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The Tale of the Output Gap

The output gap, is a seldom mentioned economic statistic compared to some more readily recognizable ones like Gross Domestic Product (GDP) or Consumer Price Index (CPI), yet its implications have just as much sway over monetary policy as its better-known cohorts.

The output gap is defined as the difference between the actual output measured in GDP, and the potential output of the economy at full employment without evidence of inflationary pressure. A positive output gap refers to a period where the economy is producing above its long-term potential, and positive inflationary pressure is evident in the economy. A negative output gap refers to a period in which the economy is producing below its long-term potential, and negative inflationary pressure is evident in the economy. The Great Recession, was not the first period in American economic history where the output gap was negative, though it does stand out for its duration compared to other recessions. When it’s all said and done, the US output gap is likely to drift back into positive territory to offset the current period of a negative gap. I am interested more specifically in the overall trend unfolding in the time series of the output gap statistic.

 

After a short glance at the time series going back to 1949 of Output Gap data, a downward trend becomes apparent. My intuitive conclusion is that the American economy has been progressively falling behind its long-term potential for output, over the past 65+ years. This timeline coincides with the lifecycle of the Baby Boomer generation. In other words, the Industrial Revolution that occurred in the US economy leading up to the Great Depression, set the bar so high for relative expansion of production potential, that the following generation spent the sum of its working years perniciously falling short on the whole. Not to be understated, this is the generation that built on decades of industrialization to create what we now consider the difference between developed and developing economies. As a final act, the Baby Boomer generation facilitated the transition from the manufacturing centric economies of their boom years, to the service centric economies the developed world enjoys today.

The next Act is set to be as spectacular as, if not more so than, the previous Acts of the Industrial Revolution and the post World War 2 manufacturing boom seen in the developed world. The next Act is the story of the Millenials and a service driven economy that does not place a premium on labor. The x-factor in this part of the narrative is how integrated and extensive the role of technology will be in the resounding success, or epic failure of the next generation to ‘have a turn’. To the credit of the Millenials, technology is an incumbent part of their everyday existence, and integration of ideas both abstract and mundane, is second nature. The frontier of human-technology interfacing may prove to be ground upon which this next generation of entrepreneurs and problem solvers cultivates the next burst of economic expansion.