Tuesday, 29 May 2012

How big is the UK's output gap?

So what is the British economy's 'output gap'?

Sounds arcane, doesn't it? One of those economics stories you turn over before you get to the comment pages? Something that's for statistical pedants and economic technocrats?

Nothing could be further from the truth.

The 'output gap', as any A-Level economist can tell you, is basically the difference between an economy's potential - where it should be on its long term growth trends - and the reality. Any layman would have the impression that, right now, that gap is massive. We might not be as wealthy as we were in 2007 any time soon - until after the next election, possibly - so there must be a massive gap, right? Well, not if you listen to some of the more gloomy prognostications, which paradoxically argue that permanent harm might have been done to the UK's economy, lowering the output gap between where we are and where we might be to a very small number indeed.

This matters. If the gap is large, we can inflate, spend, borrow and party. If it's small, there's no point - and a broad measure of austerity really is a good idea.

The outgoing Labour government thought that the output gap was pretty wide (scroll down to page twenty in the report if you want a quick look). Now the new Office for Budget Responsibility has looked back over the last thirty years (PDF) and concluded that the economy was operating above capacity in the early 2000s, meaning that the output gap can't be as wide as it looks. If we've tumbled from unsustainable heights, so the argument goes, we should maybe get used to thinking of our trend rate of growth as rather slower than we imagined. That makes the 'output gap' between our wealth and our potential wealth that bit smaller.

What do I think? Well, it's a statistical artefact. Different ways of looking at it - in accounting for wages, credit and inflation - will make the output gap look different (above). The output gap is highly unstable, and might change rather more slowly (PDF) than we used to think. And the effects of commodity-hungry developing countries may make it smaller, by stoking world inflation and lowering non-inflationary growth, or bigger, by fuelling world demand. Certainly we may have over-estimated our room for manouevre - if the structure of the economy has taken a permanent hit.

But there's no need to think that the output gap has shrunk as small as two per cent - the Treasury's very, very cautious view. The respected Institute for Fiscal Studies think it's five per cent; the EU four per cent. The growth outlook may well be weak. But we've been here before - in despair during 1929-32, 1975-76 and 1992-94 - before a vigorous new growth spurt came along and proved the naysayers and doomsters wrong. Perhaps pessimism can be overdone.

But we can take this lesson at least: something as boring as the nature of obscure numbers is vital to the health of our nation, polity and economy.

Technical? Yes. Important? You bet.

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