"The" output gap doesn't exist
By Scott Sumner
Robin Brooks has a couple tweets that express frustration with IMF estimates of output gaps:
Campaign against Nonsense Output Gaps (CANOO): since 2007, German real GDP is up 12%, Spain is up 1% and Italy is down 8%. Yet the latest numbers from the IMF, published today, say these countries have the same output gaps: Italy (-1.0%), Spain (+0.7%) and Germany (+0.8%). What?!
In another tweet he illustrates his problem with IMF estimates in a graph:
I am not a big fan of output gaps and have argued that these estimates should play no role in monetary policy. Instead I favor NGDP targeting. Nonetheless, I can see both sides of this issue.
I’d argue that the basic problem here is that the term ‘output gap’ has multiple meanings. Among academic economists, the output gap is supposed to measure the difference between the current level of output and the output level that would occur once wages and prices had adjusted to previous nominal shocks. By that measure, Italy’s output gap might be relatively low, say minus 1%. You could view that definition as the gap between current output and output levels under appropriate monetary policy. (That’s not to say I have a strong opinion on the -1% figure, the output gap defined this way might well be considerably larger.)
Another definition of output gaps is the difference between the current level of output and the level of output that would occur with appropriate economic policy (including more efficient taxes, spending, regulations, etc.) By this definition, Italy’s output gap might be minus 10% or 20%, or even more. Indeed Italy’s per capita GDP is 20% to 30% lower than in most northern European countries, and that gap has widened considerably in recent decades. It’s hard to see how that reflects anything other than Italy’s dysfunctional economic policies. Economists label these problems “structural”, not demand related.
Output gaps are basically about policy counterfactuals. And because there are an almost infinite number of policy counterfactuals, there is no single true output gap, which we can precisely measure. (Just as there is no single “true” rate of inflation.) The real question is: What are you trying to measure?
PS. While I believe that Italy’s output gap is now relatively small if we use the “appropriate monetary policy” counterfactual, it was considerably larger in 2009, and also in 2013, using that same definition.
HT: David Beckworth