August 16, 2002

How Large Is the Output Gap?

How large is the output gap--the gap between the economy's current level of production and potential output, the level of production consistent with stable inflation? Paul Krugman has some smart things to say about this question.

My answer? That two years ago the output gap was -1 percent--that is, actual production was 1 percent higher than the level consistent with stable inflation--and today the output gap is 4 percent: we could be making 4 percent more stuff without having to even begin to worry about inflation starting to creep upward.

I do, however, have one criticism to make of Paul Krugman's argument. He talks about "excess capacity." There can be--and is--excess capacity in individual industries, like telecom (although this will be quickly taken care of as telecom firms go bankrupt, their assets are taken over by other companies with rational capital structures, and telecom service prices fall through the floor). There's no such thing as "excess capacity" for the U.S. economy as a whole. Further declines in the dollar would spur demand for U.S. exports and for U.S. producers of import-competing goods. Further declines in interest rates would (with proper management of the state of our financial institutions and operating companies) boost demand for investment goods.

The mantra: there is no such thing as (aggregate) excess capacity, there is only insufficient demand.


Mind the Gap: The U.S. economy's "potential output" -- what it could produce at full employment -- has lately been growing at about 3.5 percent per year, thanks to the productivity surge that began in the mid-1990's. But according to the revised figures released a couple of weeks ago, actual growth has fallen short of potential for seven of the last eight quarters. The conventional view is that we had a brief, shallow recession last year, and that recovery has begun. But the output gap tells a different story: Two years ago we went into an economic funk, and it's not over.

In a way the whole double-dip controversy is a red herring; the real question is when G.D.P. will start growing fast enough to narrow the output gap. And so far there's no sign of that happening. There's no mystery about the causes of our funk: the bubble years left us with too much capacity, too much debt and a backlog of business scandal. We shouldn't have expected a quick and easy recovery, and we're not getting one...

The New York Times

August 16, 2002

Mind the Gap

By PAUL KRUGMAN

How much has Japan's economy shrunk since its bubble burst? It's a trick question; Japan's economy hasn't shrunk. It had only two down years over the past decade, and on average it grew 1 percent per year.

Yet Japan's is a genuinely depressed economy. Because growth has been so slow, an ever-increasing gap has opened up between what the economy could produce and what it actually produces. This "output gap" translates into rising unemployment and accelerating deflation. Slow growth can be almost as big a problem as actual output decline.

Now the non-trick question: What would a similar analysis say about the United States?

The U.S. economy's "potential output" what it could produce at full employment has lately been growing at about 3.5 percent per year, thanks to the productivity surge that began in the mid-1990's. But according to the revised figures released a couple of weeks ago, actual growth has fallen short of potential for seven of the last eight quarters.

The conventional view is that we had a brief, shallow recession last year, and that recovery has begun. But the output gap tells a different story: Two years ago we went into an economic funk, and it's not over. In a way the whole double-dip controversy is a red herring; the real question is when G.D.P. will start growing fast enough to narrow the output gap. And so far there's no sign of that happening.

There's no mystery about the causes of our funk: the bubble years left us with too much capacity, too much debt and a backlog of business scandal. We shouldn't have expected a quick and easy recovery, and we're not getting one.

Some readers have already guessed where I'm going with this. The U.S. stock bubble in the second half of the 1990's was just as big as Japan's bubble in the second half of the 1980's. Will our two-year funk turn into a five-year or ten-year funk, the way Japan's did?

A loud chorus is already shouting "We're not Japan!" Half the time, depending on what I had for breakfast (rice and pickles?), I'm part of that chorus. But let me share some disquieting thoughts.

Back when I first got professionally obsessed with Japan's problems, around four years ago, I made myself a mental checklist of reasons that Japan's decade of stagnation could not happen to the United States. It went like this:

1. The Fed has plenty of room to cut interest rates, which should be enough to deal with any eventuality.

2. The U.S. long-term budget position is very strong, so there's plenty of room for fiscal stimulus in the unlikely event interest rate cuts aren't enough.

3. We don't have to worry about an Asian-style loss of confidence in our business sector, because we have excellent corporate governance.

4. We may have a stock bubble, but we don't have a real estate bubble.

I've now had to strike the first three items off my list, and I'm getting worried about the fourth.

More and more people are using the B-word about the housing market. A recent analysis by Dean Baker, of the Center for Economic Policy Research, makes a particularly compelling case for a housing bubble. House prices have run well ahead of rents, suggesting that people are now buying houses for speculation rather than merely for shelter. And the explanations one hears for those high prices sound more and more like the rationalizations one heard for Nasdaq 5,000.

If we do have a housing bubble, and it bursts, we'll be looking a lot too Japanese for comfort.

A recent Federal Reserve analysis of Japan's experience declares that the key mistake Japan made in the early 1990's was "not that policy makers did not predict the oncoming deflationary slump after all, neither did most forecasters but that they did not take out sufficient insurance against downside risks through a precautionary further loosening of monetary policy." That's Fedspeak for "if you think deflation is even a possibility, throw money at the economy now and don't worry about overdoing it."

