Arnold Kling  

The Output Gap Story

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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.


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CATEGORIES: Macroeconomics



COMMENTS (9 to date)
Rebecca Burlingame writes:

Two sentences Russ wrote jump out at me: "The money gets spent and then it's over. The multiplier never materializes." This is what I worry about when knowledge is primarily considered in the marketplace of consumers to be a passive product, to be digested, end of story...unless of course we're hired. If not, then what? If the multiplier never materializes, the knowledge is forgotten, like the dusty old books where the time machine goes far into the future and no one knows what the books are about anymore.

Money was created for building, for commodities, for real products we can see and touch. People had lots of economies in place before money ever came along, and while we tried to make money represent them so as to free up our own time, every time more money came into the marketplace, it gravitated towards those physical commodities that it knew so well, the best example being the housing market, where every time income rises, housing prices rise. We wanted money to represent human services. Money doesn't get human services, because they operate on an entirely different plane that includes things inimical to money, like infinite resource capacity. Even so, money points to those things and tells us, this is possible, not for me, but for humans. Go for it.

Chris Koresko writes:

@Arnold:

What you're saying here sounds like an idea I've been floating in the hopes that a qualified economist would comment on it. I think my picture can be looked at as a simplified, and more mathematically oriented, version of yours:

A free-market economy seeks an optimal equilibrium in which all possible activities with a positive marginal product, and no activities with a negative marginal product, are carried out. The details of the mechanism by which it seeks the optimum aren't important for this argument.

The value of the marginal product is communicated by price signals. If the price signals are wrong, the equilibrium will be perturbed away from the optimum, such that some negative-product activity goes on, or some positive-product activity doesn't. In either case, the economy produces less wealth than it should.

Keynesian stimulus amounts to deliberately confusing the price signals to shift the equilibrium toward a higher than optimal activity level. The above picture implies that the stimulated activity will have negative marginal product. In other words, it's necessarily wealth-destroying.

So the Keynesians' Output Gap isn't real. If those unemployed workers were working, they'd be destroying wealth, not creating it. There might be sound social reasons to encourage them to work anyway, but the bottom line is that it's not much different from the old story about the WPA (dig a ditch one day and fill it in the next).

Does this picture sound sensible?


Thomas DeMeo writes:

You continually focus on labor. To me, what happens is that over time, firms inevitably make a series of structural mistakes; expensive leases, under performing investments, bad contracts, and yes, hiring of ineffectual employees, etc... During good times, it is rarely worth it to face up to these mistakes, and cash flow is sufficient to cover them.

Eventually, a small hiccup in demand ends the party. So yes, reorganization of labor is a component. But so are all the other misallocations that the firms make. At least an employee might be willing to make an adjustment. Many other errors, like bad leases and contracts can just sit there and eat away at the firm. These mistakes can drag down the efficient employees as well as the inefficient.

Silas Barta writes:

I don't know what else I can add beyond, "Well said, Arnold Kling."

There's a tendency on the part of mainstream economists to look at production from this "black-box" perespective, where it's almost an afterthought about whether this production is actually satisfying consumer demand. So they ignore the fact that they're temporarily (and pointlessly) creating demand for one kind of activity with new spending, while paving the way for the exact same problem we're in down the road, when the economy has to adjust to the removal of this (fake) demand.

This is seen over and over and over in government spending projects. (and monetary policy, too...)

Jeff writes:

Arnold, your recalculation story is incomplete because at bottom it is just a supply story. Something happens that changes relative prices, and it takes time for everyone to adjust. This is a "sand in the gears" supply shock.

You seem unwilling to consider that demand can also be disturbed. Say's Law says that the sum of all excess demands is zero. In a monetary economy you can have deficient demand for goods and services if you have excess demand for money. That is, tight money is an adverse aggregate demand shock.

Where does money enter the picture in your recalculation story? If the central bank creates too much or too little money, how does that affect your economy? In 1933, FDR raised the price of gold, i.e., he devalued the dollar. The result was an immediate surge in asset prices and industrial production. How do you explain such an episode?

Yancey Ward writes:

Wish you could more people to read this essay alone.

Bill Poorman writes:

I have been lurking on your blog for quite some time, but never commented. I am a self-described liberal, but (I don't know why I have to say "but", really) I find your posts like this one compelling. However, for me, it still leaves the very human problem of people starving, losing their homes, etc. due to economic dislocation. What solutions do you advocate, if any, to deal with the suffering caused by unemployment? Thanks.

Hyena writes:

The Keynesian is correct, though. For every objection, you simply need to modify it slightly because each is just a way of restating the fundamental problem: many economic activities are unsustainable at the current price level.

Hence why I see most neo-Keynesians argue for simply printing money, not any specific spending plan.

Chris Koresko writes:

Hyena: ...the fundamental problem: many economic activities are unsustainable at the current price level.

But can't we infer from that that those activities would not contribute to our overall prosperity?

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