How much spare capacity does the world have left?
January 13, 2013 5:12 pm
by Gavyn Davies
Most economists accept that the developed economies have been operating considerably below potential GDP since 2008, but there is much less agreement about the size of the output gap, and what should be done about it. This is obviously crucial. The larger the output gap, the greater the waste of resources (and, from an investor’s point of view, the greater the scope for future growth). Furthermore, the larger the gap, the smaller is the budget deficit when economies return to potential, so the greater is the scope for fiscal expansion today.
Keynesians have been focused on these issues for some time, and have generally had the better of the argument in the current recession. Recently, their thinking has been developing in some important respects. An example is Paul Krugman’s contribution to a panel discussion on the macroeconomics of recessions at the annual meeting of the American Economic Association in San Diego last week.
Brad DeLong, the panel chairman, has posted a transcript of the session here.
In his contribution, Professor Krugman asked the following question: if the output gap is really as large as the Keynesians have claimed, why has inflation not fallen into negative territory? In most developed economies, the core rate of inflation has remained stuck at close to 2 per cent, despite the fact that real GDP has been about 10-13 per cent below its long term trendline for several years in succession. Does this not tell us that potential GDP is in reality much lower than the simple extrapolation of previous trends would suggest? If so, the case for fiscal and monetary expansion suddenly looks much weaker.
Paul Krugman’s explanation for the absence of any significant decline in inflation, despite what he believes is a massive output gap, is that nominal wages get stuck at zero instead of turning negative as the recession takes hold. He says this:
This is sound reasoning. In 2010, Andre Meier at the IMF published an analysis of persistently large output gaps (summarised in this earlier blog), in which he concluded that global inflation should be dropping each year by about 0.5 per cent, but that this would stop happening as the rate of wage and price inflation approached zero. The estimated impact of the output gap on inflation would therefore be expected to decline as inflation falls. This prediction seems to have proven accurate.
Furthermore, to the extent that inflation expectations have become “anchored” at 2 per cent as a result of central banks’ inflation targets, we would expect the link between the size of the output gap and the change in inflation to weaken. Again, this seems to have happened. Jan Hatzius at Goldman Sachs has recently estimated a model of the US inflation process which finds evidence of both anchoring and of a drop in the estimated coefficient on the output gap as inflation moves closer to zero.
Jan Hatzius concludes that “the model implies that there is little risk of a significant rise in inflation until we are much closer to full employment”. In other words, fiscal or monetary expansion should be met with a rise in real output, not in inflation. Similar reasoning appears to underpin the Fed’s current thinking, and especially the recent change in its policy reaction function to place more importance on reducing the output gap as quickly as possible.
None of this, however, tells us anything definitive about the exact size of the output gap; a gap almost certainly exists, but is it really as large as 10-13 per cent of GDP? On that question, the following graphs are pertinent:
.
The graphs compare a simple extrapolation of the pre-2008 trend for GDP (red lines) with various estimates of potential GDP made by official bodies like the IMF, OECD and the Congressional Budget Office in the US. The estimates of these official bodies are all made with similar “fundamental economic” methods, which attempt to allow for developments in labour supply, the capital stock, total factor productivity and the natural rate of unemployment, or the “NAIRU”.
The implication of these estimates for potential GDP is that about two-thirds of the shortfall in GDP relative to the linear trendline in the G4 countries has been due to supply side phenomena, notably the low level of capital investment, the fall in underlying productivity growth as the IT revolution has waned, and a rise in the NAIRU. For the US, real GDP at present is 13 per cent below the linear trendline, but only 4.2 per cent below the average of the three “fundamental economic” estimates shown for potential GDP.
This estimate is not far from that implied by recent work at the Fed. For example, the latest update to a paper on the size of the output gap by Justin Weidner and John Williams at the San Francisco Fed shows that the output gap is in a range of 0.4 to 5.7 per cent, with a mean and a median of 3.2 per cent [1].
.
What does all this imply for the future? In the short term, it suggests that any rise in nominal demand, stemming from expansionary policy or a recovery in private spending, is much more likely to be reflected in rising real output than in higher inflation. Demand management policy can be expansionary.
However, in the longer term, it does not support the view that the developed economies can easily return to their pre-2008 trendlines for GDP through demand expansion alone. Perhaps they can never get there, or perhaps there is a speed limit which cannot be safely exceeded [2]. In either case, supply constraints would not be as remote as the use of linear trendlines would imply.
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Footnotes:
[1] The Laubach-Williams estimate is an outlier, which is derived from observing the inflation rate, not the behaviour of labour market data. Since inflation has been stuck at around 2 per cent for a long period, this method suggests that the output gap is very small. The method would produce estimates of the output gap which are too small if the relationship between the output gap and inflation has changed, as discussed above.
[2] Some of the reasons for a drop in potential GDP relative to previous trends may be indirectly caused by a shortage of demand. For example, capital investment might fall, and some workers might leave the labour force. Some of these effects might be reversible if demand recovered strongly. In that event, the supply potential of the economy would be “endogenous” to the level of aggregate demand.
