 20 per cent.

²⁰The Beveridge curve describes a relation between job vacancies and unemployment, with outward shifts implying structural deterioration. Other indicators include indexes of mismatch by skill, industry, and region, and estimated matching efficiency; see European Commission (2013, pp. 64–83) for details.

²¹The only exception, according to Lazear and Spletzer (2012, p. 33), is the ratio of long-term unemployed to total unemployed, which is higher than it was in all prior recessions. The authors, however, do not consider this to be a symptom of structural change, but rather of the depth of the current recession.

²²For Italy, the Centro Studi Confindustria (2013, pp. 20–21) provides index numbers of potential output for the various manufacturing sectors. The sectoral differences in the evolution of potential output over time are striking: the estimated cumulated loss of potential output between 2007 and 2013 was 15 per cent for the whole manufacturing sector, with a 4 per cent decline for the food industry and a 41 per cent loss for the automotive sector.

²³In a survey of Italian manufacturing sector, ISTAT (2014, p. 52) finds that the overwhelming majority of firms would have no difficulties in meeting a sudden significant increase in demand, through more intense utilization of capacity.