From the TUC

The Output Gap, the Structural Deficit & UK Macroeconomic Policy

05 Oct 2012, by Guest in Economics

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.

Paul Krugman writes that:

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.

He’s right.

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).

I’ve long argued that in the UK the labour market adjustment came mainly through falling real wages rather than rising unemployment. As I wrote earlier this year:

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.

This is a major problem with the Government’s fiscal framework.  

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.

3 Responses to The Output Gap, the Structural Deficit & UK Macroeconomic Policy

  1. Andreas Paterson
    Oct 5th 2012, 12:54 pm

    Great post Duncan, one thing that’s really depressing me at the moment is how off the radar this kind of discussion is in mainstream political debate. A lot of questioning of Labour politicians has focussed on the question “How are you going to deal with the deficit?” a question that can’t really be answered with anything other than “cuts” or “tax rises”. If the output gap is indeed larger than thought then a sensible answer to the question would probably be “Leave things as they are for about 4 years or so..” but somehow I can’t see an answer like this being accepted in our current political climate.

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