Origins of the Output Gap

Moneybox
A blog about business and economics.
March 18 2012 10:58 AM

Origins of the Output Gap

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For it to be the case that millions of people have been languishing unemployed do to policy errors by the American elite is a disturbing thought, so naturally the longer it goes on the more people take comfort in alternative storylines. Lately I've seen a lot of chatter about the idea that maybe the mistakes aren't as terrible as they seem because actually the CBO's estimates of "potential output" are wrong and all this suffering is due to a generalized productivity collapse rather than policy errors.

I thought the idea could be usefully explored by examining the specific details of the decline through the lense of the old GDP = C + G + I + NX framework, while separating residential investment from fixed investment since housing is obviously an important part of the story of the recession. What we see is that in 2007, Personal Consumption Expenditures were 71% of Potential GDP, Government Purchases were 19%, Residential Investment was 4%, and Non-Residential Investment was 12% and then you knock off -5% for imports and it all adds up to 100%. Since that time, a total output gap equal to 6% of potential GDP has opened up. That's composed of a 4 percentage point decline in PCE relative to potential, a 1 percentage point decline in government purchases, a 2 percentage point decline in residential investment, and a 2 percentage point decline in non-residential investment but it's all offset by a 2 percent increase in net exports. In other words, in 2007 when housing had already decline a lot we were operating at CBO-estimated potential. Since then we've seen a further decline in residential activity that's been precisely offset by an increase in net exports. But then over and above that we've seen a large decline in personal consumption expenditures, and small declines in government purchases and non-residential investment.

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My theory is that if we'd acted more forcefully with tax cuts and aid to state and local governments while holding interest rates at zero, households and governments would have bought more stuff and firms would have invested more (buying more delivery trucks, for example) in order to fulfill that increased volume of orders.

The contrary view is, what? That we'd have had hyperinflation rather than more real output? Now I suppose it's possible that inflation would, in fact, have gone up to the Volcker/Reagan Era 4 percent range but even if that's true why would we want to characterize that as a collapse in the US economy's potential for real output? And it's true that just as in the Reagan era the federal budget deficit would have ballooned to an even greater extent than it has. But one rarely hears the view that the whole decade of the 1980s was an inflationary phantasmagoria.

Matthew Yglesias is the executive editor of Vox and author of The Rent Is Too Damn High.

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