Comparing methods to determine the Output Gap
David Beckworth made a determination of nominal interest rates using the Output Gap from this paper…Measuring potential output: Eye on the financial cycle, by Claudio Borio, Piti Disyatat, Mikael Juselius. Determining the output gap correctly in real-time is very important for determining the nominal interest rate and many other factors. It is not good to get the output gap wrong.
In the paper they present this graph of output gaps determined by various methods, real-time and ex-post.
The red lines are what was given in real-time. The blue lines show what was determined later by looking backward (ex-post).
In the paper, they say…
“The HP filter gap and the full-fledged approaches of the OECD and IMF – a representative sample of current approaches – did not detect that output was above sustainable levels during the boom that preceded the financial crisis. In fact, the corresponding real-time estimates indicated that the economy was running below, or at most close to, potential. Only after the crisis did they recognise, albeit to varying degrees, that output had been above its potential, sustainable level. By contrast, the finance-neutral measure sees this all along (bottom right-hand panel). And it hardly gets revised as time unfolds.”
David Beckworth uses the Finance-neutral calculation for his determination of the output gap.
But now I want to show my determination which would have been real-time without being revised later. (quarterly data)
The paper criticizes the approaches of the IMF, OECD and HP filter for not seeing the economy was over potential before the crisis, but my real-time calculation would have seen that for 3 years.
Also, the Finance-neutral method did not see that the economy was running below potential after the 2001 recession. My method, along with the IMF and HP filter, did see that. Even their revisions kept showing the economy was below potential in 2003.
My method, along with all others, recognized the fall from potential in the crisis. However, my method is set up to see in real-time a fundamental shift in demand impacting potential if one occurs. My method and the HP filter show GDP returning to potential by 2011. A shift downward in potential is seen since the crisis.
The HP filter gives results that most resemble mine. HP stands for Hodrick-Prescott (HP) filter. A neighbor of mine works in the same office as Edward Prescott… Coincidence.
My method to determine potential GDP is a simple equation that does not require re-configuring ex-post…
Potential GDP = real GDP – a * (c/f – 1)
a = business cycle amplitude constant in real 2009 $$, $3.4 trillion… f = effective labor share (Labor share: Business sector * 0.762)… c = capacity utilization…
The article makes no sense. There are massive idle resources. The country is certainly not at full employment.
Since the Bush recession ended in June 2009, we’ve been in a rolling depression, where the economy improves for a few months and deteriorates for a few months, etc..
“Obamanomics” resulted in trillions of dollars of additional federal debt to maintain the huge output gap and destroy potential output, which the country cannot afford.
There remains massive idle resources, while the economy underproduces by about $1 trillion a year.
Moreover, the weak U.S. economy has slowed the global economy.
The weak U.S. “recovery” is even weaker than reflected in GDP growth, because U.S. trade deficits shrank, which add to GDP growth.
From UCLA Anderson forecast last year:
“U.S. real GDP is now 15.4 percent below the normal 3 percent trend. To get back to that 3 percent trend, we would need 4 percent growth for 15 years, 5 percent growth for eight years, or 6 percent growth for five years, not the disappointing twos and threes we have been racking up recently, which are moving us farther from trend, not closer to it. It’s not a recovery. It’s not even normal growth. It’s bad.”
Hey Edwards I’d love to see a think-piece on what “capacity” and “potential” mean — both when you use them and when others use them.
“Full capacity is when everyone is working as much as they want [at what wage?], all consumption goods are being produced as fast as businesses can produce them [and as people will buy them? and at what price?], and businesses are investing in building new productive capacity as fast as they can.”
I won’t explain all the problems with that. So what do capacity, full capacity, and potential capacity mean to you? And to others, as best as you know? Thx.
I like your estimate , both because it implies that we’re in a regime that’s likely unsustainable , and because it will drive most economists insane : “How can you say we’re above potential ?!? ”
Actually , if Borio’s estimate was updated to the present , it might be pretty close to yours , since he does factor in housing price increases , and housing prices have gone up some since the last point in his graph. I wonder if he shouldn’t have included financial asset prices as well as housing prices , to better capture the component of “phony” financial output vs “real” output.
My favorite quick-and-dirty measure of financial neutrality is to simply look at total nonfinancial debt/gdp. If it’s flat or falling , things are probably sustainable , within reason. If it’s rising continuously , clearly it’s not :
Even though this ratio is flat now , I question how sustainable things are today , and thus think your estimate might be better. If we were seeing more growth in output vs. growth in asset prices , I’d feel a little better about the future.
Btw , I should mention that I disagree with your graph for that early 2000s period. The value of the finance-neutral concept is that it would have warned us earlier about the debt and asset bubbles. The widespread belief that we were below potential , along with low inflation , gave us “full-speed ahead” permission for the credit boom.
So it would seem…
You brought a big laugh to me… thank you.
And then You make a good point about asset prices. and non-financial debt.
