Friday, June 26, 2009

The Output Gap - A false and Dangerous Theory

Please click on image to see details.

In my last post, I talked about the likelihood of inflation in the U.S. in the near future and I was trying to debunk some of the theories that claim the opposite. I will continue on that note today and talk about one issue that is supposed to make inflation an impossibility during an economic downturn: the output gap.

The “output gap” is a measure of the difference between economic activity in an economy when times are sustainably good, and when there is a downturn. A lot less goods and services are produced during an economic crisis, for obvious reasons, and that is what accounts for the output gap.

Most economists who are currently advising the Obama administration or who are given time in the media are pointing to this output gap. They are saying that the current level of production in the U.S. economy is “unnaturally low”, and hence there is a lot of “slack” in the economy.

This slack, it is thought, can simply be filled in by printing more money, in order to save the economy. Because of the slack, inflation will not be created because the money printing is simply making up for the consumption which has disappeared, but should still be there, it is thought.

In other words, they are saying that the level of production today in the U.S. is not as high as it’s “supposed to be”.

In reality, they are saying that factories are “supposed to” produce more cars, TVs and clothes, and that people are “supposed to” get more haircuts and eat out more often.

But why should this be? Who says that there’s a “natural level” at which consumption should be? Definitely not me…

Please take a look at the model that I drew up in the beginning. This is an illustration of the U.S. economy. The important thing to see in the model is that both consumption and economic output will very likely be lower in 2009 compared to what they were in 2006. My model explains the very simplest of economic linkages: output follows consumption, or put in other words: supply follows demand.

Since the crisis started, demand has gone down rapidly all across the economy. Demand for houses, labor, haircuts and basically everything else has gone down. Naturally, there would be no point in producing any of those things if nobody wants to pay for them, so production goes down.

In order to find out what happened to the demand, what made it go down, one must look at what was fueling it, where the money was coming from.

Maybe the country had an export good, the price of which suddenly dropped like a rock. This recently happened to Russia and its oil. Consumption in Russia consequently went down because a lot of money disappeared.

Maybe the country had a brain drain of people which made key industries less productive. This happened in Zimbabwe when the country expelled its white farmers. A lot of money disappeared, and, incidentally, the Zimbabwean government tried the trusty method of printing money, with less than fabulous results.

There are many ways in which an economy can get in trouble, but no matter what, during times of crises, consumption and output will go down. Where was the money coming from in the U.S.? The answer is: credit.

Wages in the U.S. have been stagnant for over 30 years, and in order to make up for that, Americans have been taking loans to fuel consumption. Credit is the very thing that disappeared in this crisis, and that is what is decreasing demand.

In order for the output gap to be closed without anything radically changing in the economy, credit would have to come back as an economic force just as strong or stronger than before. We all know that that is not going to happen, so where does that leave us?

If there are no prospects of this gap being closed by new credit, then there is no slack in the economy, and money printing will simply be the futile and devastating activity it was in Germany and Zimbabwe.

The gap would have to be closed by something else, such as a more successful export industry. If, by some miracle, the U.S. export industry were to become extremely successful within a matter of months, so that the trade gap could be closed and turned into a surplus, then maybe the theory of the output gap could be relevant. The U.S. would have to stage an unprecedented economic miracle. Somehow I don’t see that as very likely.

The theory of the output gap can be relevant in normal economic times, when simply analyzing small ups and downs. But this theory is wholly irrelevant in a structural crisis or a depression.

In conclusion: the theory of the output gap is false and irrelevant because it is based on a notion of the imminent return of the credit-fueled good times. Using this theory as a justification to print money has been done before, with disastrous inflation as a result.

The economy is not "supposed to be" anything. It is only what you make it in to!

Moreover, I advise that the winner-takes-all voting system should be destroyed.


Anonymous said...

You have to put this blog on twitter. it would greatly increase it's popularity.

Why are you so grim on exports? haven't you seen how well the iphone has been selling? and in that sense, isn't that where America's strength lies in terms of exports? in it's innovative technological products that it keeps producing?

Also, hollywood movies. Look at how well the transformer did.

Jacob said...

Yeah, sure, that's where America's strength lies. America just needs to become more successful across the board so that the country can have a trade surplus, like Germany and China.

