Winner of the New Statesman SPERI Prize in Political Economy 2016

Friday, 23 March 2018

The Output Gap is no longer a sufficient statistic for inflationary pressure


One of the features of the latest OBR forecast is that they believe the economy is operating slightly above its sustainable level (a positive output gap), where the sustainable level is the level that would keep inflation constant. To see how startling that hypothesis is, here is the latest version of a chart I have probably posted more than any other since I started writing this blog.


It is UK GDP per head (source), which is a pretty good measure of average prosperity, and a trend line in red for 2.23% growth p.a. So from 1955 to 2007 prosperity grew at an average rate of almost two and a quarter percent each year. Since then it has increased at an annual rate of around 0.35%. And if the OBR are right, none of this is due to unutilised resources and lack of demand.

The shift in trend is just as clear if we look at output per worker. Some people try and rationalise this by saying that 2007 was a boom year, and so trend growth had really been falling long before the Global Financial Crisis (GFC). But the evidence does not support more than a slight downward shift in the growth trend before the GFC: the OBR estimate an output gap of 0.7% in 2006/7 and 1.8% in 2007/8.

I find it extraordinary that most economists still talk about the output gap after the GFC in the same way that it was talked about before the crisis: as a limit to how far and fast the economy can expand. To do that is in my view quite wrong. It ignores what I call the innovations gap: the difference between actual output and the level of output that firms could achieve if they started using the best technology available to them. Because there is currently a large innovations gap, firms are likely to meet additional demand not be raising prices but by investing in these more efficient techniques.

Before the GFC, we could ignore the innovation gap because it was relatively small. But since the crisis that gap for the UK and many other countries must have increased, because it is simply not plausible to assume that since the GFC technical progress has come to a virtual halt. Innovations may not have been increasing at the pre-GFC rate, but they cannot have almost stopped, which is the implicit assumption in the OBR’s analysis. Hence we have in the UK, and I suspect in many other countries, a subsrantial innovations gap which will prevent any excess demand leading to significant inflationary pressure. Some supporting evidence for this comes from the growing productivity divergence between leading firms and the rest.

Why have most firms not been investing in the most productive equipment and techniques since the GFC? I think the simple answer is fixed costs and demand. Investment projects almost always involve a large fixed cost element (disruption, retraining), and with static demand those fixed costs may exceed any efficiency gain. But in a normal recovery from a recession, where demand is growing rapidly, firms are happy to incur that fixed cost because they need to expand capacity anyway to meet growing demand. In a weak recovery, on the other hand, many firms may not need to expand capacity, with any modest increases in demand going to leading firms, firms that do invest in the latest technology. Hence the divergence noted above.

Exactly the same argument applies to the NAIRU: the level of unemployment at which inflation is constant. The NAIRU is almost certainly lower than most central banks think for a variety of reasons, but when it is approached I expected to see a pick up in investment and innovation more than a pick up in wage inflation. Investment and productivity growth go together, as a nice chart in the OBR’s latest forecast report shows (page 43).

A large innovation gap in the UK is being enhanced by Brexit. The more uncertain future demand is the more firms are likely to postpone productivity enhancing investment. It may be politically useful to delay creating a new customs union/SM for goods with the EU to try and keep the Conservative party together (as regular readers will know, I think this is inevitable because of the Irish border), but the uncertainty that delay creates just holds back UK growth. Just one more way in which both Brexit and more generally a Conservative government is an economically destructive project.

The existence of a large innovations gap, both in the UK and elsewhere, means that we need two things. First, we need a monetary policy that is very relaxed about raising interest rates. Second we need, in the UK and pretty well everywhere, a large increase in public sector investment. The first needs independent central banks to be less inflation averse and to stop treating the sustainable level of output as something which is independent of what they do. The second requires governments to stop being obsessed about deficits and instead to start investing in the future of all the people they govern.


13 comments:

  1. It really is a shocking graph. Can you imagine the outcry if a left wing government has pursued policies leaving everyone £6000 a year worse off..?

