News Flash: The CBO Isn't Stupid: It’s actually much worse than even Brad seems to realize. The potential output series he’s using comes from the Congressional Budget Office, which describes its method….
CBO’s estimate of potential output is based on the framework of a textbook model of long-term economic growth, the Solow growth model. The model attributes the growth of real GDP to the growth of labor (hours worked), capital (an index of capital services emanating from the stock of productive assets), and technological progress (total factor productivity). CBO estimates trends —that is, removes the cyclical changes—in the labor and productivity components by using a variant of a relationship known as Okun’s law. (In principle, other “detrending” methods could be used to extract the trends in those inputs.)
So the CBO already takes into account the effect of a smaller capital stock on potential output. That’s part of the reason CBO’s projections of future potential have in fact been marked down since the crisis began.
ME STUPID TODAY. NEED COFFEE!!