July 25, 2003

Stephen Roach Talks About the Output Gap

Morgan Stanley's Stephen Roach talks about the output gap--how what matters for the changing rate of inflation isn't whether the economy is growing fast, but whether there is a lot of slack in the labor market:

Morgan Stanley: Macro certainly has its moments in captivating financial markets. I suspect another one of those moments is now at hand. The debate over deflation has been given a new lease on life by Federal Reserve Governor Ben Bernanke. He has now set the risks of deflation squarely in the context of an "output gap" framework -- long a central tenet of macroeconomic analysis (see his July 23, 2003, speech, "An Unwelcome Fall in Inflation?" available on the Fedís website). Using this macro construct, Bernanke has concluded that even if the US economy now enters a period of solid recovery, the risks of deflation are going to be with us for some time to come. I couldnít agree more.

Like most concepts in economics, the output gap is a complex restatement of a very simple premise -- the inflationary consequences of disparities between aggregate supply and demand. Alas, what always sounds simple in macro rarely is. Economists attempt to get at the notion of aggregate supply by assessing the growth of "potential" output (GDP) -- defined broadly as the sum of labor force growth and trend productivity. In essence, the output gap is then calculated as the difference between an economyís growth potential and its actual level of aggregate activity. When output gaps are at "zero," it's the best of all worlds -- supply and demand are in perfect balance and, at least theoretically, the economy is at full employment and able to enjoy the luxury of a stable inflation rate. When demand exceeds potential -- a positive output gap -- inflation can be expected to accelerate. Conversely, shortfalls from potential -- a negative output gap -- are invariably associated with falling inflation; they reflect excess slack that gives rise to a phenomenon referred to as "disinflation." As such, recessions are generally depicted as disinflationary macro events, while recoveries are thought to be inflationary.

As presented in this fashion, the output gap is all about levels of aggregate activity. This stands in contrast to the growth rates that color most of our impressions about the performance of economies. This is a critical distinction. An economy can be growing at, or even above, its potential growth rate and still have ample margins of slack capacity in labor and product markets; disinflationary pressures would prevail in such instances. Conversely, a fully employed economy growing slower than its potential growth rate would still be biased toward an inflationary outcome. In other words, initial conditions matter. An economy's growth speed is not enough, in and of itself, to determine the ups and downs of the inflation cycle. The verdict is critically sensitive to the state of resource utilization...

Posted by DeLong at July 25, 2003 08:03 AM | TrackBack

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http://www.nytimes.com/2003/07/25/opinion/25KRUG.html

Dropping the Bonds
By PAUL KRUGMAN

In his July testimony to Congress on monetary policy, Alan Greenspan was cautious but _ adjusting for his usual funereal demeanor _ quite upbeat. ``Although the uncertainties of earlier this year are as yet not fully resolved,'' he declared, ``the U.S. economy appears to have withstood a set of blows. Not surprisingly the depressing effects of recent events linger. Nevertheless, the fundamentals are in place for a return to sustained healthy growth.''

O.K., I cheated: those quotations come from his testimony in July 2002, not July 2003. Needless to say, ``healthy growth'' failed to materialize. Undaunted, he said pretty much the same thing last week _ and the result was to reinforce a huge sell-off in the bond market, which may undermine the very recovery he predicted....

Posted by: jd on July 25, 2003 08:16 AM

There is a lot of slack in the labor market and there will contiue to be a lot of slack. Labor in America is increasingly competing with labor in China and India, not unskilled labor but skilled labor, not only in manufacturing but in services. We really have global labor markets, and China in particular and India somewhat less so have highly skilled workers and the investment flows to compete with American and European and Japanese workers.

Global supply is large, global demand is not strong enough to tax global supply. Indeed, in America, productivity is growing strongly. There is simply not enough demand to significantly cut American joblessness.

Posted by: anne on July 25, 2003 08:31 AM

Given the output gap between capacity and demand, isn't the current fiscal policy mis-targeted? The current policy is giving huge tax cuts to the wealthy investor class in an effort to stimulate business investment and hiring. But doesn't that overlook the need to increase demand in order for business investment to be productive? Wouldn't it make more sense to target fiscal policy at increasing demand and let investment and productivity take care of itself until demand starts to increase?

