The Output Gap, the Structural Deficit & UK Macroeconomic Policy
Yesterday the FT’s Alphaville blog published a long post about Capital Economics latest missive on the UK economy. It argues that the output gap is potentially a lot bigger than many people think.
I won’t attempt to summarise it here, it’s important and those interested in the UK macroeconomic policy debate should go and read it.
And here’s the thing: if British capacity is a lot bigger than estimated, everything people say about fiscal policy, in particular, is wrong. The structural budget deficit is much smaller than claimed, as is the need for adjustment. The case for austerity is also weaker, and the costs of austerity in keeping the economy depressed are much larger.
In my mind the idea that the output gap might be much bigger than estimated has three important conclusions:
First – the case for a fiscal stimulus is much stronger than currently thought and the case for immediate austerity is even weaker. Now this isn’t anything new – as Nicola has argued – on the current OBR numbers the UK economy has spare capacity and the impact of an interest rate rise (which properly won’t happen anyway!) would lessen than many assume. But if the output gap is bigger, then this argument is stronger.
Second – ‘supply side pessimism’ is doubly damaging. Many observers are confused about the current paradox in the UK economy – why is output doing so badly whilst employment is doing so “well” (I use the term “well” in speech marks deliberately, 8.1% unemployment in the US is rightly seen as a disaster, I’m continually amazed at it being ‘good news’ in the UK).
This collapse in real wages maintained employment at a higher level than it otherwise would have done and also supported corporate profits. But – given weak demand, higher employment means (all things being equal) lower output per worker…
In other words, via the connection of real wages, the UK’s weak productivity growth may be a function of low demand rather a problem affecting the supply side of the economy.
If the ‘productivity problem’ is actually caused by weak demand, then the Government’s austerity drive risks making it worse. And policies that boost demand will increase productivity.
Third – the Government is targeting the structural deficit. The size of the structural deficit depends upon estimates of the output gap. If the output gap is larger than estimated, then the structural deficit is smaller than estimated and we have more austerity than ‘is required’ to close it.
Does it really make sense to be planning fiscal policy 4 to 5 years out on the basis of something like this? Does the Chancellor not risk aiming at a moving target?
As I said, it’s an important post from Alphaville and I highly recommend reading it.