Winner of the New Statesman SPERI Prize in Political Economy 2016

Friday, 10 March 2017

The Output Gap and the Innovations Gap

A major objection to my suggestion that the UK is in an self-fulfilling expectations led recession is that measures of the output gap suggest that gap is near zero. What I want to argue here is that measures of the output gap ignore what I will call the innovations gap, and the innovations gap could indicate that demand expansion would not be inflationary.

The output gap is the difference between actual output and trend output, where trend output is the level of output at which inflation is stable. The OBR are the output gap kings. They have a composite measure, which Ben Chu shows here, but this is derived from many different measures, shown in the OBR’s latest forecast on page 36. The OBR also show (p38) that estimates produced by other organisations vary widely. Most measures of the output gap can be categorised into four kinds.

  1. Time series filters. These, at their most simple, just smooth the data on actual output to produce the measure of trend output that is one half of the output gap. These have no economic content and therefore tell us almost nothing.

  2. Production function estimates. These combine measures of the labour force with the capital stock to give potential output: the level of output that could be produced if all factors of production were fully utilised. The major problem with these measures is that they have no measure of technology: how much can be produced by capital and labour. What is generally done is to use time series methods to estimate this, which takes us back to the smoothing idea. As a result, measures produced by the IMF and OECD suggest the years before the recession were a huge boom, which is implausible given other evidence we have.

  3. Labour market measures, like unemployment or participation. There are of course many problems in knowing what the non-inflationary level of these variables are.

  4. Firm surveys. These ask questions like are you producing at normal levels of capacity utilisation. The answer you get right now is that firms are indeed working close to normal capacity.

With these definitions in mind, what we have to ask is do any of these measures tell us what we really want to know, which is would firms react to increases in demand by raising prices and wages. I want to argue that they may not after an economy has grown at rates well below previous trends for a while. The reason is that, in these circumstances, firms may know that their current production methods are outdated, too labour intensive and inefficient, but at current levels of demand it is not worth them investing in new techniques. However if demand did increase, rather than raise prices to choke off that new demand, it would be more profitable to investment in new equipment to meet that additional demand. An expansion in demand would not be inflationary because firms would not raise their prices. In addition, because these new techniques were labour saving, there would be no inflationary pressure in the labour market (although real wages would rise because productivity increased).

We can tell the following story about the UK economy. At the peak of the recession, unemployment was high and firms had spare capacity. All the output gap measures said the output gap was large. What would normally happen next is that output would start recovering rapidly at above trend rates of growth, leading to a pickup in investment and new techniques being embodied in new production. But that didn’t happen in the UK, mainly because austerity held back demand and interest rates couldn’t go negative. 

When demand did finally begin to expand at a modest rate in 2013, cautious firms decided to meet that additional demand not through new investment but by using existing spare capacity. During 2013 and 2014 employment increased and the output gap fell, but productivity was stagnant because most firms were not investing in new techniques. (The market leaders were, because being market leaders they were expanding more rapidly and investing. So as Martin Sandbu has discussed, the UK productivity puzzle is associated with the average firm, not leading firms.)

This meant that by 2015, unemployment had fallen to more normal levels, and firms no longer had spare capacity. All this had been achieved with stagnant productivity growth, because most firms had stopped investing in new innovations. It was not because those innovations had stopped being made. So the output gap had been replaced by an innovations gap, with most firms using out of date production techniques that are too labour intensive.

If this story is right, we have become locked in a self-fulfilling low growth trap. Firms will not invest because they see recent slow growth continuing. They are right, because policymakers, looking at the output gap rather than the innovation gap, are doing nothing to expand demand for fear of inflation, or worse still because of mistaken worries about government debt. I do not know if this story is right, but it seems to me that the cost in lost output if it is right is so great that it is foolish to ignore this possibility.   


  1. The piece by Martin Sandhu is persuasive but I wonder if there are other factors at play.

    If investment will save labour then it may be profitable anyway, even at depressed levels of demand. What I am suggesting is that demand may not be a necessary condition for investment (the investment deepening argument).

    I wonder if the middling firm has become more highly leveraged since 2008 and its borrowing capacity has become constrained and this, in addition to inertia, is a reason for lower investment.

    Has the continuing drift away from manufacturing and towards services had anything to do with this?

