The Output Gap Problem

by Shaun Richards

The new pandemic economic era has brought some new features to our lives but some things have remained the same or as The Four Tops put it.

Now it’s the same old song
But with a different meaning
Since you been gone

It is also an example of how once some people get wedded to a concept no amount if reality can shake them from it. Or if you prefer a type of institutional group think where they are so busy telling each other that they are clever and intelligent they are then unable to accept that they have been consistently wrong. That is usually associated with people who via their circumstances are insulated from the effects of the error.

Let me see if you can guess it from this reference in the Financial Times?

One reason the measure often gets overlooked in mainstream headlines is because it doesn’t sound all that consequential. Yet it is. Arguably more so than ever. Encumbering its popularity, however, is the fact it’s not always universally considered to be a thing. Saltwater-type economists (a.k.a the stimulus inclined) are far more partial to backing its theoretical existence than fresh water austerity types because it helps them justify more government spending. Added to that, it’s also notoriously difficult to measure in real time.

Some might think that not being able to measure something is quite a hurdle! In some circumstances like a pandemic we are still learning because it is new but this issue has been round for decades. Another warning klaxon is fired as we note that some consider it is not a thing as surely it should be clear. We see a potential angle for the FT as one impact of its Japanese ownership is that it has become a strong supporter of stimulus.

Anyway as I am sure some and maybe many of you have guessed here it is.

In its simplest terms, the output gap measures the difference between actual output (or GDP) and potential output (or potential GDP). Since this gap illustrates how much better the economy could be faring at any given time had whatever demand shock which slowed growth not occurred, it indicates the theoretical excess supply capacity in the system. Whenever output is running under potential output, there is said to be economic slack, which supposedly justifies additional stimulus as the slack is the factor that is likely to keep price inflation at bay. Or so the theory goes.

As you can see they are unable to resist loading a factual statement with value judgements. This is especially disappointing from two of its better journalists ( Izabella Kaminska and Claire Jones) which reminds me that the better ones are usually women. The confusion continues here.

However, if lockdown-type measures are to persist for up to two years — as is increasingly thought — the impact would be not only an upper double-digit trillion bill in terms of overall economic losses, but could also destroy supply capacity and potential GDP. The longer the lockdowns last, the graver the supply-side impact is likely to be.

Again they are merging two concepts which highlights the confusion. Has supply capacity been destroyed? Yes for example if we think of the airline industry in the UK we may be shifting to us going forwards with Heathrow but Gatwick being closed for example. That would be quite a change and may not be that literal but also some examples of that are already happening. On a personal level I guess it is bad for me ( noisy planes overhead) but good for the aunt I spoke to yesterday as she lives near Gatwick as there wont be any over her. Although of course the economic effects will be the opposite of that.

However “potential GDP” means what exactly? In the end that is always the problem as supporters end up echoing Alice In Wonderland.

“When I use a word,’ Humpty Dumpty said in rather a scornful tone, ‘it means just what I choose it to mean — neither more nor less.’

’The question is,’ said Alice, ‘whether you can make words mean so many different things.’

Let me however agree with the authors on this point as frankly some of the analysis suggesting this has been laughable.

This is important because so much private and public policy is now being determined by the notion that the economy can be easily stop-started without any real long-term negative consequences. It’s this sort of thinking that is backing the V-shaped recovery argument, which in turn is justifying putting the economy’s needs second to the needs of saving lives (whether rightly or wrongly, we won’t and don’t want to speculate).

The idea that we would rebound like Zebedee from the Magic Roundabout always was silly as this morning in the UK has demonstrated. From the BBC.

Business groups have called for clarity on what will need to change in the workplace as Boris Johnson unveils a “conditional plan” to reopen society.

“Businesses need their practical questions answered so they can plan to restart, rebuild and renew,” said the British Chambers of Commerce.

The prime minister said those who could not work from home should be “actively encouraged to go to work” in England.

Those that can return are trying to figure out how they can? It will take a while and perhaps places will begin with half production.


Let me give you an example of a policy error from my home country as it tried to implement output gap theory. So if we jump into Doctor Who’s TARDIS and go back to the summer of 2013 here is the Bank of England.

In essence, the MPC judges that, until the margin of slack within the economy has narrowed significantly.

The choice of words “margin of slack” is/are significant but please park that for a moment as we check what that meant in practice.

At its meeting on 1 August 2013, the Monetary Policy Committee (MPC) agreed its intention not to
raise Bank Rate from its current level of 0.5% at least until the Labour Force Survey (LFS) headline
measure of the unemployment rate had fallen to a ‘threshold’ of 7%, subject to the conditions below.

They used “margin of slack” as explicitly using the phrase “output gap” had failed. The UK had one in theory but inflation had surged over target so it was a bit of a laughing stock. As they are slow learners they kept the policy and changed the language used instead. Next they used the employment rate because using GDP had failed.

The problem was that the “unemployment rate” was an even worse measure than GDP! There is some good news here as the UK labour market improved quickly but the Bank of England was left with a whole pack of eggs on its face. This matters as people made real decisions on Forward Guidance like this. You see whether how much you regarded 7% as a threshold there was also this.

Bank staff estimate that the medium-term equilibrium unemployment rate is presently in the region of 6.5%.

So when it went below 4% as it later did in the UK you might have expected Bank Rate to have been raised several times to say 2.5%. I will just leave that there….

Returning to GDP as the authors of the FT piece have there are other problems. The first is that it was abandoned as a signal for this sort of thing because it failed and indeed sailed utterly. But it gets worse because there are plenty of grounds to argue it will do even worse now. A lot of the issues come around the fact that it only counts things that are paid for. If people work from home more they are likely to use the commuting time gained to do more for themselves. An example of this sort of thing is one of my neighbours who due to the situation did not get a repair(wo)man in when his washing machine broke he ordered a new motor and fitted it himself. That is the same effect but lower GDP. Some might be able to do more of their own childcare and so on.

But we seem to keep finding supporters of the output gap no matter how often it fails or as The Eagles put it.

“Relax”, said the night man
“We are programmed to receive
You can check out any time you like
But you can never leave”