And yet the Fed chose not to cut rates on Tuesday. Why?

Last year some economists began privately referring to the Fed chairman as "Greenspan-san." The joke faded out as optimism about recovery became conventional wisdom. But maybe it's not a bad nickname after all.

Posted by DeLong at August 16, 2002 01:50 PM | TrackBack

Comments

I'm curious- what do you think the output gap of Japan is? If the Japanese suddenly fixed their problems, would they be able to have 4% growth for ten years straight?

Posted by: Mitch on August 16, 2002 03:43 PM

Japanese Productive Potential :

Employable Population SHRINKING maybe 1-2% p.a.

Productivity running flattish.

Could it be that Japanese Potential Growth is ZERO ???

Might this have been the argument the Bank of Japan thought when they tightened monetary policy in the midst of their troubles ?

Posted by: 49eels on August 16, 2002 04:50 PM

When Krugman talks about "full employment" is it safe to assume he's referring to NAIRU? I can't make any sense otherwise of his claim that anything less is deflationary.

And as much as I admire Krugman in general, His analogy to Japan is really sensational. Frankly, I find it very hard to believe that American homeowners are as chronically overleveraged today as Japanese land speculators were in the 1980s, or that American homeowners are leveraging their properties as collateral for yet other investments. If there's a lesson here, I'd humbly suggest it's exactly the opposite of what Krugman wants to conclude. If anything, the comparison seems to suggest that the recent American bubble was far, far milder than its Japanese counterpart. If one has to have a mania, after all, how much better is it to have one that actually stimulates productivity and economic growth in the process?

Posted by: david on August 16, 2002 09:21 PM

I was also somewhat puzzled by Krugman's "excess capacity" comment. He's given the exact same "there is no such thing as (aggregate) excess capacity" lecture in a few of his online articles. If he wasn't Paul Krugman, I'd refer him to Paul Krugman.

Posted by: Patrick M. on August 16, 2002 09:31 PM

Japan's bubbles have also contributed to years of economic growth and productivity gains especially in export oriented industries. These gains have not been undone by even the last decade of very low growth. Though Japan needs to grow faster, there is a high level of satisfaction among middle class Japanese.

Japanese workers are quite well paid, employment remains reasonably high, families are more likely to be intact than in America. Savings are ample. Still, Japan sorely needs to grow faster.

America, on the other hand, needs to look carefully to Japan to avoid a sustained period of slow growth. I see no reason for smugness. Learn from the problems in Japan and hope to more quickly recover from the bursting of our bubble.

Steve Roach has been making many of the same points as Krugman, to general derision. The points are not sensational, merely made to offer a considerable needed caution. Remember, Krugman was as cautious about the bubble in 1999 and 2000.

Much damage may sadly yet be evident from the equity market decline. Careful.

Posted by: on August 17, 2002 10:12 AM

Through Japan, I have found a mixture of the most impressive productive technigues and those that appear bafflingly poor. Export industries appear models of productivity. Then, there are areas such as retailing and wholesaling where the productivity of a Wal-Mart is not yet welcome. These productivity sluggish areas serve as sort of a safety-net for the Japanese, keeping employment levels artificially high. Of course, those so employed do not argue about artificiality.

Posted by: on August 17, 2002 11:17 AM

Brad, can you clarify your "there is no such thing as (aggregate) excess capacity" mantra?

On the opposite hand, tt seems clear enough that (real) aggregate borrowing is impossible (except in the case of labor, where providers may be induced to bring units to market in exchange for claims on goods that have not yet been produced).

But aggregate dis-use of available resource in presence of rising demand (due to uncertainty, social policy barriers, speculation, indecision, disorganization, monopolistic competition, institutional underdevelopment, stupidity, stranding, transaction cost effects, etc.) seems easily illustrated.

Care to elaborate on your perspective?

Posted by: RonK, Saettle on August 17, 2002 11:36 AM

Re-reading I think the point is that if demand is sufficient there should never be excess capacity in the economy as a whole. That is why the Japanese Central Bank made a drastic mistake in not taking interest rates down as soon as the slowing of the economy was evident in 1991. Indeed, Japanese taxes were raised several times during the slowdown of the 90's. Krugman wishes the FRS had lowered interest rates again this week. So do I.

Remember, Argentina slowed its economy for the sake of the currency peg and turned a recession to a depression.

Posted by: on August 17, 2002 01:06 PM

Krugman's early writing about the liquidity trap in Japan was important because there was really no reason to expect that a developed economy would experience such a problem after what had been learned from England in the 20's and America in the 30's. If the liquidity trap in Japan developed from growth below capacity after the bubble, then we have to worry about the same no matter much we may mock Japanese macro policy. Deflation seems a danger to be closely attended to in America as slow growth persists.

Posted by: on August 18, 2002 09:08 AM
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