We saw some output growth at the end of 2013. Yet, I put myself in the head of business people. What are they thinking? Do listen to the what economists say about negative interest rates and a huge output gap? Do they base their decisions on what they hear? And then what do they see in their own numbers from their business? Do they see something different? Do they think that they are different from everyone else if their numbers don’t stack up like what economists are saying? How much confusion is out there? How much contradiction is out there between what businesses see in their own numbers and what economists say?
Answer to your second comment coming…
Labor share rose more than 3% from 1998 through 2000. In my method, this was rasing potential. Then capacity utilization was falling in 2000 and 2001. The combined effect was to move the economy below potential.
If I was to use the constant of the labor share anchor which was lower than actual labor share, the negative line would not have been as low in 2000 and 2001.It would make sense to use the anchor because that tells where labor share will be when the economy reaches that sustainable output level. I didn’t use it in my graph though. Maybe next time.
Yet, being below potential through 2001 and 2002 after a recession was normal. But the low interest rates after that were justified to restore the economy in the business. cycle. The problem with the credit boom was not low interest rates. Even David Beckworth explains that low interest rates are normal in his post that I cite.
The problem with the credit boom was the massive toxicity developed from all kinds of shenanigans in the financial sector. If not for those shenanigans, the recession would not have been so catastrophic.
Even the crisis would have been fairly a normal recession. But there was a shift in the making too for labor share. When the crisis hit, labor share had space to fall after years of wanting to fall in the face of cheap Chinese imports.
Think about… from its peak in 2001 until now, labor share has fallen 10%. To me that is a big drop in potential. We were below potential when labor share was high, now with the same capacity utilization we are above potential.
But I hear you, that debate about low interest rates back under Greenspan will go on for years. I only think that the interest rates were low in 2004, when the re-election of Bush was taking place.
didn’t we try to write about that before? Time to do it again?
It should be noted, the 2001 recession was so mild per capita real GDP growth didn’t fall that year.
Also, the 2001 recession proved the U.S. can have a quick and massive Creative-Destruction process (mostly from 2000 to 2002) in a mild recession (in large part thanks to the Greenspan Fed and the Bush Administration).
The “Misunderestimated” President:
Bush inherited the worst stock market crash since the Great Depression and a recession. However, the Bush Administration turned the recession into one of the mildest in U.S. history, after the record economic expansion and structural bull market from 1982-00.
Over a five-year period in the mid-2000s, U.S. corporations had a record 20 consecutive quarters of double-digit earnings growth, two million houses a year were built, 16 million autos per year were sold, U.S. real GDP expanded 3% annually, in spite of 6% annual current account deficits (which subtract from GDP).
The U.S. economy was most efficient, while Americans stocked-up on real assets and goods, and capital was built-up. It was one of the greatest periods of U.S. prosperity, the fourth longest economic expansion in U.S. history, and in a structural bear market that began in 2000.
The Bush Administration was adept at minimizing the recession in 2008, including providing a tax cut in early ’08 for the Fed to catch-up easing the money supply, until Lehman failed in Sep ’08, which caused the economy to fall off a cliff. However, appropriate policy adjustments were implemented quickly.
If Bush could’ve been reelected and had his way, the U.S. would’ve completed a recovery in 2010, and we’d be in a strong disinflationary expansion instead of this on-going depression and “train wreck.”
I stated in Feb ’09:
1. Obama should change his stimulus plan to a $5,000 tax cut per worker, along with increasing unemployment benefits by a similar amount. This will help households strengthen their balance sheets [i.e. catch-up on bills, pay-down debt, increase saving, spur consumption of assets and goods, etc.]. This plan will have an immediate and powerful effect to stimulate the economy and strengthen the banking system. When excess assets and goods clear the market, production will increase.
2. Shift “toxic” assets into a “bad bank.” The government should pay premiums for toxic assets to recapitalize the banking industry and eliminate the systemic problem caused by global imbalances. The Fed has the power to create money out of thin air, to generate nominal growth, boost “animal spirits,” and inflate toxic assets.
3. Government expenditures should play a small role in the economic recovery. For example, instead of loans for the auto industry, the government should buy autos and give them away to government employees (e.g. a fringe benefit). So, automakers can continue to produce, instead of shutting down their plants for a month. Auto producers should take advantage of lower costs for raw materials and energy, and generate a multiplier effect in related industries.
Massive idle resources are reflected in idle labor (e.g. from weak demand, high household debt, and low income, particularly low-wage income), and idle capital, e.g. $2 trillion held in cash or equivalents (earning enough for capital preservation) by non-bank corporations, and another $2 trillion held by banks in excess reserves (most likely because “too-big-to-fail” is no longer a policy).
It should be noted, prices don’t have to fall, to stimulate demand, profits can rise instead.
Paul Krugman makes an interesting case how the U.S. economy has changed, particularly since 2000 (with implications how a combination of efficiency and regulation, for example, led to lower wages and weaker demand):
Profits Without Production
June 20, 2013
“Economies do change over time, and sometimes in fundamental ways.
