If one were to point to a single metric to explain why economics is frequently held in low regard by other scientific disciplines and the man in the street, it would be hard to find a better example than the output gap.
Methodologically torturous? Check. Obscure? Check. Effectively unprovable? Check. Conceptually contentious to the point where entire schools of economic thought dispute its existence? Check and double check.
While it might be tempting to look at the above and conclude this is strictly a debate for academics, to do so would ignore the fact this is now one of the most important questions facing the UK economy and one of the biggest determinants of your future wealth.
The output gap is essentially the difference between real and potential GDP and so the limit beyond which growth begins to get seriously inflationary. That apparent simplicity rapidly gets muddied by the many ways it is possible to measure productivity, the fact that potential GDP is unknowable and any attempt to calculate it is intrinsically speculative.
The growing urgency of the question is of course due the UK’s suddenly soaraway growth and the BoE’s extended period of easy policy: how long can it sit on its hands without inflationary friction taking root? Or if it acts soon, will the increasing cost of household leverage choke the recovery?
Given the number of variables and the lack of a single universally recognised methodology, the range of opinions on the size of the gap is unsurprisingly large (see chart on opposite page) – basically as large as the number of economists willing to hazard an opinion.
The increasing significance of the output gap can be read in its increasingly prominent place in BoE communications, and the level of disagreement it has generated between policymakers, taking something like a starring role in Monetary Policy Committee (MPC) minutes released last week.
Futures markets brought forward the expected timetable for an increase in interest rates following the minutes, after MPC members said they anticipated spare capacity in the economy equivalent to between 1-1.5% of GDP, but added there was ‘considerable uncertainty around that central estimate, however, and a range of views on the committee’.
If the actual figure was the cause for debate inside the committee, there was considerably less genteel disagreement outside it, ranging from the exceptionally hawkish view of the former BoE economists at Fathom that that the UK is already operating at above nominal capacity and inflation already building, to the doves of Capital Economics, who believe the UK will need years of easy money to approach its potential.
‘With productivity drifting sideways for the past five years, in our judgment the output gap has already closed,’ said Fathom in a recent research note, which predicted consumer price inflation would bounce back to 3% and wage inflation climb to 4% by the end of the year.
‘Labour shortages have become more widespread, and are feeding through to higher wage inflation. If we are right about the output gap and the MPC’s reluctance to respond with interest rates – then sterling will fall sharply from today’s levels.’
The MPC clearly leans closer to this view than the most dovish end of the spectrum – hence at least two members beginning to talk about a ‘more balanced’ view of rate policy. But a significant number believe that falling unemployment will only begin eroding unused capacity once they begin to utilise the underemployed and those registered as ‘self-employed’. About 40% of part-time workers say they would like to work more hours.
The argument that the crash and subsequent depression destroyed much of the UK’s potential output is a central plank of the hawk’s argument. But the persistence of under-employment is, among other reasons, why doves such as Capital Economics argue this idea is overdone.
‘Underemployment, where people are in employment but want to work more hours, reached a record high in the first half of 2013,’ wrote Martin Beck of Capital Economics.
‘This means there is more slack in the labour market than the unemployment rate suggests and implies wages will recover more slowly than in past recoveries. The fact that falling underemployment is likely to slow the decline in the unemployment rate should also push back the date at which the MPC considers raising interest rates.’
There is the risk, though, that regardless of the state of the economy, belief in the existence of an output gap can easily become a self-fulfilling prophecy – if business managers are convinced that they have to add additional capacity, then they create their own bottlenecks.
‘The [Office for Budgetary Responsibility] remains cautious about the remaining scope for expansion given the rapid decline in unemployment and continuing weak productivity performance,’ said Andrew Smith, chief economist of KPMG.
‘But this “output gap pessimism” risks being self-fulfilling – if there is actually more spare capacity and we don’t use it, we will indeed lose it.
‘No-one really knows how much headroom there is and the cost of underestimating productive potential in terms of permanently lost output and jobs, not to mention unnecessary austerity measures, would be unacceptably high.’