The ‘output gap’: another piece of economic mumbo-jumbo

The concept of the 'output gap’ is central to mainstream macroeconomics. It is not merely of academic interest. The Office for Budget Responsibility (OBR) has a specific requirement to estimate the output gap, which it defines formally as “the difference between the current level of activity in the economy and the potential level it could sustain while keeping inflation stable”. The output gap is a key consideration for central banks around the world including the Bank of England. If output is well below its potential, nominal interest rates should be kept low, to try to stimulate the economy. And a large output gap should keep cost and price inflation low. Prices are hard to put up in a depressed economy. See: http://www.bbc.co.uk/news/business-23145755 for a discussion of the changes made to the policy of forward guidance.

The task of estimating the output gap empirically is fraught with difficulties. The OBR points that there are at least three recognised ways of doing this, none of which will make sense to anyone lacking an advanced training in statistics. So there is plenty of scope for disagreement amongst orthodox economists who believe in the concept.

Yet rather like the medieval debates about how many angels could dance on a pin, these disputes have little meaning in the economy of the 21^st century.

The economy is not a physical object and cannot, say, be placed on a pair of scales and weighed.

GDP has to be estimated, using a wide range of information. The basic principles of how to measure output were worked out in the 1930s and 1940s. A major problem is that these principles are much more suited to an economy which, as it was at that time, is dominated by the production of goods rather than services.

We can count how many Ford Model Ts have been built. It is much less clear what the outputs of Google or Facebook are.

The problems are even more acute with the concept of potential output. Many internet-based services incur substantial fixed costs in order to have just a single customer.

But the additional cost of servicing the second customer, and all subsequent ones, is effectively zero. Potential output does not have much meaning in these contexts, it is not obvious what the limit might be.

A powerful blow against the concept of potential output has been published in the latest edition of the American Economic Association’s journal Applied Economics. Igal Hendel and Yossi Speigel document the evolution of productivity over a 12 year period in a steel mini-mill producing an unchanged product, working 24/7.

The steel melt shop is almost the Platonic ideal from a national accounts perspective of output measurement. The product – steel billets - is a simple, homogenous, internationally traded product. There was virtually no turnover in the labour force, very little new investment, and the mill worked every hour of the year.

Yet despite production conditions which were almost unchanged, output doubled over the 12 year period.

As the authors note, rather drily, “the findings suggest that capacity is not well defined, even in batch-oriented manufacturing”. Time to put the concept of potential output into the rubbish bin!

Paul Ormerod is an economist at Volterra Partners LLP, a Visiting Professor at the UCL Centre for Decision Making Uncertainty, and author of Positive Linking: How Networks Can Revolutionise the World

Read this article relating to the output gap from the Wall Street Journal: http://blogs.wsj.com/moneybeat/2014/03/20/looming-..