Several months ago there was a lot of hot blogospheric debating about the so-called output gap — the gap between what the economy is producing and what it could be producing.
The fact that this gap was significant was enough for the likes of Paul Krugman to argue that there was no reason for the Fed to do anything but pump or the Congress to do anything but stimulate, since with a large output gap (slack, basically) there would be no chance of inflation.
We disagree with this and think the output gap is a lousy concept.
Imagine if we had a gigantic boom in the hula-hoop industry and everyone in the country became skilled in designing, marketing, and manufacturing hula-hoops.
Then hula-hoops go bust. Sure we have a huge output gap then, but merely stimulating the economy with cheap money won’t help because all anyone knows how to do is make hula-hoops, an industry that’s of no use anymore.
Well that’s what we did have, except… instead of hula-hoops we built homes. And the skills that allowed us to create (and sell, and finance, and market) homes en masse, aren’t translating into a post-housing economy.
The reason this idea invalidates the output gap is that there’s no real potential for output. Sure you have idle hands and idle factories, but they can’t actually be used to produce anything, and thus stimulus won’t actually work. Despite a seemingly big output gap, you might actually have very little slack.
Let’s go back to this Census hiring question. They’re having trouble finding workers qualified to count our growing Spanish-speaking population.
The housing boom was great for Spanish-speaking immigrants, and it allowed us to paper over any integration problems we might have worried about. Now it’s an issue.
The bottom line: The economy isn’t just a machine that can one day produce hula-hoops and the next day produce wind turbines, so long as you provide enough cash and cheap money. We may have a lot of unused capacity. It doesn’t mean we know how to do something with it.
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