FT calculations reveal little spare capacity in economy

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There is little or no spare capacity in the economy, limiting the scope for above-average growth in the next few years, according to calculations based on the Treasury’s methods for assessing the state of the economic cycle.

A Financial Times analysis, using exactly the same techniques as the Treasury deployed to justify its decision to assert the economic cycle started in 1997, suggests that there is no more evidence of spare capacity in the economy in 2005 than there was in 1997.

This result contradicts the Treasury’s pre-Budget report assumption that the “output gap” – a measure of spare capacity that estimates the difference between the economy’s level of output and what it could produce without generating inflation – was 1.4 per cent of gross domestic product, or £17bn.

If there is little or no spare capacity in the economy, the underlying potential of the economy and the strength of public finances would be considerably weaker than Gordon Brown, the chancellor, outlined in the pre-Budget report last month. His bullish forecasts for 2007 and 2008 relied on the view that the output gap was at a 10-year high, which would enable rapid growth in these years to close the gap.

In the pre-Budget report the Treasury said it chose 1997 as the year when the economic cycle started because its analysis of 26 economic indicators suggested the output gap was roughly zero. Mr Brown asked the National Audit Office to audit this decision and the NAO said the analysis was reasonable.

Taking the same indicators for 2005, there appears to be, if anything, marginally more evidence to suggest the economy was operating with no output gap than there was in 1997.

The difference between the view of the output gap shown by the 26 indicators and the Treasury’s official estimate suggest three possible explanations. First, that the long-term sustainable growth rate of the economy has fallen, so there is no spare capacity even though growth has been disappointing in recent years.

Second, that the official figures have been understating the strength of economic growth recently and will subsequently be revised upwards.

In either of those cases, the scope for strong non-inflationary growth and a painless improvement in public borrowing would be less than the Treasury has been assuming.

A third possibility is that the 26 indicators are giving misleading signals, casting further doubt on the credibility of the Treasury’s analysis of the economic cycle and its fiscal rules.

Economists agree that estimating the size of the output gap can be only an inexact procedure and the Treasury conceded in the PBR that “considerable uncertainty surrounds current estimates of the output gap”.

There are few more important concepts for macro-economists than the output gap. It is an attempt to measure the difference between the level of output in an economy and what could be produced without sparking inflationary pressures.

As so often in economics, the jargon is unhelpful; the gap cannot be measured with any precision and the concept itself is slippery.

But, in a nutshell, economies with large “negative” output gaps have the potential to grow faster than normal for a period without fear of inflation, while economies with a “positive” output gap need a period of slower than normal growth to avoid inflation taking off.

The output gap therefore governs what is possible for an economy and takes a central role in the Treasury’s economic forecast and those of almost all other forecasters.

As Mr Brown said the negative output gap was 1.4 per cent of gross domestic product in 2005-06, the largest for more than a decade, it allowed him to forecast above average economic growth in 2007 and 2008 to close the gap. The Treasury pencilled in growth of 2.75 per cent to 3.25 per cent in both years. Mr Brown’s rapid growth forecast meant he could assume buoyant tax revenue growth and a steep reduction in public borrowing. Without the output gap assumption, he could not have been nearly so confident about the sustainability of the public finances and meeting his fiscal rules.

A difficulty for the Treasury is that it has two distinct methods of estimating the output gap, which the Financial Times analysis shows are contradictory.

Mr Brown’s estimate of a 1.4 per cent of GDP gap starts with the assertion that the last time the economy was operating without any spare capacity was in 2001. It then compares the current level of economic output with what the Treasury believes could be produced if the economy had expanded at the Treasury’s 2.75 per cent a year estimate of its long-term potential. Economic growth in recent years has fallen short, so a gap has opened up.

But when the Treasury comes to deciding start and end dates of the economic cycle – also, on its definition, when the output gap is zero – it looks at a wide number of economic indicators of slack in the economy to see whether there appears to be spare capacity or not.

Before the PBR report, the chancellor also asked the National Audit Office to examine whether it was reasonable to declare 1997 to be the start date of the economic cycle.

The NAO said it was reasonable to say 1997 was a time of zero output gap because five of the Treasury’s 26 indicators were below their long-term averages, 16 were close to these averages, and six were above. The FT repeated the exercise for 2005. Rather than finding many more of the indicators below their long-term average as might be expected for an economy with a 1.4 per cent of GDP output gap, 10 were above, eight were close to these marks and only seven were below. In fact, there was more evidence to say there was no output gap in 2005 than there was in 1997.

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