In the real world, these factors of production are utilised and combined to generate economic activity, and then policymakers decide how the fruits of economic growth are utilised and divided up among members of society.
An economy is said to be operating at its maximum potential, or achieving ‘potential output’, when all of the factors are fully utilised. When an economy is said to be operating above potential — when the factors of production are being stretched beyond their capability — an economy tends to generate intense inflationary pressures and overheat.
We all found out about the consequences of this here in Ireland after the pot boiled over in devastating fashion from 2008 onwards.
When an economy operates below potential, it is basically failing to realise its capabilities and we end up with unemployment and lots of spare capacity among the other factors of production. Neither is ideal.
For policymakers, the prudent or correct way to manage the economy is to keep growth as close to potential as possible. When an economy is growing above potential, policymakers should act in a counter- cyclical way and reduce economic activity through a combination of tax increases and/or cuts in government expenditure.
When an economy is growing below potential, policymakers should cut taxes and/or increase public expenditure. The absolute wrong thing to do is increase expenditure and/or cut taxes when an economy is growing strongly, or to increase taxes and/or cut expenditure when an economy is struggling.
Here in Ireland, we pursued such pro-cyclical policies during the boom years. By cutting taxes and increasing expenditure, our policymakers made the boom boomier. During the economic collapse, taxes were increased and expenditure cut, which had the effect of making the bust bustier.
And while the concept of managing the growth cycle around its potential growth level is important, it is also important to recognise that an economy’s potential growth is not fixed. It can be damaged by policies that undermine the quality or quantity of the factors of production, or it can be boosted by policies that enhance the quality or quantity of the factors of production.
Investment in education, encouraging inward migration, spending on infrastructure, and using tax policies to promote investment and entrepreneurship are examples of policies that can improve the quality and quantity of the factors of production and lift an economy’s growth potential.
Boosting an economy’s growth potential is important because increased growth will generate resources to engage in social and economic policies that can boost economic welfare and improve the quality of life for many.
I can never decide if politicians either fail to understand the concept of potential growth or refuse to understand it, due to the fact that investment in things that raise growth potential very often have a long-term, rather than a short-term, impact. Unfortunately for most politicians, the long term does not extend beyond the next election.
In a week when the Government laid out its policy platform, one can justifiably have concerns about the fact that many of the policy proposals are all geared at the election that must be held within the next year.
Indeed, if one peruses the economic and social policy platforms of the parties in opposition, one could certainly have the same reservations. That, unfortunately, is the nature of politics. That is why it is important and good that there is some external surveillance and fiscal rules emanating from the EU that impose some control over the behaviour of our elected policymakers, who can never help themselves.
For those interested in the long-term future of Ireland, we should stand up against populist policies.
A look at the events of 1977 should provide sufficient evidence of just how dangerous politicians bearing gifts actually are.