Arnold Kling  

What is the GDP Gap?

Two Disagreeable Questions for... Government Fundamentalists...

Doug Elmendorf writes,

the difference between the economy's actual and potential output will average 7 percent of GDP (which is equivalent to about a trillion dollars) this year and next, and that gap in output will not close until 2013.

In macroeconomics, economists act as if we all produce one good called GDP. When we don't produce as much as economists think we could with full employment, we call this the GDP gap.

But what does it mean in a multi-good economy? To close the GDP gap, should we go back to producing millions of houses to be bought by speculators and financed by hundreds of billions in junk mortgages?

If I were reconstructing macroeconomics, I would describe this as a resource reallocation problem. It combines permanent reallocation and temporary reallocation. That is, some workers need to leave housing construction forever (relative to peak production) and some need to leave only for a while (because we need unusually low production for a while to work off the excess). Output appeared to be higher before the need for reallocation. And after reallocation is finished output will be higher. Meanwhile, output will not be so high, but calling that a "gap" makes it sound as if there ought to be no friction at all in the reallocation process.

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CATEGORIES: Macroeconomics

COMMENTS (17 to date)
cputter writes:

Isn't that very much the Austrian way of thinking?

Austrian Capital theory here on Econlib

barghest writes:

Interesting, one should not think of the economy as underperforming in a recession such as this. The true underperformance was in the boom. The recession is the sober reavalutation and planning stage. How does one tell how well this process is going?

Mattyoung writes:

The ratio of permanent workers to temporary workers during periods of no gap would be similar across all sectors, I think. During period of severe output gap that ratio diverges across sectors.

If I were reconstructing macroeconomics I would try and fix the ratio to a particular number.

Bill Woolsey writes:

The concept of "potential income" includes the concept of "structural unemployment." If structural unemployment is extra high, then potential income is extra low. Anyway output gap, is how far output has fallen below potential income.

The notion that there are no shifts in the composition of output is mistaken. It is rather than sectors that should decrease, decrease too far. Industries that should grow, either shrink or grow too little.

The idea of an output gap is tied to the notion that falling aggregate expenditure, or perhaps even slower growth in aggregate expenditure, in the face of sticky prices, result in changes in real expenditure and production that part of necessary sectorial shifts.

If prices are assumed to be perfectly flexible, then this is never a problem.

If this is a world of scarcity, then overproduction of single family houses means that the value of these houses is less than their opportunity costs--the value of the other goods that the resources could have been used to produce. Overproduction of single family houses _means_ that there are other sectors of the economy that have been starved for resrouces and should be expanding. The "structural unemployment" and reduced potential income is the result of an inability of those sectors to adapt redeployed resources fast enough. There should be rising relative prices, profits, and production in some sectors.

Anyway, I think the best interpretation of the current situation is there is a needed shift of labor and other resources from the production of single family homes. Structural unemployment is higher than normal and potential income is lower than normal (below long term trend, really.)

At the same time, those lending into the shadow banking system lost confidence and switched to holding FDIC insured deposits, reserve balances a the Fed, and T-bills. The result of these factors is that money demand has risen faster than a rising money supply, resulting in a drop in aggergate expenditures (it is about 4% below its pre-2008 growth path.) This drop in nominal expenditures has resulted in production falling in nearly every sector of the economy.

Instead of potential income being low only because the sectors that were starved for resources take time to deploy the resources now freed from single family housing, income is below potential income because of reduced spending and sales across the board.

There is an output gap because of the drop in nominal income.

Gary Rogers writes:

Is it fair to say that a GDP that is maintained through unsustainable borrowing is actually beyond the sustainable potential GDP and the same Keynesian formulas that predict the benefits of a stimulus would work in reverse to calculate our long term sustainable GDP? We may be in for a rude awakening, especially when you further reduce future sustainable GDP to account for paying down our debts.

dWj writes:

I'll see barghest and raise him: we should go back to the GDP numbers from 2004-2007 and revise them, valuing residential fixed investment based on its value now.

Milton Recht writes:

GDP is a flow measure comparable to business revenue. Next quarter's GDP does not capture the long-term gains from the economy's current restructuring and capital investment.

In addition to revenue, businesses have a second measure; the present value of all future income streams. For business, it could be market value based on its publicly trading securities or it can be a business sale value based on comparable prices for similar businesses.

Furthermore, business owners consider future sales and profit prospects as part of their business decisions.

The goal of GDP management should be a present value decision, but as far as I know, there are no stock measures of future GDP available. A stock measure would capture the benefits of an economy's restructuring and reinvestment during recessionary times.

It seems that focusing on GDP gap is equivalent to a business owner worrying about next year's revenue without considering the ongoing stream of future revenue and the value of the business.

It reminds me of the occasional criticism we hear against business that it worries too much about next quarter's earnings and not enough about the long term.

If we had some readily available present value measure of all future GDP, I think the focus on next quarter or next year's GDP gap would diminish. Economists that now focus on GDP gap would switch to discussions about the present value measure of future GDP. Maximizing GDP, while maintaining some politically comfortable level of unemployment, would become the goal of economists and government.

Daublin writes:


Thank you for the clarification. What do you think about the article title, though? Should we in retrospect say that there was a "GDP gap" during the housing boom, due to there being massive overinvestment in housing?

The "GDP gap" point of view appears to make it hard to do. To take a try at it, would it mean that the historical productivity figures should be lowered, now that we know that prices were inflated compared to real value?

Jared writes:

"Meanwhile, output will not be so high, but calling that a "gap" makes it sound as if there ought to be no friction at all in the reallocation process."