Posted by: bakho on July 25, 2003 08:52 AM

Oh, I get it, we should have a temporary tax cut that would most benefit for middle class families and add some money to state budgets that would avoid cuts in services or fee increases. Sure, but that would take another Congress and another Administration. As Garrison Keeler say, "we're all Republicans now." Yeah.

Posted by: lise on July 25, 2003 09:02 AM

Bakho, I think that that's been the message of Brad and Krugman for quite a while - that it would be better policy to target tax cuts to lower income people, who will spend it immediately. Bush's tax cuts have been targeted far higher on the income scale. In fact, there's been at least one post where Brad was pointing out that Bush was (by mainstream economic theory) hurting his chances of re-election by doing so.


Posted by: Barry on July 25, 2003 09:06 AM

http://www.nytimes.com/2003/07/25/business/worldbusiness/25TRAD.html

Textile Industry Seeks Trade Limits on Chinese
By DAVID BARBOZA

In another sign of how American companies are struggling in the face of China's export powerhouse, a coalition of textile and apparel industry groups asked the federal government yesterday for new protections against what it called unfair competition....

Note: Chart on Chinese Competitiveness

Posted by: anne on July 25, 2003 09:14 AM

I think people are looking at this in "old world" type ways, as though buying more manufactured products is going to get us out of this. Personally I have just about all the Rubbermaid containers full of stuff in my house that I can possibly stand to have around. I see younger people that are more conservative in their buying habits, and not everybody believes that the buying binge that we have been on in the US since the 70's has been a good thing, and you may not be able to increase "demand" by any means. Many people do not accept that pushing the world to our level of consumption is even possible or sustainable anyway. More the problem is how to pay for services like health care, education, insurance that do not price compete on world market.

Posted by: northernLights on July 25, 2003 09:22 AM

"Many people do not accept that pushing the world to our level of consumption is even possible or sustainable anyway. More the problem is how to pay for services like health care, education, insurance that do not price compete on world market."

Services surely do price compete on the world market unless there are artificial limits to competition. Of course health care and insurance and education price compete.

Again, I would surely wish to raise the level of consumption in much of the world. If only there were far far more consumption in sub-Saharan Africa and most of Asia including China. Imagine the demand that could be filled from 550 million "middle class" people in southern Africa.

