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Should We Mind the Gap? New Economic Perspectives

This is a syndicated repost courtesy of New Economic Perspectives. To view original, click here. Reposted with permission.

Should We Mind the Gap?

By*:  Dylan Steelman, Samuel Ellenbogen, Scott Frank and Steve Bodenheimer

Introduction

In his May 2011 column, “Is There Really an Output Gap,” CNBC financial blogger John Carney argues that the output gap—the difference between the economy’s potential performance and its actual performance—is a flawed theoretical construct that policymakers should avoid using as a basis for economic policy.  Carney presents most of this through a “thought experiment” involving a hypothetical tobacco-based U.S. economy called Tobacco America.  In the thought experiment, demand for tobacco explodes driving up prices for various tobacco inputs and taking the economy to new heights.  Eventually the dangerous health aspects of tobacco become widely known and the demand for tobacco plummets, taking the economy down with it.  Carney uses the Tobacco America thought experiment to make two arguments against the concept of an output gap—one is stated directly and the other is strongly implied.

Has the Potential of the U.S. Economy Been Overstated?

Carney directly argues that the potential economy, a theoretical construct against which the actual economy has been benchmarked, is grossly overstated.  The estimate of an economy’s potential is derived from the actual economy’s long-term performance trend.  Carney contends the trend used by most economists has been inflated by the pre-recession housing bubble (or in the case of his thought experiment, the tobacco bubble), and as a result, estimates of the economy’s potential are significantly inflated.  Rather than the economy suffering from an output gap (as it appears when compared against the inflated long-term trend), he argues that it is more likely that the economy is performing at an appropriate level, given that resources that were previously dedicated to meeting the pre-recession housing bubble (or tobacco bubble, in the case of his thought experiment) are no longer as useful after the bubble has burst (Carney 2011).

While Carney’s argument may seem reasonable on its surface, it does not appear to be supported by the empirical evidence.  As Carney contends, there clearly was a housing bubble which contributed to the economic boom in the years prior to the recession, and using unsustainable economic performance to project the economy’s future growth would seem likely to overstate its potential.  However, according to an analysis by the Federal Reserve Bank of Dallas, domestic production did not show excessive rates of growth in the years leading up to the recession.  Rather, the pre-recession boom inflated domestic demand, but the demand was met through imports rather than domestically produced goods (Atkinson, Luttrell and Rosenblum 2013, p. 5).  If this conclusion is correct, then there was no real bubble in domestic production, and using the pre-recession performance of the U.S economy to estimate its future potential would not necessarily result in inflated estimates.

Should Policymakers Intervene or Just Let it Ride?

By way of his thought experiment, Carney argues that government should not attempt to stimulate the economy through fiscal and monetary actions.  Although he stops short of saying it, his thought experiment strongly suggests he believes that attempting to stimulate the economy will prop up industries (like tobacco or housing) whose products are no longer in demand and whose resources are no longer as productive as they were before the recession. Rather than prop up those industries, government should allow markets to do their work and force labor and capital to realign themselves with the industries that are now in demand after the recession.  Assuming that this is his underlying position, Carney has missed important issues regarding the potential of economic stimulus and the long-term effects of a stagnant economy.

Carney is correct in his belief that the economy’s productive resources need to move away from the bubble industries and into new industries.  However, because he misses the distinction between demand for specific products and aggregate demand in the economy, he is incorrect in his assessment of the value of fiscal and monetary stimulus.  As he points out, demand has shifted away from housing speculation and toward other goods and services.  Demand for those goods and services should attract resources to the industries that supply them.  However, when aggregate demand in the economy as a whole is depressed, households lack sufficient income to purchase those goods.  This is where stimulus comes into play.  Rather than propping up the demand for specific goods and services, stimulus actions prop up aggregate demand for products in general.  Households would be better able buy the goods and services they demand, and that demand would attract productive resources to those industries.  Assuming the economy needs to produce fewer houses (or less tobacco), stimulating aggregate demand can make the transition to the new economy quicker and easier.

Another argument for the importance of economic stimulus is the long-term impact that economic stagnation has on the productive capacity of the economy.  Where the economy will be tomorrow depends in large part on where it is today, and a lack of demand today will eventually erode the economy’s potential in the future.  When an economy goes through a slump, two things happen that reduce the economy’s capacity to produce.  First, because future profits seem doubtful, businesses are reluctant to make capital investments.  This means physical capital is not replaced and upgraded as quickly as it should be and workers have to work with older, less productive capital for longer periods.  Second, the productive capacity of human capital atrophies the longer workers remain unemployed.  Extended unemployment causes their skills to fall out of date and they come to be viewed by employers as less reliable (Mitchell 2013).  Taken together, the two forces indicate that the failure to fully employ the economy’s resources today can significantly limit its growth in the future.

Conclusion

The economic stagnation of the recent recession has already taken a serious toll through lost production, a painful deleveraging process, the erosion of valuable employee skill-bases, and the destruction of aggregate wealth. The Federal Reserve Bank of Dallas has recently published an alarming record of these losses. The authors estimate that when it is all said and done, the U.S. economy will lose between $6 trillion and $14 trillion in output—40-90% of the economy’s output in 2007 (Atkinson, Luttrell and Rosenblum 2013).

Allowing the economy to perform below its capacity for an extended period of time exacerbates those losses.  While the potential economy may be a mere theoretical construct, the output gap is a problem of real significance.  Far from Carney’s thought experiment where stimulus policies are used to prop up outdated industries, fiscal and monetary stimulus can facilitate the transition away from those industries and toward the new economy by providing households the income needed to buy new goods. and services.  Is there really an output gap?  Yes.  Should policymakers just let it ride?  Absolutely not.

*Authors are graduate students in Stephanie Kelton’s Macro Economic class at UMKC

 

Should We Mind the Gap?

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