Mind the Gap

I’ve been very busy over the last few weeks, which is why there hasn’t been much on here of late and why I missed some fascinating discussions a few weeks ago about the size of the Output Gap. No, don’t switch off. The Output Gap is not just a concept invented to amuse economics wonks. It’s actually quite important.

As Economics Help explains, the Output Gap is the difference between the economy’s actual and potential output. If the economy’s poor performance is simply due to recession and it has the capacity to bounce back, then there is plenty of potential growth and the Output Gap is high. If, however, the economy is performing badly because it has fundamental structural problems, then the Output Gap is much lower. The problem with recessions is that, until the economy picks up again, we don’t really know what the underlying strength of the economy is.

It’s a bit like houses after a storm. Every house in the road has suffered damage so you  simply put the fact that your house is a wreck down to the recent high winds. However, when the surveyor comes round he tells you that the storm has exposed the dangerous lack of structural underpinning in your house. Superficially, your neighbour seems to have suffered just as badly but his foundations were much more solid, therefore his house will be much quicker to repair than yours. Because the storm wrecked everyone’s house, it disguised the fact that yours was on the verge of falling down anyway. It’s only when the reconstruction starts that the desperate state of your house becomes clear.

Some argue that Britain’s economy is suffering from deep structural problems. The OBR, for example, reckons the Output Gap is only 2.7 percent of GDP – in other words, there is very little room for growth in the economy, or, to use my house analogy, the foundations are badly damaged. The Fiscal Fallout paper I referred to a couple of weeks ago has an even more pessimistic 2 percent. If the pessimists are right, then the economy has lost a lot of its productive capacity and, even when growth returns, it will be slow.

Not everyone agrees with the gloom-fest though. According to Capital Economics, the Output Gap is more of a chasm than a crack. (Report summarised by FT AlphavillePaul Krugman and Benjamin Studebaker.) A conservative estimate, they say, puts the Output Gap at around 6 percent of GDP and it could even be as much as 13 percent.

Which, if they are right, is good news because it means that the low growth forecasts are too pessimistic and there is a lot more oomph in the economy than other estimates suggest.

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The problem is, as Gavin Kelly points out in the New Statesman, an educated punt is about as good as we’ll get on any of this. Until the recession is over and economies start growing again, we won’t know how badly damaged ours is. And, because no-one can tell how much of our economic underperformance is structural and how much is cyclical, George Osborne can’t possibly have any idea how big the structural deficit is.

It struck me, though, that the Output Gap is a concept that could apply to individual firms too. I remember an executive from a what had been a fairly profitable company telling me about how they fared during the last recession. He had a sneaking feeling, he said, that things had not been right for some time. New people were moving into the market and some were doing some interesting and innovative things. Some of the clients they’d had good relationships with had retired or moved on. Even before the crash, there had been a few little warning signs. His colleagues, though, blamed all the firm’s performance problems on the downturn. Everyone was experiencing a drop in sales, they said. No need to panic. It was just a sign of the times.

It was only when the economy picked up that my friend was proved right. As he feared, other firms, including some of the new upstarts, began to outstrip them and they were suddenly left looking old and tired. The ground had, indeed, been shifting beneath them but the economic storm had given everyone an excuse to ignore it.

Most economies and most organisations are going through a bad patch at the moment but it’s worth stepping back for a minute and asking yourself how much of it is really due to the recession. How big is the output gap in your business? What potential do you have to exploit the upturn when it finally comes? Recessions are convenient scapegoats but they also cover up deeper performance issues. Is your business just suffering a bit of storm damage, or, when you start to rebuild, will you discover that the foundations have been shaky for some time?

(More on the Output Gap at Touchstone and IPPR.)

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2 Responses to Mind the Gap

  1. Pingback: Mind the Gap - Rick - Member Blogs - HR Blogs - HR Space from Personnel Today and Xpert HR

  2. Another point to bear in mind is that the output gap, as a measure of potential, is not constant during a depression (i.e. the period until you get back to your previous output high), which is where your house analogy breaks down. If the depression is prolonged, then capacity can degrade due to under-investment. In other words, while you might have been able to make up a lot of ground after a 6-month depression, you may find that you can’t do so after a 36-month hiatus.

    What we should be worried about is that the decline in productivity since 2009 may be the result of labour being too cheap and the difficulty of getting bank loans. In combination, this may have discouraged capital investment in favour of more low-wage and part-time workers. When the recovery occurs, too many businesses may find themselves hampered by old tools and creaking systems. Attempts to then catch up may prove difficult because of rising interest rates. These in turn may flush out the zombie firms currently limping along on bank forebearance. We may then see a major boost in productivity, as new market entrants replace the zombies with up-to-date technology, but output may stay below trend and we could even see a contraction in exports as market share is lost to overseas businesses that have invested.

    The output gap is not merely a problem in itself, e.g. in terms of future revenue projections. It may indicate that UK industry faces an even more stressful time in the not-too-distant future.

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