Benjamin Studebaker

There’s an interesting assumption going on behind the estimation of the output gaps (the difference between the economy’s current output and the economy’s estimated maximum potential output)–that not only did the economy decline during the recent crisis, but that the economy’s potential declined as well. This assumption leads to governments believing that their economies are less capable than perhaps they are, that the output gaps are not especially large, and that there is little revenue to be raised to offset stimulus spending, but what if it is not true? The idea comes from Capital Economics, a macroeconomics research company, has received attention from the Financial Times and Paul Krugman, and now it will receive attention from me as today’s topic.

The key example the Capital Economics guys use is the UK, but much of what they say applies strongly to many other western economies. In the UK, most estimates of the output gap have put it at around 3% of GDP:

The principle reason for this has been the rate of inflation in the UK, which, until recently, was high enough to make it look like the economy was not operating far below potential. An economy operating persistently below potential usually has very low inflation or deflation because many workers and much capital remains idle.

The seemingly higher level of inflation the UK was experiencing a few months ago made it appear that the UK economy was operating much closer to potential, but it turned out that much of this inflation was the result of temporary outside factors–as Krugman explains it:

the great bulk of UK inflation these past few years reflects one-off factors: VAT increases, commodity prices, and import prices. Domestically generated inflation is low, and headline inflation is declining too.

The British government increased value added tax (VAT), which raises prices across the board on goods sold. Commodity prices (gold, silver, oil, raw materials, food) have been pushed up by the commodities bubble. As the euro has weakened in response to the Eurocrisis, the pound has gotten stronger, increasing the costs of imports from Europe. All of these factors combine to make UK inflation seem higher than it really is, and, aside from VAT, the latter two of these factors also influence the United States and other non-euro western nations. As the VAT increase wears off, some commodities ease up, and the pound stabilises against the euro, the outside factors inflating inflation subside, and we can see that the UK does indeed have a low baseline inflation consistent with a larger output gap. Why is not inflation lower still, or the economy deflating? This is likely the result of what Keynesians call “wage stickiness” or “downward wage rigidity”–in other words, it is difficult to get wages to actually fall for any length of time. Even during the prolonged massive unemployment of the depression, wages were reluctant to fall very far and refused to stay down:

This illustrates that it is actually quite difficult to achieve extremely small amounts of inflation or any amount of deflation–and why countries like Spain are currently having a great amount of difficulty reducing their prices and wages through wage cuts, or what is often called “internal devaluation”.

As a result, Capital Economics puts forth the idea that the UK really did not see a drop in its economic potential at all, only in its output. Think about it this way–the global crisis was driven by high levels of private sector debt. As Krugman observes with respect to our case study, the UK:

Between 2000 and 2008, household debt rose from 96% of US personal income to 128%; meanwhile, in Britain it rose from 105% to 160%, and in Spain from 69% to 130%.

The economic crisis was triggered by a “Minsky Moment”, named for the economist who theorised it, in which a great many people realise all at once that they are carrying too much debt, and try to reduce spending all at the same time in order to shrink their debts. When everyone tries to reduce spending all at once, demand falls, so subsequently supply must contract, which means production and wages also fall. As a result, everyone spends less, but everyone’s income also falls. It is necessary for the private sector to reduce its debt, but it is not necessary for total demand to fall, for economic growth to cease, and for long-run potential to fall. The state can step in with spending of its own, maintaining demand and keeping the economy growing while the private sector deleverages. When private sector debt is down to a more acceptable level, the private sector resumes higher levels of spending and high levels of growth can result. This means that the high levels of unemployment and weak economic growth are not  necessary and that they represent a considerable amount of unnecessarily idle capital. With all this in mind, Capital Economics estimates an output gap not of 3%, but of 13.7%:

This represents around 386 billion dollars based on Trading Economics’ estimate of the UK GDP levels, or around 240 billion pounds. A boost in demand of that size would, if Capital Economics is correct, result in a rapid  recovery in Britain. Spending reductions by Britain’s government only serve to further exacerbate the output gap.

In the British government’s zeal to demonstrate “fiscal responsibility”, it has unnecessarily created a prolonged period of British economic stagnation in which the economy operates far below potential and millions of people remain unnecessarily out of work or underutilised. The cost of such a stimulus to Britain would be alleviated considerably on two fronts–the rate of inflation remains slightly higher than Britain’s interest rate on 10 year bonds, meaning that the British government is paid by investors to borrow their money, and the very large surge in growth that would result from proper fiscal policy would lead to a large boost in the government’s tax revenues. The output gap of 13.7% reflects the percentage of the potential at which the current British economy is operating–the potential itself is around 16% higher than current British GDP, so British tax revenues could expect to increase as much as 16%–as much as 92 billion pounds of the stimulus could be paid for in higher revenues in a single year if Britain attained its estimated potential GDP and did not fundamentally change the percentage of GDP taken in taxes by the state each year. The 92 billion pounds in higher revenue would pay for the stimulus in just three years, and that assumes no additional growth in the economy in line with further potential going forward, no shrinking of the debt via inflation, no other outside assisting factors at all. With other factors included, the timetable would be reduced further, and all future growth from potential would only mean higher revenues and higher profits for the government. The reality here is that the British government can invest in growth, can get a substantial return on that investment, and can close this output gap. Only pessimism about the British economy stands in the way, and the same situation may very well exist in other places.