“…the growing importance of monopoly rents: profits that don’t represent returns on investment, but instead reflect the value of market dominance.
…consider the differences between the iconic companies of two different eras: General Motors in the 1950s and 1960s, and Apple today.
G.M. in its heyday had a lot of market power. Nonetheless, the company’s value came largely from its productive capacity: it owned hundreds of factories and employed around 1 percent of the total nonfarm work force.
Apple, by contrast…employs less than 0.05 percent of our workers. To some extent, that’s because it has outsourced almost all its production overseas. But the truth is that the Chinese aren’t making that much money from Apple sales either. To a large extent, the price you pay for an iWhatever is disconnected from the cost of producing the gadget. Apple simply charges what the traffic will bear, and given the strength of its market position, the traffic will bear a lot.
…the economy is affected…when profits increasingly reflect market power rather than production.
Since around 2000, the big story has been one of a sharp shift in the distribution of income away from wages in general, and toward profits. But here’s the puzzle: Since profits are high while borrowing costs are low, why aren’t we seeing a boom in business investment?
Well, there’s no puzzle here if rising profits reflect rents, not returns on investment. A monopolist can, after all, be highly profitable yet see no good reason to expand its productive capacity.
And Apple again provides a case in point: It is hugely profitable, yet it’s sitting on a giant pile of cash, which it evidently sees no need to reinvest in its business.
Or to put it differently, rising monopoly rents can and arguably have had the effect of simultaneously depressing both wages and the perceived return on investment.
If household income and hence household spending is held down because labor gets an ever-smaller share of national income, while corporations, despite soaring profits, have little incentive to invest, you have a recipe for persistently depressed demand. I don’t think this is the only reason our recovery has been so weak — but it’s probably a contributory factor.”
Yeah that’s part of what we talked about, but I think a post that just defines and discusses those words would be valuable.
We’re above “capacity” or “potential” as those things are constrained by demand. We obviously have the human and real-capital capacity to produce more than we do. Is your measure something like “demand-constrained capacity” or “capacity given demand constraints”? Is there a better, clearer, more descriptive term?
Thinking of a term that will let people grok this measure straight out of the gate, without parsing the whole mode.
Potential implies a sustainable level… but even if you are perfectly sustaining potential output, all of sudden, you have a demand shock or supply shock that disrupts the balance of sustainability.
But shocks don’t necessarily change potential, only your ability to sustain it.
The key to shifts in “sustainable” potential is recognizing when a demand or supply shock is more than a shock and goes to the level of a permanent shift. For example, labor share can drop 10% over a year, and you have a demand shock for a year and then you get back to normal. But if labor share falls 10% and is likely to stay there for years and years, you have a long-term demand shock. Thus potential must shift long-term in response.
This real shift in labor share is what the other models are not taking into consideration. They must not be seeing it as a shock, or maybe they are seeing as something already assimilated by potential. But then at what point was it assimilated?
How about “Sustainable Capacity”?
“Sustainable capacity” would stop the confusion quickly I’d imagine.
“Effective” capacity would be better. It is more realistic, because it depends on the strength of demand.
I think of latin america where capacity is low due to low wages. The capacity is effective due to low domestic demand among the people, but I would not want to call it sustainable, I would not want to see it as sustainable. And I hope the US does not sustain this low labor share, but it is likely it will.
Okay Effective Capacity it is.
I think that helps people grasp what you’re saying right off without having to internalize your whole model.
Especially with a short, clear definition:
The economy’s ability to produce output given existing demand constraints.
The amount it can realistically produce given current economic conditions.
You might find this new book of interest :
The Aggregate Production Function And The Measurement Of Technical Change
‘Not Even Wrong’
Jesus Felipe , John S.L. McCombie
” ‘Felipe and McCombie have gathered all of the compelling arguments denying the existence of aggregate production functions and showing that econometric estimates based on these fail to measure what they purport to quantify: they are artefacts. Their critique, which ought to be read by any economist doing empirical work, is destructive of nearly all that is important to mainstream economics: NAIRU and potential output measures, measures of wage elasticities, of output elasticities and of total factor productivity growth.’ ”
– Marc Lavoie, University of Ottawa, Canada
I guess this means we can look forward to the birth of a new paradigm in economics , one more aligned with real-world outcomes , rather than one based on fantasy models.
Yeah , right.
The comments under the book sure are interesting. I am looking to get that book. I will look through Jesus Felipe’s website first.
Thanks for that link. I’d never buy the book , but I will browse some of the free stuff on his website.
BTW , a new paper by Borio is up on the BIS site which details some of his thinking on the conduct of monetary policy during booms and busts , and how to minimize the boom-bust cycle preemptively. He refers to the output graphs you reproduced above.
Borio does a better job of seeing the big picture and explaining it clearly than most , IMO.