Keynesians have been focused on these issues for some time, and have generally had the better of the argument in the current recession. Recently, their thinking has been developing in some important respects. An example is Paul Krugman’s contribution to a panel discussion on the macroeconomics of recessions at the annual meeting of the American Economic Association in San Diego last week.
Brad DeLong, the panel chairman, has posted a transcript of the session here.
In his contribution, Professor Krugman asked the following question: if the output gap is really as large as the Keynesians have claimed, why has inflation not fallen into negative territory? In most developed economies, the core rate of inflation has remained stuck at close to 2 per cent, despite the fact that real GDP has been about 10-13 per cent below its long term trendline for several years in succession. Does this not tell us that potential GDP is in reality much lower than the simple extrapolation of previous trends would suggest? If so, the case for fiscal and monetary expansion suddenly looks much weaker.
Paul Krugman’s explanation for the absence of any significant decline in inflation, despite what he believes is a massive output gap, is that nominal wages get stuck at zero instead of turning negative as the recession takes hold. He says this:
The inflation process is one area in which I have changed my views. It has become much more apparent that downward nominal rigidity—not just stickiness but people don’t like to cut nominal prices and wages—is a very significant factor. When you have a depressed economy in a state of initially low inflation, the zero bound not just on interest rates but on wage changes becomes a really big deal. The reason that average wages continue to rise is that we have truncated the left edge of the distribution, not that we have anything close to full employment.
This is sound reasoning. In 2010, Andre Meier at the IMF published an analysis of persistently large output gaps (summarised in this earlier blog), in which he concluded that global inflation should be dropping each year by about 0.5 per cent, but that this would stop happening as the rate of wage and price inflation approached zero. The estimated impact of the output gap on inflation would therefore be expected to decline as inflation falls. This prediction seems to have proven accurate.
Furthermore, to the extent that inflation expectations have become “anchored” at 2 per cent as a result of central banks’ inflation targets, we would expect the link between the size of the output gap and the change in inflation to weaken. Again, this seems to have happened. Jan Hatzius at Goldman Sachs has recently estimated a model of the US inflation process which finds evidence of both anchoring and of a drop in the estimated coefficient on the output gap as inflation moves closer to zero.
Jan Hatzius concludes that “the model implies that there is little risk of a significant rise in inflation until we are much closer to full employment”. In other words, fiscal or monetary expansion should be met with a rise in real output, not in inflation. Similar reasoning appears to underpin the Fed’s current thinking, and especially the recent change in its policy reaction function to place more importance on reducing the output gap as quickly as possible.
None of this, however, tells us anything definitive about the exact size of the output gap; a gap almost certainly exists, but is it really as large as 10-13 per cent of GDP? On that question, the following graphs are pertinent:
.
The graphs compare a simple extrapolation of the pre-2008 trend for GDP (red lines) with various estimates of potential GDP made by official bodies like the IMF, OECD and the Congressional Budget Office in the US. The estimates of these official bodies are all made with similar “fundamental economic” methods, which attempt to allow for developments in labour supply, the capital stock, total factor productivity and the natural rate of unemployment, or the “NAIRU”.
The implication of these estimates for potential GDP is that about two-thirds of the shortfall in GDP relative to the linear trendline in the G4 countries has been due to supply side phenomena, notably the low level of capital investment, the fall in underlying productivity growth as the IT revolution has waned, and a rise in the NAIRU. For the US, real GDP at present is 13 per cent below the linear trendline, but only 4.2 per cent below the average of the three “fundamental economic” estimates shown for potential GDP.
This estimate is not far from that implied by recent work at the Fed. For example, the latest update to a paper on the size of the output gap by Justin Weidner and John Williams at the San Francisco Fed shows that the output gap is in a range of 0.4 to 5.7 per cent, with a mean and a median of 3.2 per cent [1].
.
What does all this imply for the future? In the short term, it suggests that any rise in nominal demand, stemming from expansionary policy or a recovery in private spending, is much more likely to be reflected in rising real output than in higher inflation. Demand management policy can be expansionary.
However, in the longer term, it does not support the view that the developed economies can easily return to their pre-2008 trendlines for GDP through demand expansion alone. Perhaps they can never get there, or perhaps there is a speed limit which cannot be safely exceeded [2]. In either case, supply constraints would not be as remote as the use of linear trendlines would imply.
—————————————————————————————-
Footnotes:
[1] The Laubach-Williams estimate is an outlier, which is derived from observing the inflation rate, not the behaviour of labour market data. Since inflation has been stuck at around 2 per cent for a long period, this method suggests that the output gap is very small. The method would produce estimates of the output gap which are too small if the relationship between the output gap and inflation has changed, as discussed above.
[2] Some of the reasons for a drop in potential GDP relative to previous trends may be indirectly caused by a shortage of demand. For example, capital investment might fall, and some workers might leave the labour force. Some of these effects might be reversible if demand recovered strongly. In that event, the supply potential of the economy would be “endogenous” to the level of aggregate demand.
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