One of the most economically important yet technically boring stories of our time is the way that policymakers have defined down success to the point that they’re saying, for example, that Spain is doing better with its 13.9 percent unemployment rate than Germany is with its 3.1 percent one.
It has to do with what’s called the output gap, which is just how close the economy is to operating at its full — but not too full — potential. What do we mean by that? Well, it’s not about unemployment being as low as possible, but rather being as low as possible without making inflation go any higher. That last part is tricky, though, because we can’t really predict what that’s going to be ahead of time. All we can do is try to guess at it based on past experience — experience that may not be that relevant anymore because of how much the economy has changed in the meantime.
In any case, there are two ways that economists try to do this. The first is to look at inflation, and then try to figure out what the Goldilocks level of unemployment is that will neither make it go up or down. The idea being that low unemployment leads to workers getting bigger raises, which, by cutting into companies’ profits, will eventually force them to raise prices. And that high unemployment does the reverse by hurting sales instead.
But the problem is that while this might have been a pretty good description of the way the world used to work, it isn’t right now. Why not? A few, somewhat contradictory, reasons. Part of it, you see, is that workers have lost enough bargaining power that even low unemployment doesn’t seem to give rise to the type of much higher wages that it did before. At the same time, though, this hasn’t changed the fact that workers are able to resist being forced to take pay cuts when times are bad, effectively putting a floor under how far prices can be cut. So, when you put it all together, it means that inflation no longer tends to spiral up or down in response to either higher or lower unemployment, but only moves within a fairly narrow range instead. Which is even more true now that central banks have done such a good job at getting people to expect inflation to stay the same no matter what.
The result is that inflation doesn’t change very much anymore whether unemployment is 4 or 6 or even 8 percent. And that means that trying to use it to judge the economy’s potential will, more often than not, be completely misleading.
Not that the other way economists try to measure this is any better. That’s just looking at how the economy has done, on average, the last couple of years to try to get an idea of where it should be now. The assumption being that any shock to the economy — like, say, a housing crash — will be short-lived enough that things will quickly revert to whatever their long-term trend was. What if it isn’t so temporary though? What if the crisis knocks the economy off course for five or six years instead of one or two? Well, in that case, this would tell you that a longer recession wasn’t a recession at all, but was rather the new normal that was all we could aspire to. In other words, it interprets a medium-term decline in actual output as a long-term decline in potential output too. This, as Paul Krugman points out, would lead you to believe in absurdities like that the United States having fully recovered from the Great Depression by 1935, when unemployment was still somewhere around 17 percent...
... Or, as we mentioned before, that Spain’s economy is operating at a higher capacity than Germany’s is today. Now, on the one hand, it is true that for a variety of reasons, including an undereducated work force and a relatively large shadow economy, Spain has tended to have a higher official unemployment rate than other countries even when things are going well. But, on the other hand, it seems pretty crazy to say that this means Spain’s economy has gone past its potential into inflationary territory with its 13.9 percent unemployment rate while Germany is still below its with its 3.1 percent unemployment rate. Especially when, as the Institute of International Finance Chief Economist Robin Brooks points out, other measures of labor market slack also show that Spain has a quite a bit of it left, and confirm that Germany does not. Or when Spain’s economy, adjusted for population, has grown 10 percent less than Germany’s since the crisis started in 2007.
Nonetheless, that is exactly what the European Commission is saying right now. It thinks that Germany’s economy is about as hobbled as Italy’s is right now — despite the fact that Germany has, in per capita terms, outgrown Italy by nearly 20 percent the past 12 years — and that both of them are well behind Spain in terms of reaching their full economic potential.
It’d be laughable if it weren’t so tragic. That’s because this nonsense idea that Spain’s economy doesn’t need any more help is really just an excuse not to help it. There’s no need, after all, for any more fiscal or monetary stimulus if this is as good as it gets for them. Which is to say that this is an attempt to declare victory over mass unemployment by changing the definition of the word “mass.”
Policymakers might be able to convince themselves with these statistical games, but voters aren’t so easily fooled.