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The Myth of the Output Gap

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The GDP framework and the output gap is an abstraction that does little more than provide justification for the interventions of government officials.

According to popular thinking, the key cause behind either inflation or deflation is the difference, or the gap, between what an economy is producing and its potential output. Potential output is the maximum amount of goods and services an economy can turn out when it is at full capacity.

A positive output gap occurs when actual output is more than full capacity output. It is held that a positive output gap sets in motion upward pressure on the prices of goods and services in general due to the fact that demand is in the excess of supply.

A negative output gap occurs when actual output is less than what an economy could produce at full capacity. A negative gap is viewed by popular thinking as spare capacity, or slack, in the economy due to weak demand. As a result it is held this could lead to a general fall in the prices of goods and services.

The output gap is viewed by central bank policy makers and most experts as a key determinant of inflationary or deflationary pressures. Hence most experts and central bank policy makers regard output gap data as an important input that helps policy makers keep the economy on a stable economic growth path with stable inflation.

By means of statistical methods, government statisticians generate a periodical estimate of "gross domestic product" and "gross domestic potential output."

On account of a positive output gap, central bank policy makers may thus subject the economy to a tighter monetary stance i.e. raise interest rates and reducing monetary pumping, in order to lower the overall demand for goods and services and bring demand in line with potential output. This in turn, it is held should eliminate inflationary pressure.

Conversely, if the output gap is negative i.e. when demand is below the potential output, policy makers may aim at lifting overall demand in the economy in line with potential output by lowering interest rates and lifting monetary pumping. Once the balance between demand and supply is attained this should arrest the decline in the prices of goods and services i.e. deflationary pressures, or so it is held.

The Output Gap and Changes in Prices

Superficially it sounds logical that a positive output gap, (i.e. where demand is in excess of what the economy can produce), should lead to upward pressure on prices. It is however not sufficient to say that an excess in demand is the cause of a general rise in prices. Before we proceed in ascertaining the cause we first need to begin by correctly defining exactly what a price is.

A price of a good is the amount of money paid for the good. Hence in the analysis of prices one needs to pay attention — in addition to the amount of goods in the economy — also to the amount of money.

For a given amount of goods and services, in order to have a general increase in prices there must be an increase in the money supply. Conversely, for a given amount of goods and services a fall in the money supply will result in a general decline in the prices of goods and services.

We suggest that as a rule the key factor in monetary expansion are central bank policies that are aimed at countering recessions i.e. a negative output gap — where an economy’s demand is below the potential output.

(By means of loose monetary policies and via fractional reserve banking, central bank policy makers can lift the money supply growth rate).

Elsewhere, I have noted that loose monetary policy is responsible for the weakening of the process of wealth formation and to the weakening in the pool of real wealth.

It is this that leads to a decline in commercial banks’ inflationary lending and this in turn results in the decline of money. This in turn, after a time lag, results in a general decline in the prices of goods and services.

Whenever the central bank reacts to an emerging economic slump, which they label as a negative output gap – where output is below potential output – via loose monetary policy, this inflicts further damage on the process of wealth generation. Over time, this is likely to weaken so called potential output and also actual output.

A situation could emerge where on account of the difference in the time lag between changes in the money supply and its effect on prices and output, prices will increase while the economy is in a severe slump. This is commonly labeled as stagflation. Note that the occurrence of stagflation contradicts the concept of the output gap. Again according to this concept a general increase in prices cannot occur whilst an economy is in a recession.

Does the Output Gap Make Sense?

We have seen that in order to gain insight into the state of an economy via the output gap, policy makers and economists rely on a statistic called gross domestic product (GDP). The GDP framework looks at the value of final goods and services produced during a particular time interval, usually a quarter or a year. This statistic is constructed in accordance with the view that what drives an economy is not the production of wealth but rather its consumption. What matters here is demand for final goods and services. Since consumer outlays are the largest part of overall demand, it is commonly held that consumer demand sets in motion economic growth.

By focusing exclusively on final goods and services, the GDP framework lapses into a world of fantasy wherein goods emerge because of people's desires. This is in total disregard to the facts of reality (that is, the issue of whether such desires can be accommodated). All that matters in this view is the demand for goods, which in turn will give rise almost immediately to their supply.

