The Output Gap Story
By Arnold Kling
Russ Roberts asks whether spending creates prosperity.
has foreign aid spending created prosperity in those countries? Usually not. Or maybe never. The money gets spent and then it’s over. The multiplier never materializes. And that’s because these economies are broken. They have lousy government. They have corrupt practices. They have stagnant labor markets. So the influx of money doesn’t create prosperity. It simply creates rent-seeking for the politically favored.
I am not sure about the economic parallel between stimulus spending and foreign-aid spending. But the political parallel is clear. I think that people who believe in foreign aid are not going to change their minds, and I think that people who believe that stimulus works are not going to change their minds.
I’ll put my economic comments below the fold.Keynesians think of economic activity as spending in the first place. You measure economic activity as spending by households plus spending by businesses plus spending by government, and then you net out imports and add in exports.
Suppose that we all work at the GDP factory making GDP. Unfortunately, spending is down, so some of us are laid off. The difference between the amount of GDP that the GDP factory could produce using all of us and the amount that is actually demanded is called the Output Gap.
The Output Gap looks like a $20 bill that is being left on the sidewalk. If somebody would just increase spending, it would help close the Output Gap, raising GDP and lowering unemployment. Stimulus certainly must work.
I am not comfortable with the GDP factory picture. We are not all interchangeable inputs producing the identical output. To me, economic activity is patterns of sustainable specialization and trade (PSST). Economic activity takes place only because we produce different things.
The PSST concept makes the Output Gap harder to define. I want to say something like “The Output Gap is the value of the output that idle workers could produce if the economy valued their output.” It is sort of like the old joke, “If we had some ham, we could make ham and eggs, if we had some eggs.”
Workers are idle because the economy does not value their output as highly as workers value their time. Keep in mind that in a Garett Jones economy, what workers produce in many cases is organizational capital, which is difficult for anyone to value objectively. A CEO can wake up one morning and decide that many of the firm’s departments have Zero Marginal Product. And chances are those workers have close to ZMP elsewhere as well, at least in the short run.
Keep in mind also that many of the jobs gained and lost in the economy are at young firms, where sustainability is uncertain. Is what the firm is selling really worth more than the cost of providing it? The market will tell the cold truth.
In short, when you think of the economy as a GDP factory, it is obvious that more spending helps create prosperity. More spending necessarily means more GDP, and since everyone works at the GDP factory, more GDP means more employment and prosperity.
Once you drop the crutch of the GDP factory and switch over to the PSST concept of economic activity, things are not so clear. There are these millions of jobs being created and destroyed each month, many of these at young firms, and you ask whether government is helping the market find PSST or not. I suspect not, because what the government can do that the market cannot is perpetuate unsustainable activities, like cash for clunkers, unfunded pension plans for teachers, and $500 million loan guarantees for electric car manufacturers.
I wish more people would read my essay on expert failure. In it, I wrote,
So how does the economy create jobs? There is a sense in which nobody knows the answer. In his essay, “I, Pencil,” Leonard Read famously wrote that not a single person on the face of this earth knows how to make a pencil. Pencils emerge from a complex, decentralized process. The same is true of jobs.
The same is true of economic activity, or prosperity. When a politician asks, “Who can tell me how to create economic activity?” the Keynesian raises his hand and says, “I can help. You should spend more money.”
This answer is very well received, for two reasons. First, it is an answer. Second, it tells politicians to do what they would like to do, anyway.
Instead, to say that nobody knows how to create economic activity is to self-marginalize. Politicians do not want to hear that at all. They want to hear that there is an Output Gap, and their spending can help to fill it.