Sunday, April 03, 2011
How much should we mind the output gap?
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

The amount of slack in the economy, the output gap, matters hugely. It matters for fiscal policy, and the government’s efforts to reduce the budget deficit.

If the economy is operating well below capacity it is fair to assume that the budget deficit we have now, projected by the Office for Budget Responsibility to be £122 billion or 7.9% of gross domestic product for the coming 2011-12 fiscal year, is significantly influenced by the economic cycle.

Take away these cyclical effects and the deficit is still there, at just over 5% of GDP, but looks more manageable. The difference between the two numbers reflects the OBR’s estimate of the output gap.

If the official forecaster thought there was no spare capacity, the spending cuts and tax hikes George Osborne would need to meet its aim of eliminating the deficit would be that much larger. Fiscal policy is couched in terms of the “structural”, or cyclically-adjusted deficit.

This is not always well understood. Thanks to my new status as a tweeter (dsmitheconomics), I am privy to some interesting exchanges. One, last Thursday, was between Peter Hain, the shadow Welsh secretary, and Evan Davis, the BBC Today programme presenter.

After Davis interviewed Ed Miliband, Hain said he was too hard on the Labour leader and “a growth denier”. Davis and the rest of the media refused to accept that more growth would mean less need for spending cuts and tax hikes, Hain said.

You would expect me to come to Davis’s defence. He is, after all, a former member of the economics editors’ club. But I would anyway. Hain’s attack shows a common misunderstanding. If you have a structural budget deficit - one that exists even if you adjust for the economic cycle - a burst of more rapid growth does not make it go away. The only growth that matters is the long-term or trend rate of growth.

That, as discussed in my comments on the budget, takes years to shift. Cutting the deficit more slowly does not raise it. We could do with higher trend growth; the OBR estimates it to be 2.35% up to the end of 2013 and just 2.1% thereafter.

George Osborne has come up with a few ideas about lifting it, though they need fleshing out, while Labour has yet to venture into this territory. Trend growth and the output gap together give us what matters, which is the size of the structural deficit.

This does not just matter for fiscal policy. When it comes to monetary policy, the most powerful argument at the Bank of England for not responding to the surge in inflation to 4.4% is the expectation it will drop because of the amount of slack in the economy. Having a large output gap is crucial to the Bank’s story, as set out in it last inflation report. that “downward pressure from spare capacity” will bear down on price rises.

So fiscal and monetary policy and the reputations of Osborne and Mervyn King rely on the output gap. Unfortunately, it is something of a will of the wisp; hard to spot and difficult to measure.

The OBR, while guessing at spare capacity of about 3% of GDP, has been quick to issue health warnings. Estimating the output gap, it says, “is difficult because we cannot observe the supply potential of the economy directly so as to compare it to the actual level of GDP”.

It notes estimates of the gap vary widely. At one extreme you could argue that spare capacity left over from recession is worse than useless, because it exists to meet a pattern of demand that will never return.

Take the housing market, which for the foreseeable future will be operating at half activity levels that existed before the crisis, so spare capacity in estate agents, mortgage brokers and other parts of the industry is irrelevant.

At the other extreme, some would argue there is at least as much spare capacity as the drop in GDP (6.4%) that occurred in the recession. The OBR goes for something in the middle, not by guessing but by monitoring over 30 different indicators, from business surveys and official statistics.

The Bank also thinks there is significant spare capacity but appears to be becoming less sure of its ground. In its most recent inflation report it was confident that there was plenty of slack in the labour market but warned that “it was difficult to judge the extent of spare capacity in businesses”.

So, quite a lot rests on a hard-to-see, difficult-to-measure concept. It seems to me quite likely that there is spare capacity in the economy, as there always is after recessions. How big it is, and whether it is big enough to bear down on inflation as the Bank hopes, is another matter.

The question, for the Bank and other Western central banks, is whether the spare capacity that exists in their economies is big enough to offset the inflationary effects of strong growth in emerging economies like China and India, which may already be bumping up against capacity limits.

It may be the nature of the global recovery, driven by commodity-hungry emerging economies. But, as Andrew Sentance, the Bank’s arch-hawk has pointed out, the relationship between global inflationary pressures and the world’s output gap - appears weaker than it was even as recently as the first part of the 2000s.

How will we know? Only by watching what happens. If pricing pressures persist and are reflected in higher wage settlements, meaning higher inflation persists. Or, on the fiscal side, if the budget deficit stays high in later years, despite recovery It all depends on the output gap. And we can’t be sure how big it is.