In the real world, it is not enough to have demand for goods — one must have the means to accommodate people's desires. Means — i.e., various intermediate goods that are required in the production of final goods — are not readily available; they have to be produced. In order to manufacture a car, there is a need for coal that will be employed in the production of steel, which in turn will be employed to manufacture an array of tools. These in turn are used to produce other tools and machinery and so on, until we reach the final stage of the production of the car. The harmonious interaction of the various stages of production results in the final product.

The GDP framework gives the impression that it is not the activities of individuals that produce goods and services, but something else outside these activities called the "economy." However, at no stage does the so-called "economy" have a life of its own which is independent of individuals. The so-called economy is a metaphor — it doesn't exist.

By lumping the values of final goods and services together, government statisticians concretize the fiction of an economy by means of the GDP statistic. The whole idea of GDP and the output gap gives the impression that the production of goods and services is done by some collective, which is supervised by a supreme commander(central bank).

The economy is guided all the time by the supreme commander in order to stay on the stipulated growth path by the commander. Any deviation from this path prompts an intervention by the commander in terms of monetary and other policies.In the real world every businessman makes his own decision regarding the production of goods and services.

The Problem with Calculating GDP 

In addition to all these issues, there are serious problems regarding the calculation of the GDP statistic. To calculate a total, several things must be added together. To add things together, they must have some unit in common. It is not possible to add refrigerators to cars and shirts to obtain the total unit of final goods. Since total real output cannot be meaningfully defined, obviously it cannot be quantified.

To solve this problem, economists employ total monetary expenditure on goods which they divide by an average price of those goods. There is, however, a serious problem with this which can be illustrated in the following example.

Suppose two transactions were conducted. In the first transaction, one TV set is exchanged for $1,000. In the second transaction, one shirt is exchanged for $40. The price or the rate of exchange in the first transaction is $1000/1TV set. The price in the second transaction is $40/1 shirt. In order to calculate the average price, we must add these two ratios and divide them by 2. However, $1000/1 TV set cannot be added to $40/1 shirt, implying that it is not possible to establish an average price.

The employment of various sophisticated methods to calculate the average price level cannot bypass the essential issue that it is not possible to establish an average price of various goods and services. Accordingly, various price indices that government statisticians compute are simply arbitrary numbers. If price deflators are meaningless so is the real GDP statistic.

So what are we to make of the periodical pronouncements that the economy, as depicted by real GDP, grew by a particular percentage? All we can say is that this percentage has nothing to do with real economic growth and that it most likely mirrors the pace of monetary pumping. We can draw the same conclusion regarding the output gap.

As a rule, the more money created by the central bank and the banking sector, the larger the monetary spending will be. This in turn means that the rate of growth of what is labeled as the real economy will closely mirror rises in money supply.

So it is no wonder that in the GDP framework, the central bank can cause real economic growth, and most economists who slavishly follow this framework believe that this is so. Much so-called economic research produces "scientific support" for popular views that, by means of monetary pumping, the central bank can grow the economy. It is overlooked by all these studies that no other conclusion can be reached once it is realized that GDP is a close relative of the money stock.

The Role of the Entrepreneur 

One is also tempted to ask why it is also necessary to know if the so-called "economy"is growing and at what pace. What purpose can this type of information serve? In a free unhampered economy, this type of information would be of little use to entrepreneurs. The main indicator that any entrepreneur relies upon is profit and loss. How can the information that the so-called "economy" grew by 4 percent in a particular period help an entrepreneur make profit?

What an entrepreneur requires is not general information but rather specific information regarding the demand for his specific product, or products. The entrepreneur himself has to establish his own network of information concerning a particular venture.

Things are quite different, however, when the government and the central bank tamper with businesses. Under these conditions, no businessman can ignore the GDP statistic since the government and the central bank react to this statistic by means of fiscal and monetary policies. Likewise, participants in financial markets closely follow the GDP statistic in order to assess the likely responses of the central bank.

If the effect of policy makers tampering were confined only to the GDP statistic then the whole exercise would be harmless. However, these policies tamper with activities of wealth producers thereby undermine people's well-being. By means of monetary pumping and interest rate manipulations, the central bank doesn't help generate more prosperity, but rather sets in motion a "stronger GDP" and the consequent menace of the boom-bust cycle—i.e., economic impoverishment.

We can thus conclude that the GDP framework and the output gap is an empty abstraction devoid of any link to the real world. The GDP framework and the output gap are highly sought by governments and central bank officials since they provide an illusory frame of reference to assess the performance of government officials.

Note: The views expressed on Mises.org are not necessarily those of the Mises Institute.
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