But financial institutions and policymakers could – and should – have been more alert to the vulnerabilities that were building during the years leading up to the crisis and therefore to the possibility of a major shock to the financial sector and to the economy more generally. It is somewhat analogous to seismologists trying to predict earthquakes along a fault line. It is impossible to predict the day and magnitude of a shock with any precision, but it may be possible to say something about the likelihood of an earthquake occurring within a given period from seismic measurements and indicators of latent stress. Now it might seem natural to measure the severity of a recession by the magnitude of the fall in output. Indeed, a recession is sometimes characterised in the media as being two or more consecutive quarters of falling output, with the end of the recession being marked by a return to expansion. But that is not a very useful definition, as the mere resumption of growth will still leave some plants idle and some workers unemployed. From an economic perspective, it should be the margin of unused resources in the economy – the difference between actual and potential output – that we care about. And it is also the margin of unused resources that determines how much the economy can grow during the recovery before it puts significant 3 upward pressure on inflation , the control of which is the MPC’s primary objective.
The problem is that the level of potential output is inherently difficult to measure. For an individual firm, the notion of capacity is slippery. A car manufacturer might be able to say how many units can be produced if all production lines are operating 24/7, but he knows that to do so would prevent essential maintenance and impair the firm’s ability to produce output later. And in the service sector, the notion of capacity is even more complex. What is the capacity of a law firm, for instance? One might be able to say how many hours the existing partners could work, but that is not the same as how much output they could produce. Moreover, it is impossible to match unemployed workers to unfilled vacancies instantaneously, so it is not appropriate to ask what level of output could be achieved if all  3  Of course the margin of spare capacity is only one determinant of inflation. Other factors include commodity prices, the exchange rate and inflation expectations. And the rate at which the margin of spare capacity is closed may also matter – so-called “speed limit” effects. BIS Review 142/2010  3  those who wanted a job were actually in one. The frictions and the institutional characteristics of labour and product markets need to be taken into account too. Economists studying business cycles have used a variety of approaches to construct proxies for potential output.