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  2. GDP is not a good measure of average prosperity! it doesn't show inequality at all! a footballer earns 100k a week whilst 4m people earn one tenth of that and therefore pay no income tax in a year!! in one year the footballer earns that of 520 of those people!who pays no income tax! yet indirect taxation is extortion on them!by comparison! ie 10% own 90% of the wealth or means to pay,pay 28% of tax so 90% who own 10% of the means to pay ,pay 72% of all tax!

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  3. I think you nailed it!

    My experience as a development engineer is two fold 1) Companies are not initiating investment which maybe due to inexperience or the lack of animal spirits. 2) There is a lack of technical people to support any investment.

    I believe companies are struggling as wages are going up but the selling price for goods is stagnant. Companies are being forced to look how they can increase production without increasing costs.

    Unfortunately many managers and directors will be inexperienced when it comes to investment so its going to be a big learning curve for them. Investment involves risk and failures.

    On top of all this is the political environment where we have a self centred government without any big ideas which is stifling the UKs prosperity. People and Companies believe they must follow a path of austerity and keep tightening their belts. This must be dampening our animal spirits. Making work a very dull place since over the last 10 years our working environment has been stagnant.

    MPC.

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  4. Hi! Thank you so much for this article! Definitely agree on incorporating the 'innovation gap' into current inflation models, or at least having a more robust inclusion of technology parameters is useful. With regard to current trailing of UK production technology, I was wondering whether it could be due to cash and equity being (artificially) cheap. Firms are able to see better returns on short to medium term investments in ramping up capacity or superficial engagement with technology because the cost-benefit analysis is much less robust- compared as to the necessity of long-term (and concurrently more meaningful) technology development if equity was expensive. Would love to hear your thoughts, and thank you so much again for sharing!

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  5. The problem as I see it is that too many people--and unfortunately that includes some academics have forgotten the theoretical underpinnings of economic concepts. So Output Gap and NAIRU are seen as rules not as a concept that relies on fundamentals. Kind of the same with minimum wage debate since input price floors don't mean the same thing unless you are analyzing markets that very rarely exist.

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  6. Oh I get it. We should just extrapolate the trend created by two of the biggest speculative bubbles in world history (late 1990s tech bubble and mid 2000s housing bubble) and then complain that we are not back to that bubble-juiced trend. In the words of John McEnroe: "You cannot be serious!"

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  7. - The UK needs a Job Gty as part of a Full Employment Fiscal Policy.
    - http://mmt-inbulletpoints.blogspot.com/2017/09/im-just-responding-to-various-economic.html
    - Financing should be undertaken by Central Bank money issuance.
    - Public sector spending and workers' spending will increase demand and will induce private sector to hire more unemployed and produce even MORE GOODS AND SERVICES.
    - The added GOODS and SERVICES will offset the new money issued so no inflation should be created.

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  8. The point about Brexit is well taken; in my view it was bound to induce uncertainty and lead firms to postpone investment and I am surprised its effect appears to be relatively muted.

    As to the remedies being less inflation averse you could argue we're already there and unchecked inflation, even modest inflation, does lead to its own distortions if treated with insouciance.

    With regard to the differences between smaller and larger firms I am not so sure I would agree. I think you are right about the relative approach; however, the implication is that larger firms will capture more demand and this has two results: it will force smaller firms out of business and enhance their own productivity, a double effect on sectoral productivity. Why, therefore, have the productivity figures been so bad? You would surely notice some effect?

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  9. Our blogger interprets the numbers as usual in the sense that implies that overall, fiscal+monetary, policy is not expansionary enough (and therefore asset prices could be rising a lot faster if fiscal policy were expansionary too).

    «So from 1955 to 2007 prosperity grew at an average rate of almost two and a quarter percent each year. Since then it has increased at an annual rate of around 0.35%.»

    More insightfully the GDP per person compound growth rate for various periods is:

    * 3.0% from 1955 to 1970.
    * 2.5% from 1955 to 1980.
    * 2.0% from 1981 to 1997.
    * 1.9% from 1998 to 2006.
    * 2.0% from 1981 to 2006.
    * 1.5% from 1981 to 2015.
    * 1.0% from 1998 to 2015.
    * 0.5% from 2010 to 2015.

