The so-called ‘output gap’: another piece of economic mumbo-jumbo

The concept of the’ output gap’ is central to mainstream macroeconomics. It is not merely of academic interest. The Office for Budget Responsibility (OBR) has a specific requirement to estimate the output gap, which it defines formally as “the difference between the current level of activity in the economy and the potential level it could sustain while keeping inflation stable”. The output gap is a key consideration for central banks around the world. If output is well below its potential, interest rates should be kept low, to try to stimulate the economy. And a large output gap should keep inflation low. Prices are hard to put up in a depressed economy.

The task of estimating the output gap empirically is fraught with difficulties. The OBR points that there are at least three recognised ways of doing this, none of which will make sense to anyone lacking an advanced training in statistics. So there is plenty of scope for disagreement amongst orthodox economists who believe in the concept. Yet rather like the medieval debates about how many angels could dance on a pin, these disputes have little meaning in the economy of the 21st century.

The economy is not a physical object and cannot, say, be placed on a pair of scales and weighed. GDP has to be estimated, using a wide range of information. The basic principles of how to measure output were worked out in the 1930s and 1940s. A major problem is that these principles are much more suited to an economy which, as it was at that time, is dominated by the production of goods rather than services. We can count how many Ford Model Ts have been built. It is much less clear what the outputs of Google or Facebook are. The problems are even more acute with the concept of potential output. Many internet-based services incur substantial fixed costs in order to have just a single customer. But the additional cost of servicing the second customer, and all subsequent ones, is effectively zero. Potential output does not have much meaning in these contexts, it is not obvious what the limit might be.

A powerful blow against the concept of potential output has been published in the latest edition of the American Economic Association’s journal Applied Economics. Igal Hendel and Yossi Speigel document the evolution of productivity over a 12 year period in a steel mini-mill producing an unchanged product, working 24/7.  The steel melt shop is almost the Platonic ideal from a national accounts perspective of output measurement. The product – steel billets – is a simple, homogenous, internationally traded product. There was virtually no turnover in the labour force, very little new investment, and the mill worked every hour of the year. Yet despite production conditions which were almost unchanged, output doubled over the 12 year period. As the authors note, rather drily, “the findings suggest that capacity is not well defined, even in batch-oriented manufacturing”. Time to put the concept of potential output into the rubbish bin!

Paul Ormerod

As published in City Am on Wednesday 22nd January 2013

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Alex O’Byrne, Associate at Volterra, is an experienced economic consultant specialising in economic, health and social impact, economic strategy, project appraisal and socio-economic planning matters.

Alex has led the socio-economic and health assessments of some of the most high profile developments across the UK, including Battersea Power Station, Olympia London, London Resort, MSG Sphere and Westfield. He has significant experience inputting to EIAs and s106 discussions as well as drafting economic statements, employment and skills strategies and affordable workspace strategies.

Alex is also experienced at economic appraisal for infrastructure. He was project manager of the economic appraisal for the City Centre to Mangere Light Rail in Auckland. He also led the economic and financial appraisals of the third tranche of the Transport Access Program for Transport for New South Wales, in which Alex developed and employed innovative methodological approaches to better capture benefits for individuals with reduced mobility.

He is interested in the limitations of current appraisal methodologies and ways of improving economic and health analysis to ensure it is accessible to as many people as possible. To this end, Alex recognises the importance of transparent and simple to understand analysis and ensuring all work is supported by a robust narrative.

Alex holds a BSc (Hons) in Economics from the University of Manchester and he was a member of the first cohort of the Mayor’s Infrastructure Young Professionals Panel.


Senior Partner

t: +44 020 8878 6333

Ellie is a partner at Volterra, specialising in the economic impact of developments and proposals, and manages many of the company’s projects on economic impact, regeneration, transport and development.

With thirteen years experience at Volterra delivering high quality projects to clients across the public and private sector, Ellie has expertise in developing methods of estimating economic impact where complex issues exist with regards to deadweight, displacement and additionality.

Ellie has significant experience in estimating the economic impact across all types of property development including residential, leisure, office and mixed use schemes.

Project management of recent high profile schemes include the luxury hotel London Peninsula, Battersea Power Station and the Nova scheme at London Victoria. Ellie has also led studies across the country estimating the economic and regeneration impact of proposed transport investments, including studies on HS2 and Crossrail.

Ellie holds a degree in Mathematics and Economics from the University of Cambridge.