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Brad DeLong

Distinguished from the Macroblog at delong.typepad.com and from twitter at @delong...
Oct 4 '12
  • Izabella Kaminska: Capital Economics put out a cracker of a note on UK output this week. It’s taken us a while to get through it but we wanted to do it justice. Here’s the key extract: ‘Supply pessimists’ point to high inflation and growing employment as evidence of a small output gap. But inflation was pushed up by temporary factors and has eased recently, while domestically generated inflation has remained low. The rise in employment since 2010 is puzzling, but it has been concentrated in low productivity sectors where there was less labour hoarding during the recession. If we assume (generously in our view) that the economy was operating 2% or 3% above potential in 2007, and that the financial crisis dealt a permanent blow to the economy of 5% of GDP, the output gap should still be about 6% of GDP. If our view is correct, this implies unnecessary fiscal consolidation under current plans of about 2.5% of GDP, or £35bn in current prices. A large output gap offers the prospect of the UK being able to enjoy strong economic growth, if and when demand recovers, without inflation taking off. But as long as monetary and fiscal policies are conditioned on a pessimistic view of spare capacity, this prospect may be frustrated. Accordingly, supply pessimism may be self-reinforcing.