In a speech of Haldane’s published on Budget day, the chief economist said that when assessing the severity of a recession, economists use a measure called the output gap.
This measures the gap between the current rate of activity in an economy, and its long-term potential rate. If an economy is growing at a faster pace than its potential, the output gap is said to be positive.
The best way to understand the concept of output gaps is to think about a car journey. One can travel at 100mph and get to the destination very quickly, but with an increased risk of an accident.
If one travels at 10mph, the risk of an accident is minimal, but the journey will take a long time. If one travels at 60mph, the risk of accident is minimal, while the speed of travel is competitive.
So, imagine 60 is the normal rate of growth in the economy, if the economy is growing at 10, then it is likely to be in recession, and the output gap is 50. If the economy is growing at 100, then it’s likely unsustainable and the output gap is positive.
Haldane believes that while the pandemic-induced recession was deeper than that of the global financial crisis, the output gap may be smaller, because, unlike during structural recessions, the pandemic saw some parts of the economy grow rapidly, even as others collapsed, whereas, during the global financial crisis, sectors of the economy collapsed and none grew materially.
The Haldane added that while the output gap is smaller than during the last crisis, the policy response has been much bigger, and so the output gap will close quickly, and once the gap is closed, inflation happens.
An example of what happens when there is more stimulus than is needed, with resulting inflation, can be seen from Britain in 1987.
David Smith, an economist at the University of Nottingham, author and journalist, in his book The Age of Instability, describes how in October 1987, “Black Monday” wiped 20 per cent off the US stock market.
UK chancellor Nigel Lawson decided this event must inevitably lead to a recession globally, and so cut interest rates as a way to stimulate growth.
But the recession never happened globally, and the UK economy soared ahead, leading to a period known as the “Lawson boom.”
But inflation rose sharply, Lawson subsequently tightened fiscal and monetary policy to combat this, just as the rest of the world was loosening, creating a recession in the UK.
Bell believes that a rapid economic recovery will happen, but is sceptical that inflation will come through in a prolonged way.
He says: “As the economy opens up, demand will rise quickly, and inflation will rise, but it is like walking up a steep hill in the fog, you have no idea where the peak is. Very credible economists are predicting higher inflation but economists don’t have a good record of predicting inflation properly.”