    That changes the picture quite a bit, because the question is what period defines the "trend", because the trend has been towards lower growth with in more recent periods.

    Surely 2010-2015 (and up to 2017) GDP per person growth has been below trend, but the trend has been more like 1.5% than 2.25%.

    Indeed some people have written a lot about the falling trend of UK "productivity", yet the trend curve in graph above seems to hint, as it seems to slope slightly upwards, at a gently accelerating "productivity" growth trend, which to me seems wildly optimistic.

    «Some people try and rationalise this by saying that 2007 was a boom year»

    Some other people don't forget that 2007 was the peak of the "Goldilocks" economy, and therefore was above trend, and reckon it is a very optimistic practice to fit trend curves that begin with the recession (1956) and end with a peak (2006), and include two periods with very different growth rates, and are gently upsloping for a country with allegedly falling productivity. It may be also not very fruitful to compare that trend curve with a trend beginning right after that peak.


    Note that I reckon that the UK is performing below trend, but below a rather less optimistic trend. In addition I reckon that if the electricity consumption per region or per person graphs below are indicative of actual prosperity the official estimates of the index of GDP per person growth rates are towards the upper end (and probably beyond) the range of plausibility.

    https://blissex.files.wordpress.com/2018/02/dataelectrukfallbyregion2005to2015.png
    https://blissex.files.wordpress.com/2018/02/dataelectreuothersconsperhead1960to2015.png

    Thus I suspect that the regime change of 1980 when "growth" was pumped by private "borrow and spend" policies (C Crouch's "privatised keynesianism) has to come and and that there was a big regime change is evident in this graph from Steve Keen:

    https://cdn.opendemocracy.net/neweconomics/wp-content/uploads/sites/5/2017/04/Screen-Shot-2017-04-21-at-13.53.09.png

    Including the new swing upwards at the very end, as G Osborne tried to keep mortgage borrowing and thus house prices growing much faster than GDP.

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  10. An alternative graph is here:

    https://blissex.files.wordpress.com/2018/03/dataukrealgdpcapitarel1995.png

    The blue line is real GDP per person with 1995=100 1856-2015.

    The yellow and green lines are for 1955-2015 two different fits "by hand":

    * yellow: compound rate centred on 1981 with rate 2% both ways.
    * green: linear rate centred in 1988 with rate 1.7% both ways.


    Thumbometrically I reckon the linear fit is better (and the centre and rate seem also plausible), and from it it appears that 1995-2007 were above trend, and that 2007-2015 are well below trend, and we really hope it is not a new trend. The yellow fit has the slight problem that the lower part is slightly presumptuous, which to me shows that a compound fit is not as good as a linear fit.

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  11. I think the output gap is in any case a dangerous concept to use. There may be gluts in some areas and severe capacity constraints in others. It might simply be a problem relating to the importation of a critical raw material. It could be differences in the North and South. Or in particular industries or labour markets. But to impose a one-size fits all monetary policy on all of it could magnify these distortions and be exactly the wrong thing to do. But the reason neo-classical economics does these things is because of its Victorian classical philosophical roots - government's should not involved in issues relating to credit allocation.

    NK.

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  12. Bry good comments, and they fit my intuition that these gaps in the US and UK are related to depressed demsnd. Fortunately, formal changes to the monetary policy targeting regime are bring discussed by mainstream US economists now, including within the Fed. A switch to something like NGDP targeting could help what Krugman calls credible promises to be "irresponsible" in the future.

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  13. Perhaps they are just coming up with a pretext to excuse raising interest rates. The real reason for raising rates may be so that there is space to cut them in the advent of a stock market crash. Such a stock market crash could have little or nothing to do with interest rates and simply be due to mis-valuation etc. However, being able to cut interest rates enables the BoE and Fed to "look busy" and perhaps reassure market sentiment etc. This could all be a case of the real economy being sacrificed for the sake of stock market massaging.

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