Posted by: anne on July 25, 2003 09:32 AM

"... shortfalls from potential -- a negative output gap -- are invariably associated with falling inflation..."
~~~

While I don't doubt that would be true today, one might remember that during the years after 1932 deflation ended and inflation returned and accelerated while unemployment remained between 20% to 25%.

Posted by: Jim Glass on July 25, 2003 09:41 AM

>Imagine the demand that could be filled from 550
>million "middle class" people in southern Africa.

Here, here! And -- for those of us in whom pessimism about the apparent direction of the (politico-cultural-economic) world is always warring with a knee-jerk American faith in technology and progress -- imagine the science, art, engineering and philosophy that 550 million (or perhaps it's 800 million, who knows) sub-saharan Africans would add to the world's store of Good Things, were education, health care and freedom from war and famine available to most people in that region.

Posted by: Kwindla on July 25, 2003 09:45 AM

http://economist.com/markets/PrinterFriendly.cfm?Story_ID=1943917

the economist has a nice chart of OECD country output gaps -- or surfeits in the case of ireland, greece and NZ (iceland and canada remain in blessed balance :)

maybe if they included drug production and consumption [ http://economist.com/markets/displayStory.cfm?story_id=1944245 ] in GDP it'd go away!?

Re: Chinese Competitiveness

david "nuclear" wessel notes [ http://online.wsj.com/article_email/0,,SB105899883166474800,00.html ] an interesting foreign policy piece that [ http://foreignpolicy.com/story/story.php?storyID=13774 ], while not disputing "China's export powerhouse," suggests that it may be overstated, esp wrt to india; in particular noting china's achilles' heel:

Joydeep Mukherji, who tracks India and China for Standard & Poor's in New York, thinks the professors are onto something. Taking a number-cruncher's approach, he finds the Chinese miracle less impressive than its press clippings. Shave a bit off the official statistics for exaggeration, and China has grown perhaps 7% a year for the past decade or so. India has grown 6%. But China, as a nation, saves about 40% of income, and invests that plus what foreigners invest. India saves about 24% domestically, and draws relatively little foreign investment.

So China, to make it simple, is like a business that invests $40 and earns $7 a year. India invests $24 and earns $6 a year. "A huge amount of money in China is wasted," Mr. Mukherji says, particularly investments made in China by the Chinese government. "For a country that's so big and saving so much, China is unusually dependent on foreign investment." That is key to its success, but also underscores how poorly its domestic investments fare. About half the loans made by China's banks will never be paid back; a lot of Chinese savings has been squandered.

Posted by: dirk! on July 25, 2003 10:02 AM

The population of sub-Saharan Africa is about 675 million. My figure of 550 million was an imagined thought about what such a middle class population would be capable of. This is precisely the point Nelson Mandela has made over and over. Mandela by the way has often remarked that Singapore would be the proper development model for southern African states.

Posted by: anne on July 25, 2003 10:05 AM

http://economist.com/markets/PrinterFriendly.cfm?Story_ID=1943917

the economist has a nice chart of the OECD country output gaps that stephen notes -- or surfeits in the case of ireland, greece and NZ (iceland and canada remain in blessed balance :)

maybe if they included drug production and consumption [ http://economist.com/markets/displayStory.cfm?story_id=1944245 ] in GDP it'd go away!?

Re: Chinese Competitiveness

david "nuclear" wessel notes [ http://online.wsj.com/article_email/0,,SB105899883166474800,00.html ] an interesting foreign policy piece that [ http://foreignpolicy.com/story/story.php?storyID=13774 ], while not disputing "China's export powerhouse," suggests that it may be overstated, esp wrt to india; in particular noting china's achilles' heel:

Joydeep Mukherji, who tracks India and China for Standard & Poor's in New York, thinks the professors are onto something. Taking a number-cruncher's approach, he finds the Chinese miracle less impressive than its press clippings. Shave a bit off the official statistics for exaggeration, and China has grown perhaps 7% a year for the past decade or so. India has grown 6%. But China, as a nation, saves about 40% of income, and invests that plus what foreigners invest. India saves about 24% domestically, and draws relatively little foreign investment.

So China, to make it simple, is like a business that invests $40 and earns $7 a year. India invests $24 and earns $6 a year. "A huge amount of money in China is wasted," Mr. Mukherji says, particularly investments made in China by the Chinese government. "For a country that's so big and saving so much, China is unusually dependent on foreign investment." That is key to its success, but also underscores how poorly its domestic investments fare. About half the loans made by China's banks will never be paid back; a lot of Chinese savings has been squandered.

Posted by: dirk! on July 25, 2003 10:07 AM

Though the Administration has been boasting about a $15 billion AIDS package for southern Africa and the Caribbean, no money was in the budget for 2003 and the House of Representatives has put only $2 billion in the budget for 2004.

Posted by: anne on July 25, 2003 10:12 AM

aaugh!

Posted by: dirk :(( on July 25, 2003 10:14 AM