All the individuals in a geographical location are capable of producing so much of all types of output. We call it GDP. Now we are producing less of all-of-it than we could.

You indicate that we have sectoral shifts and this adjustment process will not be without "friction". There was also an adjustment process to get into this position, and yet it did not involve friction (it was, in fact, quite cozy!). Why, precisely, is is there "friction" to transition out of this particular position, but not to transition *into* it?

Mattyoung writes:

"Why, precisely, is is there "friction" to transition out of this particular position, but not to transition *into* it?"

In mid 2008 we were finishing up an economic project started around 1995, doing the detail work on a ten year old, ongoing production engine. During 2008 we all decided to start a new economy and cast off the old. Now we are working on the big components of the new engine and are not yet ready for the detail work.

cputter writes:


Your question is similar to Paul Krugman's wondering why there is no unemployment caused by the sectoral shift during the boom. (Which just shows how smart he really is.)

Entrepreneurs in the 'booming' sectors can increase their demand (the price they are willing to pay) for their factors of production, this includes labour obviously. Thus employees from other sectors will switch to working in these 'booming' sectors if the price is right. So there's no increase in unemployment, since you're not considered unemployed if you're merely changing jobs.

Whereas once the bubble inevitably bursts employees don't immediately have new jobs waiting for them in other sectors (a big difference compared to the boom) and so the time it takes them to find new jobs causes the 'friction' and leads to increased unemployment.

Like it's been mentioned by another commentator the bust is good since it frees up the factors of production that were being wasted by the 'booming' sectors. Of course it's not pleasant to loose ones job, but it's much better for the economy since someone else now has the opportunity to employ you profitably (instead of being paid for something that no one needs you to do)

Mattyoung writes:

In the boom returns to scale are strong, mainly because the long term capital investments have been proved out.

The bubbles results when constraints in some sectors begin to show up, but the long term capital equipment cannot be abandoned until the restructuring occurs. Until the restructuring, the working sectors absorb excess capital which has no other place to go.

Arnold Kling writes:

The reason that there is less frictional unemployment in a boom is that the process is slower. The increase in housing starts from a norm of, say, 1.5 million per year to a peak of over 2 million was more gradual than the drop to about 0.5 million.

Jared writes:

Dr Kling has the only reasonable answer to my query. Thank you.

cputter writes:

@Arnold Kling

"The increase in housing starts from a norm of, say, 1.5 million per year to a peak of over 2 million was more gradual"

At what point did this increase unemployment though, even if only gradually?

The increased demand for labour in the housing sector can only be satisfied by two kinds of employee: employed and unemployed

-Employed labourers shifting into the housing sector are at no point unemployed during the transition.

-Unemployed labourers moving into the sector become employed, thus decreasing unemployment.

Now of course one can make the argument that other industries competing with the final consumer good produced by the housing sector faced increased unemployment. So some workers at mobile home and tent factories might have lost their jobs.

Bill Woolsey writes:

Structural unemployment exists _all the time_. If there is a gradual "overexpansion" in a sector, then this is just one of the elements that is causing the usual structural unemployment. If there is a sudden large shift, then structural unemployment is extra high.

If housing grew so rapidly that other sectors needed to actually shrink rather than grow more slowly, then there would have been more layoffs elsewhere and more significant structural unemployment.

I think the diference beween slow growth in some sectors and somewhat more rapid growth in other sectors results in less structural unemployment than shinkage in some areas and growth in others.

However, it is symmetrical. As far as the resource reallocation goes, the surplus in housing is a shortage of other goods.

Look at the economy one year to 18 months ago. The unemployment rate was higher and growth slowed. The housing sector was shrinking. Other parts of the economy were growing on net. That is the sort of "recession" that follows from the need to reallocate resources. We could imagine it being much the same, but worse. The shrinking in housing is larger and the growth in other sectors is only slightly faster, so that measured GDP shrinks. Structural unemployment grows as the layoffs in housing related sectors are greater and the new hires in the growing sectors does not increase as much. The economy does "recover," because the shinking in housing stops and the rest of the economy continues to expand as long as resources are available.

But, about 9 months ago, it changed. Spending growth slowed rapidly in the 3rd quarter of 2008, and then in the 4th quarter of 2008 dropped significantly. It dropped again in the first quarter of 2009. That is a new problem piled on top of the needed adjustment.

Generally, readjusting all GDP figures from the past based upon what investments were trully worth is fraught with difficulty. I don't think doing it for single family housing alone is a good idea. Do we increase the valuation of investment that turned out extra profitable?

If you think about the way government output is measured, you need to already understand that GDP figures is some kind of measure of what could have been produced. (Government goods are "measured" based on their opportunity cost.) This gets to the difference between GDP as a measure of realized well being vs. trying to figure out how much stuff is being produced.

But, anyway, it certainly seems correct in retrospect that the housing was overvalued.

The "too much" debt arguments are _WRONG_. It is inconsistent with the concepts of scarcity and opportunity cost. If we can produce the goods, then there is sufficient income to buy them. There is no need for anyone to borrow more so that the things can be sold. Credit shifts spending between and among households and firms, as do debt repayments.

Implicit in the debt stories is that those who would have lent or who a receiving debt repayments increase their money holdings. Nominal expenditures drop because of an imbalance between the quantity of money and the demand to hold money.. not because people have unsustainable debts.

El Presidente writes:


Meanwhile, output will not be so high, but calling that a "gap" makes it sound as if there ought to be no friction at all in the reallocation process.

What would you say is the optimal amount of friction?

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