    I believe that aggregate demand will struggle as you suggest but this does not mean that investment is unprofitable; it seems to me that there have to be other contributory factors.

  2. As the owner of SME constantly dithering about investment in machinery, this rings true. Also, the dithering has consequences: investment procrastination fatigue makes you think less and less about investment.

  3. As I was reading though the article, I couldn't help notice the parallels between the big push model and the expectations-driven innovations gap you were describing. I've always thought that Krugman (1994, provides an elegant graphical exposition of Murphy, Shleifer and Vishny's big push model, in simplifying the complex variables involved in this underdevelopment trap (no technological externalities, only imperfect competition and a large fixed cost). If the wage premium is in the intermediate range shown in Krugman's graph, innovation is a coordination problem. If expectations of income/other people using innovative techniques are rising (demand externalities), then this might overcome the problem. If not, the state or increased openness to trade would be necessary (which on both accounts, has been undermined by the Conservatives). Was this what you had in mind when writing?

    It's also a rather sad indictment of our current government that we're looking – or at least I am – at development theory to explain the UK's woeful productivity and growth record since the financial crisis.

  4. This makes sense. If the economy is demand limited, then there is plenty of spare capacity. We know this is true of labor in that the employment / population ratio has been falling. We know this is true of capital in that interest rates are low and have stayed low through the recovery. Unfortunately, raising demand requires moving money downmarket to the undeserving lower and middle classes, and our current aristocratic ideology will not let this happen. We are as trapped by our ideology as the Soviets were thirty years ago.

  5. You may be right about the behaviour of some sectors of the economy but the model you describe sound like something out of the 1970s. We have added about 2 million jobs since 2010 with only a small dip in the dark days around 2011. Clearly there has been a lot of business formation and expansion but this has been predominantly in low paid service sectors. In most areas of the economy it is difficult to get any more productivity improvements with current technology. The UK is particularly badly affected because of the small proportion of manufacturing and a mature IT capability. Look at Uber: investment in this kind of industry creates lots of low paid jobs and seems to reduce average productivity as measured by economists. Austerity may be part of the problem but there is a lot more going on here.

  6. To maybe put a simplistic view on investment in our current climate, we are as I have said before bumping along the bottom of a depression, when expectations rise and the economy starts to expand businesses that want to keep up, i.e. progressive companies will reinvest, as things are only those that can see no other way of improving productivity will invest, and possibly cut employees at the same time.

    Could it be the final paragraph sums up the inevitable consequence of a government more driven to reducing taxation for the mega rich than stimulating the economy to benefit everyone?

  7. Simon,

    The story that you describe is generally in line with the post-Keynesian analysis about inflation, productivity, investment and the NAIRU. In many post-Keynesian models potential output and the NAIRU are a function of demand and hysteresis plays a key role. When demand increases, firms invest more (a Kaleckian function is typically used to capture the positive impact of profitability and capacity utilisation on investment). This demand-induced investment leads to more innovation and higher labour productivity (via the Kaldor-Verdoorn’s law). If labour productivity growth is not fully passed on to wage growth, the NAIRU declines and we do not have inflationary pressures. Higher investment also tends to reduce capacity utilisation, which prevents firms from increasing their mark-ups and, thus, inflation. You can find more details about the formalisation of these channels in these papers and the references therein:

    Overall, your arguments about the role of innovation could be easily formulated by using post-Keynesian models that incorporate the role of demand-led technical progress and conflict inflation.


  8. Simon,

    I think you play a dangerous game linking to the Sandbu piece. You should keep in mind that many laymen and lot's of "experts" (city economists) who just love, Love, LOVE the story that low interest rates and QE are the cause of the productivity slowdown by keeping zombie firms afloat and that higher rates/tighter monetary policy would in fact cure the problem.

    The Sandbu piece is actually clear that it is not arguing this, well somewhat clear, but you have to read most of the way down to find that out. Someone who just reads the first couple paragraphs or just the title will absolutely take the piece as supporting that story and, since you linked to the piece, they may conclude you endorse that story as well.

    I think you need to be very clear, perhaps a post devoted to the subject, that there is no automatic mechanism that says if we bankrupt the zombie firms then new, more efficient firms just magically appear to take their place. To my understanding to get creative destruction we actually need more demand and easier money, not the reverse.

    Not all destruction is creative destruction, sometimes it's just destructive destruction.

