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More on the output gap: The structural unemployment debate

By Neil Irwin

Check out the online graphic that Alicia Parlapiano and I created on the output gap, explaining why it just doesn't feel like an economic recovery. Here are a few more thoughts on the output gap and the economy that didn't fit in the graphic.

First, keep in mind that potential output is merely an estimate--we used the Congressional Budget Office's numbers. It is unknowable exactly what the nation's economic potential is, and the best that the smart economists at the CBO and elsewhere can do is come up with informed estimates. That means that it is subject to debate, and indeed, right now there is just such a debate underway. The argument is over whether there are fundamental, structural changes in the economy underway that mean one or both of these things: That with the crisis, the potential output line took a one-time, but permanent, shift downward; or that in the post-crisis world, the potential output line slopes upward more slowly than it has in the past (or than the CBO estimates for the future).

The implication of this possibility is that actual output may not be as far below potential output as my chart would suggest. That, in turn, has significant policy implications. If the output gap is lower, there would be less need for the Federal Reserve to take more action to boost growth, or for Congress to maintain its fiscal stimulus efforts.

For a sense of this debate, Narayana Kocherlakota, president of the Minneapolis Fed, makes the case in this speech. Paul Krugman, the Nobel-winning economist and New York Times columnist, smacks down these arguments here. For a more nuanced, and, to my mind, persuasive take, read this from Ryan Avent at the Economist. There really is some major structural change happening in the economy right now, Avent argues, but that doesn't mean we don't have a giant output gap that needs to be reduced.

One more point. In debating economic policy, there is a tendency to conflate two questions. One is what the government should try to do to keep output as close as possible to potential output, to minimize those deviations. The second is what mix of government policies will result in the potential output line rising as steeply as possible in the long run, which is the ultimate source of rising standards of living.

So, for example, Republicans favored the Bush tax cuts in 2001 and 2003 because they view lower-tax policies as likely to lead to steeper increases in potential output over the long run. But they sold them publicly as a way to close the temporary (and, in hindsight, quite small) output gap that existed in those years. And Democrats sold the 2009 stimulus bill as a tool to close the giant output gap that existed then. But many elements of the bill were designed to fulfill long-term policy priorities of the left that, in Democrats' view of the world, are more likely to make for a more steeply rising potential output line.

We could have better debates over economic policy if politicians--and journalists--were clearer about the distinction.

By Neil Irwin  | October 5, 2010; 11:40 AM ET
Categories:  U.S. Economy  
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Unemployment is still expected to however around 9% for most of 2011. This slight increase should bode well for staffing agencies for the coming year. VOL is one of the companies that should be a strong performer.

Here is how they have compared to Unemployment of the past 5 years. - Staffing Agencies v. Unemployment

Posted by: prime99 | October 5, 2010 12:17 PM | Report abuse

One fact is that we have had a large and growing trade deficit that has developed over the last two decades. A second fact is that Americans have grown used to consumption beyond our means. A third fact is that Americans have developed a sense of entitlement to a disproportionate share of the world's resources that is no longer justified by the competitive position of our economy. All of these facts indicate a priority to readjust our expectations and our economy to less consumption. The idea that our problems can be fixed by promoting even more consumption excess defies any kind of common sense.
Another thread of reasoning has to do with the role of automation. Our economy has the potential for more output from less labor. Trying to adjust to that reality by maintaining the same labor and finding a way to consume all the extra output just does not work. The decreasing requirement of labor for basic manufacturing implies a major change in the kind of work people do. The adjustment process is a difficult one that will not be achieved by trying to prop up past realities with handouts and make work.

Posted by: dnjake | October 5, 2010 12:20 PM | Report abuse

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