When I read the Economist on China, I am always reminded that some of the British still have not gotten over the end of empire, especially the "loss" of Hong Kong. The Economist always belittles Chinese development, but is wrong. China is making sharp and continual development gains, though there are continuous frictions socially and economically. An extensive and capable middle class has formed and is radidly growing.

Posted by: dahl on July 25, 2003 10:20 AM

yeah, it looks like africa bore the brunt of the budget cuts to foreign aid. the millennium challenge pot was also reduced. i guess something or someone had to give :((

Posted by: dirk! on July 25, 2003 10:32 AM

I think I'm going to re-iterate this idea because it is relevant re: Africa.

Once the U.S. hits near zero inflation, the Fed can print money at printing cost (i.e. not dilute its value), can it not? I mean, inflation would have to hit 3-5% before it could hit 1000%, and you could stop printing it at any time, right?

So, why not just give massive aid to Africa? You can do it for printing + shipping costs and it will stimulate global demand, won't it?

Of course, it will never happen. Neither will consumer favorable restructuring. No chance.

Posted by: Lorenzo on July 25, 2003 10:39 AM

The paradox that low interest rates may have infact increased the risk of deflation needs to be addressed. By lowering interst rates too fast, Greenspan allowed overextended companies like Worldcom to stay in business, meaning that excess capacity in many sectors has not been removed. And at current interst rates, this excess capacity has no trouble remaining.

On the other side of the coin, interest rate cuts have stimulated demand by as much as they can. Result; an enduring gap and enduring deflation

Posted by: Giles on July 25, 2003 10:52 AM

http://www1.worldbank.org/hiv_aids/

The World Bank just published a most discouraging report on the development effect or cost of AIDS in Africa. There is such potential through Africa and an avid hope that America will involve itself more deeply in African development, but other than securing strategic bases or oil field rights we are doing so little.

Posted by: anne on July 25, 2003 10:58 AM

The capacity of WorldCom or Enron or Arthur Anderson did not disappear with bankruptcy or dissolution. If the Fed had not been agressive in lowering interest rates, the recession and slow recovery would have been far worse. the idea of harming the economy to save it makes little sense. If WorldCom adds to competition in the telecom sector we are better off for it.

Posted by: jd on July 25, 2003 11:16 AM

We reportedly had a huge output gap in 1990-91, too. Then we spent most of the decade watching capital spending take off like a rocket ship, with the investment-national income ratio reaching levels not seen in several generations.

What does this tell you about the utility of the idea of an "output gap", or of "overcapacity"?

I'd rather see someone write about restructuring economic activity, which seems to be going on with incredible vigor, partly because of China and India, but mostly because we are blessed with flexible labor markets that permit sectors of the economy to shrink when they are no longer profitable. A collection of economists ought to view this as a good thing, I would think.

Posted by: Jim Harris on July 25, 2003 11:27 AM

I think I'm going to re-iterate this idea because it is relevant re: Africa.

Once the U.S. hits near zero inflation, the Fed can print money at printing cost (i.e. not dilute its value), can it not? I mean, inflation would have to hit 3-5% before it could hit 1000%, and you could stop printing it at any time, right?

So, why not just give massive aid to Africa? You can do it for printing + shipping costs and it will stimulate global demand, won't it?

Of course, it will never happen. Neither will consumer favorable restructuring. No chance.

Posted by: Lorenzo on July 25, 2003 11:30 AM

Is Mr. Roach suggesting that we can have excess demand in terms of the capital stock while we at the same time have excess supply in terms of labor? If so, this has interesting policy implications. Actually, I suspect we have a bit of excess supply for the former but then enough aggregate demand growth in the short-run could quickly put us into the dilemma he may be desribing. So how would the market react or how should policy address this? If we do have a shortage of capital and an excess demand for labor, the market would tend to reduce real wages. Then again - a policy of fostering more savings would alleviate the shortage of capital employing more workers at higher wages. So then one would think our policy makers would avoid this long-term fiscal stimulus which lowers savings.

Posted by: Hal McClure on July 25, 2003 11:51 AM

Giles, the investment in Worldcom was made years ago. If those investors had seen the future accurately they would not have made the investment at that time. As for what to do with it now, there is a difference between bankruptcy and shutting down operation. If a company's operations can generate money there is no reason to shut down because of a past financing decision. The equity holders and the debt can all be erased in court, so interest rates don't determine this.

Also, this liquidationist view of recessions is just plain incorrect. I'm not really sure what the appeal of it is to some (moral appeal?), but that way of thinking pretty much went out of fashion with the Great Depression. Just about any mainstream economist would say lower interest rates stimulate the economy and increase inflationary pressure and higher interest rates slow the economy and decrease inflationary pressure. No paradox.


