Gargantuan output gaps upon us

Via FTAlpahville:

The output gap is a concept we got familiar with during the global financial crisis. But it’s time to revisit it, in some detail.

One reason the measure often gets overlooked in mainstream headlines is because it doesn’t sound all that consequential. Yet it is. Arguably more so than ever. Encumbering its popularity, however, is the fact it’s not always universally considered to be a thing. Saltwater-type economists (a.k.a the stimulus inclined) are far more partial to backing its theoretical existence than fresh water austerity types because it helps them justify more government spending. Added to that, it’s also notoriously difficult to measure in real time.

The measure’s importance today, however, relates to it being uniquely useful in expressing the equity that’s been lost in the economic system because of Covid-19 lockdowns. This equity isn’t just something that can be conjured up out of thin air when we restart. It’s a real loss that can only be compensated for with faster than usual catch-up growth. In many cases, however, missed opportunities are gone forever.

While the scale of the lockdown-triggered economic slump may finally be penetrating mainstream consciousness, we think there’s a strange denial — even in supposedly informed policy circles — about the scale of the wealth that’s been permanently destroyed. Only the output gap can properly illustrate the damage, which is why it’s time to make the measure popular again.

So what is the output gap?

In its simplest terms, the output gap measures the difference between actual output (or GDP) and potential output (or potential GDP). Since this gap illustrates how much better the economy could be faring at any given time had whatever demand shock which slowed growth not occurred, it indicates the theoretical excess supply capacity in the system. Whenever output is running under potential output, there is said to be economic slack, which supposedly justifies additional stimulus as the slack is the factor that is likely to keep price inflation at bay. Or so the theory goes.

The last time it was sexy to sound knowledgeable about the gap, was roughly 2011 — at which time a big advocate of the concept was Paul Krugman, who used it as the basis when he called for additional stimulus.

Today’s crisis is clearly very different to 2008. But one key factor differentiating it is the widely held (and potentially very wrong) perception that the slump is only temporary. This is important because so much private and public policy is now being determined by the notion that the economy can be easily stop-started without any real long-term negative consequences. It’s this sort of thinking that is backing the V-shaped recovery argument, which in turn is justifying putting the economy’s needs second to the needs of saving lives (whether rightly or wrongly, we won’t and don’t want to speculate). What that theory neglects is the amount of damage that has been wrought on the supply side — effectively wiping out potential GDP as well as actual GDP. The output gap might offer a clue to the size of this forever-lost GDP.

Here, via Guggenheim Investments, is a good depiction of how policymakers view the current output gap stalking the US economy:

It took 10 years to catch up on the output lost in 2008. The newly formed wedge in the chart implies we are starting all over again, and this time from an even more extreme scenario.

Globally, the picture is no better. Here is BCA Research from last week illustrating some regional comparatives between this time and 2008:

It’s this sort of thinking that’s influenced the IMF’s most recent dismal forecast for the global economy which, as BCA highlight, indicates an output gap of as much as $9tn:

What these charts suggest is there will be little permanent economic damage — justifying economic policy responses that act as bridging measures, and which would later on serve to validate calls for aggressive monetary and fiscal stimulus.

However, if lockdown-type measures are to persist for up to two years — as is increasingly thought — the impact would be not only an upper double-digit trillion bill in terms of overall economic losses, but could also destroy supply capacity and potential GDP. The longer the lockdowns last, the graver the supply-side impact is likely to be.

If demand for the spare capacity sitting on the sidelines never comes back, which it may never do (especially when it comes airline and leisure assets), those assets will have to be written down. That equates to a huge economic opportunity loss. It also means the output gap is a lot smaller than policymakers now assume.

It doesn’t bear thinking about it, in other words.

Even if stimulus cheques prop up that lost demand by transferring it into new economic areas (such as stay-at-home goods and services), there’s no guarantee the economy will be able to transition quickly enough to make up the loss to potential GDP. It could therefore run hot and very inflationary in the new demand zones. And if inflation rates bifurcate, that could have a lasting impact on debt obligations and as a result global savings, many of which would then be eviscerated.

And you want to run mass immigration into this?

Only if you want Third World wages.

David Llewellyn-Smith
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