The Output Gap and the Innovations Gap

A major objection to my suggestion that the UK is in an self-fulfilling expectations led recession is that measures of the output gap suggest that gap is near zero. What I want to argue here is that measures of the output gap ignore what I will call the innovations gap, and the innovations gap could indicate that demand expansion would not be inflationary.

The output gap is the difference between actual output and trend output, where trend output is the level of output at which inflation is stable. The OBR are the output gap kings. They have a composite measure, which Ben Chu shows here, but this is derived from many different measures, shown in the OBR’s latest forecast on page 36. The OBR also show (p38) that estimates produced by other organisations vary widely. Most measures of the output gap can be categorised into four kinds.

1. Time series filters. These, at their most simple, just smooth the data on actual output to produce the measure of trend output that is one half of the output gap. These have no economic content and therefore tell us almost nothing.
   
   
2. Production function estimates. These combine measures of the labour force with the capital stock to give potential output: the level of output that could be produced if all factors of production were fully utilised. The major problem with these measures is that they have no measure of technology: how much can be produced by capital and labour. What is generally done is to use time series methods to estimate this, which takes us back to the smoothing idea. As a result, measures produced by the IMF and OECD suggest the years before the recession were a huge boom, which is implausible given other evidence we have.
   
   
3. Labour market measures, like unemployment or participation. There are of course many problems in knowing what the non-inflationary level of these variables are.
   
   
4. Firm surveys. These ask questions like are you producing at normal levels of capacity utilisation. The answer you get right now is that firms are indeed working close to normal capacity.
   
   

With these definitions in mind, what we have to ask is do any of these measures tell us what we really want to know, which is would firms react to increases in demand by raising prices and wages. I want to argue that they may not after an economy has grown at rates well below previous trends for a while. The reason is that, in these circumstances, firms may know that their current production methods are outdated, too labour intensive and inefficient, but at current levels of demand it is not worth them investing in new techniques. However if demand did increase, rather than raise prices to choke off that new demand, it would be more profitable to investment in new equipment to meet that additional demand. An expansion in demand would not be inflationary because firms would not raise their prices. In addition, because these new techniques were labour saving, there would be no inflationary pressure in the labour market (although real wages would rise because productivity increased).

We can tell the following story about the UK economy. At the peak of the recession, unemployment was high and firms had spare capacity. All the output gap measures said the output gap was large. What would normally happen next is that output would start recovering rapidly at above trend rates of growth, leading to a pickup in investment and new techniques being embodied in new production. But that didn’t happen in the UK, mainly because austerity held back demand and interest rates couldn’t go negative. 

When demand did finally begin to expand at a modest rate in 2013, cautious firms decided to meet that additional demand not through new investment but by using existing spare capacity. During 2013 and 2014 employment increased and the output gap fell, but productivity was stagnant because most firms were not investing in new techniques. (The market leaders were, because being market leaders they were expanding more rapidly and investing. So as Martin Sandbu has discussed, the UK productivity puzzle is associated with the average firm, not leading firms.)

This meant that by 2015, unemployment had fallen to more normal levels, and firms no longer had spare capacity. All this had been achieved with stagnant productivity growth, because most firms had stopped investing in new innovations. It was not because those innovations had stopped being made. So the output gap had been replaced by an innovations gap, with most firms using out of date production techniques that are too labour intensive.

If this story is right, we have become locked in a self-fulfilling low growth trap. Firms will not invest because they see recent slow growth continuing. They are right, because policymakers, looking at the output gap rather than the innovation gap, are doing nothing to expand demand for fear of inflation, or worse still because of mistaken worries about government debt. I do not know if this story is right, but it seems to me that the cost in lost output if it is right is so great that it is foolish to ignore this possibility.