The output gap: how much economic potential has been lost?

An interesting piece in the Economist about the current state of the output gap – the difference between an economy’s actual output and its potential output.Paul Ormerod argues that this value is almost impossible to estimate, so it is a pretty useless concept. Others think trying to estimate the size of the gap is valid, and knowing how much spare capacity the economy has could be a crucial guide to economic policy makers.What are the thoughts of economists who have been looking at recent OECD data?

According to the article, later this year British output should regain the level it reached in early 2008. Yet relative to what was expected of it pre-crisis, it will therefore be producing far less than once seemed possible. This is a worrying thought, but it wouldn’t be too bad if you optimistically assumed that as this potential output could spring back into life once the economy picks up speed again. A big output gap should mean the economy can go through a massive phase of expansion before ‘running out’ of spare AS, triggering inflation.

But economists very often aren’t so optimistic. Since early in the recession they have fretted that it might leave permanent scars. A long slump can lead to low levels of investment, leaving economies ill-equipped to grow in future. Labour markets can suffer from hysteresis, in which short-term joblessness leads to higher long-run unemployment as workers’ skills, motivation and connections erode. In other words, there might not actually be much spare economic potential if it has withered away.

Each year the OECD releases an economic outlook which includes estimates of members’ potential economic output: the highest level of production each economy could feasibly sustain without igniting inflation. This is calculated based on long-run trends in investment, labour-force growth and the productivity of workers and capital; more of each means an economy boasts a greater economic capacity.

Before the crisis some economies were operating a bit above their true potential, thanks to unsustainable credit growth. Yet in the tumult that followed, the rich world gave back that ground and much more. A few rich countries, like Australia and Switzerland, came through the past seven years largely unharmed (see graph above). Yet Britain took a huge hit – and by 2015 the weighted average loss among rich countries as a whole is projected to reach 8.4%—as if the entire German economy had evaporated. According to the article, the figures suggest that many economies, in Europe especially, have suffered structural damage that can be fixed only with ambitious reform and booming investment.

There’s more you can read about precisely where this potential has been lost; with four main contributors to disappointing growth: unemployment, labour-force participation, capital investment and productivity.