The fly in the ointment is that if the measure of the output gap is incorrect any policy measures, even if rightly conceived which itself is debatable, would have smaller or nonexistent effects on the broader economy.
This may be the reason that the incredible liquidity* supplied by Central Banks has ended up in excess reserves or in the commodity and equity markets.
It may be that the multiplier for deficit spending has gone below 1. If that is the case, say it is 80 cents of economic growth for each dollar of borrowed money, we have passed the point of no return for Keynesian prescriptions, the only thing left is the awful advice of Treasury Secretary Mellon to President Hoover:
“Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate…it will purge the rottenness out of the system. High costs of living and high living will come down. People will work harder and live a more moral life. Values will be re-adjusted, and enterprising people will pick up from less competent people.”From Sober Look:
Economists continue to be fixated on the supposedly massive output gap in the US economy as determined by the Bureau of Economic Analysis (BEA) and the Congressional Budget Office (CBO). This now-famous graph below has made rounds across multiple (sometimes politically motivated) publications, websites, and blogs. It speaks to an enormous output capacity built into the US economy that for one reason or another seems unachievable since the 08 crisis.Here's Krugman in January 2011 (NYT):
Source: Economic Policy Institute
This output gap, thought often taken for granted, may in fact be much smaller. Some recent work by Barclays Capital has already shown that the potential GDP (red line) is basically extrapolating the bubble of the pre-crisis era and is therefore unreliable.
The CBO number crunchers wish to believe in their ability to compute the potential GDP of the US economy. The reality is that nobody knows how much output the US economy is truly capable of. But there are signs that the gap may now be below the CBO's assertion.
The folks at Capital Economics plotted the CBO estimated output gap against "inflation acceleration" - the difference between consecutive YOY core inflation measures. The argument is that if the economy is operating significantly below potential, inflation should have negative acceleration into a deflationary environment. However the two measures have diverged recently, indicating that the slack in the economy may not be that great.
Inflation Acceleration vs. CBO's output gap (Source: Capital Economics)
Another indicator of slack in the economy is the manufacturing capacity utilization....MORE
The Output Gap
Menzie Chinn has a useful post reminding us just how much output we could and should have been producing is being lost to the slump. He includes this picture:August 2011 (NYT):
What I would add is that these numbers aren’t very different from what we were expecting — or at least what I was expecting — in early 2009. And that’s why I warned from the beginning that the Obama stimulus was too small...MORE
Bubbles and Economic Potential
February 15, 2012
Duy on Bullard on Duy on Bullard on Tinker to Evers to Chance
OK, only the first half. Tim Duy offers the latest entry in the dispute over whether we should accept a permanently lower track for output in the aftermath of the housing bubble....MOREAnd many more.