Posted by: snsterling on July 25, 2003 12:00 PM

This coming year, America will have a combined private and public saving rate that is zero or negative. Private saving is quite low, and there is a sharply rising public deficit. There will be an absence of domestic saving to fund investment, and we will be relying on foreign capital inflows of about $3 billion a day to fund the balance of payments deficit. We are saving far too little, and draining off savings from other countries.

Posted by: jd on July 25, 2003 12:09 PM

We must think of capacity now in international terms to a much greater dgreee than in 1990. The competitive structure of the world economy has changed significantly. There must be an increase of demand both in America and abroad to deepen capacity use, but American private demand has remained high for a recession and slow growth period and demand abroad has never jumped for the declines of 1998.

Posted by: anne on July 25, 2003 12:21 PM

jd

So true. Net investment as a share of NNP is now about half what it was from 1951 to 1980. Back then - all of our investment was financed by national savings as our current account was virtually zero on average. Now none of our investment is financed by savings as what little investment is done is financed by our huge current account deficits. And the White House talks about saving and investment for long-term growth while their fiscal policies eat up what little private savings exists. Bad for growth, bad for real wages, and promotes great income inequality over time (= rising poverty).

Posted by: Hal McClure on July 25, 2003 12:51 PM

Question - Does the recent rise in interest rates threaten to slow the economy? Suppose the mortgage refinancing boom slows? A raid rise of 110 basis points strikes me as sharp.

Posted by: dahl on July 25, 2003 12:52 PM

Hal McClure - Powerful comment!

"Now none of our investment is financed by savings as what little investment is done is financed by our huge current account deficits. And the White House talks about saving and investment for long-term growth while their fiscal policies eat up what little private savings exists. Bad for growth, bad for real wages, and promotes great income inequality over time (= rising poverty)."

Posted by: anne on July 25, 2003 01:05 PM

Hal McClure

We must think more about the declining pool of savings. Why are we pulling savings from other countries given our development level? Worrisome.

Thanks
JD

Posted by: jd on July 25, 2003 01:26 PM

I'm not saying viable companies should be liqudated to close the gap, merely that when there is not interest spike going into a recesssion firms that have over extended themselves are not driven out of busiess.

And when Interest rates remain very low, then firms with debts they will never be able to repay, remain solvent on a day to day cash flow basis. This is the Japanese scenario where the Banks keep bad debts on the books because at 1/2 interest rates even the worst businesses can keep servicing their debts.

The second reason is a matter of signalling - by bankrupting over extended debtors a signal is sent out to the rest of the market about where the excesses were and where the mistakes were made. With this new infomation, the potential GDP of the economy is increased. Without it stays the same and hence exacerbates any deflation.

Posted by: Giles on July 25, 2003 02:51 PM

Dirk! writes:
>>>>>>
So China, to make it simple, is like a business that invests $40 and earns $7 a year. India invests $24 and earns $6 a year. "A huge amount of money in China is wasted," Mr. Mukherji says, particularly investments made in China by the Chinese government. "For a country that's so big and saving so much, China is unusually dependent on foreign investment." That is key to its success, but also underscores how poorly its domestic investments fare.
<<<<<

This is a good superficial point. Meaning that it is true, and important to understand, but insufficiently nuanced.

Much of the discrepancy in the Chinese ROI numbers (particularly, the bad debt problem) derive from the way the Chinese leadership has chosen to transition its economy from state-owned five-year planning to regulated markets of shareholding corporations.

In reality, the anamolous savings and loans situation is a disguised form of transfer payments from beneficiaries of the growing private sector economy to those stranded in the shrinking legacy economy.

Thus, ROI is not what you want to look at in terms of competitiveness vis-a-vis China and India. Much more reflective of China's underlying economic transformation is the breadth and depth of its absorbtion of the global manufacturing value chain.

The last ten years has seen China evolve from being a provider of low-value-added unskilled labor to a nest of fledgling high-value global brands (Haier, Legend, Huawei, etc.). India, on the other hand, has largely been exploiting a pre-existing resource (well-educated English-speaking professionals) that has only become exportable through recent advances in information technology.

Posted by: Michael Robinson on July 26, 2003 07:05 AM

http://online.wsj.com/article_email/0,,SB10591745276924200,00.html

good point, which i think underlies the argument for upward revaluation of china's currency, way below PPP according to the economist's BMI :D and it was the CIA i think, which did a study that suggested china's economy on an upwardly revalued basis is already #2..!

would india's capital account become freely convertible?

Posted by: dirk on July 26, 2003 10:12 PM
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