America has relied too much on "paper profits", a lot of which has now disappeared. For 20 years, it has been said that American workers are more productive than European or Asian workers, but if you factor in paper profits, that has only been an illusion

Anonymous said...

You have twisted or misrepresented what RESPONSIBLE supporters of the stimulus are saying, which is that there is an INVESTMENT gap, as consumers are now NOT spending (if not saving, which many are) and it takes investment (by business, which under the current drop in consumer spending, sees no reward in making investments) which is why it falls to the government as agent of last resort, to meet the investment demand by buying goods (public infrastructure), sponsoring research into needed goods (green energy) and supporting state services that the falling economy is putting in peril along with the needed continuation of state employment. It is this last that is being seriously stressed at the moment with the passage (or not) of state budgets.

Anonymous said...

Why is inflation dangerous? Well, it isn't. It harms people with money and helps people with debt? Who has money? People in power.
The only way out of this jam is for inflation to liqidiate everyone's debt, make Chinese wealth turn to pennies, and allow people to pay off homes they could not afford in yesterday's dollars with tomorrow's enormous wages.
Let interest rates climb to 17% and the minimum wage go to $17/hr and we'll see people out of their consumer debt in no time.

Jacob said...

Back in the 30s, that's exactly what the Germans did. They turned their debt to the French and English into pennies, but German money became so worthless that people used it for firewood.

When you have healthy and steady growth, moderate inflation can be good, but when times are bad, inflation is usually devastating.

Of course it can be good for people with debt, but eventually there's no avoiding massive job losses and economic stagnation.

Anonymous said...


I applaud your efforts in this blog, but I believe you are not fully engaging in what the output gap meanst.

You are saying that the demand of the past was buffed up by credit, and if that credit goes away, demand will fall, as will production.

But it is final production that falls, not productive capacity. You see, if John had a factory producing 100 widgets a year in 2006, and in 2009 demand falls to 50 widgets a year, John will only produce 50 widgets a year in his factory. It does not mean that his factory is unable to produce 100 widgets. It only means he is running at 50% capacity!

And what happens in this scenario? The price falls! Why? Because the productive capacity is the same, but demand has gone down. When you shift the demand curve to the right, with fewer buyers, price goes down.

The result is deflation. This is why printing money during a time of credit contraction will not create inflation. More money is being created yes, but at the same time an even greater amount of money is being destroyed through the process of deleveraging. The money which was created by fractional reserve banking is being destroyed. Total money in the economy does not increase, it decreases.

You talk about the US becoming competitive in exports. The only way the US will become competitive in exports, is if it becomes worthwhile for foreigners to buy things that Americans make. And the only way for that to happen is to allow the US dollar to trade at market price. Period. The reason the Chinese are such huge exporters is that Chinese stuff is cheap to buy... because their currency is cheap. The dollar has been artificially propped up by foreign central banks as a form of 21st century mercantilism, and we have allowed them to do it. That is why we have had such huge deficits and declining industry. An overvalued currency has also encouraged Americans to over-consume on imported goods. Only by devaluing the dollar, to its true market value (which is a lot lower than today's price), can Americans hope to restore industry and thrift.

Jacob said...

Dear anonymous,

when I talk about how a lot of people think that the economy is "supposed to" be at a certain level, I am talking about the capacity, such as the capacity in your example with the factory.

With this blog entry I'm saying that traditional economic theory does not apply in a structural crisis, and as a result, demand curve theory is irrelevant right now. You should seriously consider this possibility.

Consider any industry that has gone obsolete in this country. It would not have mattered how much stimulus the garment industry in the Western world had received, it was doomed anyway.

A more relevant example might be the lucrative trading in railroad bonds wrapped up in complex derivatives back in the 1870s. Investors fueled railroads to nowhere just like they fueled McMansions in the desert in present times with subprime derivatives. It was all a job that didn't need doing; it was a bubble.

That is the structural crisis now: what we used to do, we cannot do anymore, and there's nothing we can do about it.

So, that which used to be, has to be taken out of the demand equation. A new excess of money will chase new things, unrelated to the old ones, which were part of the capacity which is now irrelevant.

It is not a zero-sum game in this environment, and for that reason, your theory does not work.