Jacques R. Artus
The potential output of an economy is the output that would be realized if the labor force were fully employed, and labor and capital used at normal intensity. Although the concept is difficult to define and even more difficult to quantify, the need for such a measure, however imprecise, is not in doubt. Estimates of potential output and the ratio of actual to potential output—the output gap—are crucial in assessing the economic situation of a country and the appropriateness of its policies. These estimates are particularly crucial at the present time when there are serious divergences of views on whether more expansionary policies are needed in a number of industrial countries.
The burning issue is: how large are the prevailing output gaps? If it is true, as some observers believe, that the rates of growth of potential output have been reduced sharply in recent years (in particular because of increased oil prices), and that prevailing output gaps are small, then expansionary measures would lead rapidly to widespread bottlenecks in production and to an increase in inflationary pressures. If, by contrast, the large and increasing numbers of unemployed indicate wide prevailing output gaps, as other observers believe, there would be no risk of widespread bottlenecks over the foreseeable future and no risk of an intensification of inflationary pressures caused by excess demand conditions. The issue is also important for investment. If prevailing output gaps are large, the present low investment can be explained by an excessive current capacity in relation to present and projected capacity needs. If not, the low investment must be attributed to “structural” factors, such as a possible secular decrease in the profit rate or increased uncertainty in economic conditions. Expansionary policies would be more likely to lead to an increase in investments if the cause for prevailing low investments were a large output gap, rather than structural factors.
To cast some light on these issues, a study was made to estimate consistent series of potential output in manufacturing for seven industrial countries—Canada, France, the Federal Republic of Germany, Italy, Japan, the United Kingdom, and the United States—between 1956 and 1977, and to project these series for the medium term (1978-80) on the basis of the projected availability of resources. Manufacturing was chosen for three reasons: (1) it is one of the main sectors in industrial countries; (2) it is subject to large fluctuations in output; and (3) it plays a dominant role in world trade. It also has a more homogeneous set of inputs and outputs than a whole economy or, say, the private nonfarm sector, and this greatly increases the accuracy of estimation. This article will review the results of that study, and then briefly discuss the concept of potential output, and the method used to quantify the concept.
The estimated rates of growth of potential output in manufacturing from 1956 to 1980 are presented in Table 1. The results show a striking fall in the rate of growth of potential output in a number of industrial countries during the 1970s. In Japan this rate fell from about 13 per cent in 1969 to 4 per cent in the late 1970s. The fall in the other countries was less extreme, ranging from about one half a percentage point to one percentage point for France, Italy, the United Kingdom, and the United States, to one and one half to two percentage points for Canada and the Federal Republic of Germany. Potential output decelerated particularly sharply after 1973, but the process was already in evidence before then, at least in Japan and in the Federal Republic of Germany.
An earlier version of this article was published as “Measures of Potential Output in Manufacturing for Eight Industrial Countries, 1955–78,” by Jacques R. Artus, in the Fund’s journal, Staff Papers, Vol. 24 (1977), pp. 1–35. This version includes a discussion of the estimation techniques used in the study.
(Percentage change in potential output per annum attributable to each source)1
|Canada||Federal Republic of Germany|
Components may not add to totals because of rounding.
Components may not add to totals because of rounding.
Table 1 shows the clear role of slower growth of the capital stock in reducing the growth of potential output in Japan and the European countries during the 1970s. (In Canada and the United States, on the other hand, the rates of growth of the capital stock and their contributions to growth have remained fairly stable.) The growth of capital stock in Japan and Europe was affected by a marked fall in the rate of investment in the 1970s, especially after 1973, which also led to an increase in the mean age of the capital stock for these countries. These effects were particularly pronounced in Japan. Despite the marked cutback in investment in many countries after 1973, however, not one of the industrial countries considered here experienced an actual contraction in its capital stock. The low levels of investment observed since 1973 are still considerably higher than the amount of capital stock discarded each year.
The falling rates of growth of potential output were also caused by the slower growth, or in some cases even a decline, in the labor force available to the manufacturing sectors (measured in man-hours). This factor is important in the Federal Republic of Germany, Italy, Japan, and the United Kingdom. The major reason for this phenomenon was the reduction in the average yearly number of hours worked per employee. The tendency for shorter workdays and longer vacations (already marked in the 1960s and early 1970s) has accelerated since 1973, often as a result of changes in labor legislation.
Higher oil prices and related factors also had a large impact on potential output, because they made part of the capital stock obsolete. The effect was to reduce the level of potential output in each country by 2.6 per cent in a single step (a reduction that cut the average growth rates of potential output between 1974 and 1977 by about 0.6 percentage points per annum). Separate estimates were also calculated for the individual countries but none differed significantly from the above estimate. However, two points are in order here. First, while the estimate looks reasonable, it should be treated with caution. The period between 1974 and 1977 is too short and too highly influenced by the world recession to permit a very precise estimation of the effect of the rise in oil prices on potential output. In fact, the estimate could be too high, because the dummy variable introduced to identify the effect of the increase in the price of oil may have in addition picked up abnormal transitory cuts in productivity caused by the world recession. Second, the estimate calculated here refers only to the impact on productivity in the manufacturing sector. Possible long-run effects on the rate of economic growth remain to be assessed.
A final reason for the decline in potential output that emerges from the data is a reduction in the “residual,” or trend rate of growth of disembodied technical progress, which also seems to have taken place in a number of countries. The extreme example, again, is Japan where the estimated trend rate has fallen by 2.2 per cent—that is from 3.6 per cent to 1.4 per cent since 1970. There are three main reasons for this fall: (1) part of the investment made during this period was to reduce pollution rather than increase output; (2) environmental constraints may also have led to a fall in the degree of returns to scale that shows here in the change in the trend rate; and (3) the opportunity for introducing “new” industries with ready-made technology decreased during that period. The trend rate also fell significantly in Canada, France, and the United States; here, also, one of the reasons may be that the capital stock series do not properly discount pollution-related investments.
The estimates of the decline in the rates of technical progress after 1970 may be on the high side, however, particularly for Japan. The recession in 1974 and 1975 may have led to a fall in the intensity of use of capital and labor within firms which is only partly “reflected” by the proxy variables included in the equation to take this effect into account. The problem here is similar to the one discussed with respect to the effects of the increase in the price of oil, namely, some of the impact of the fall in the intensity of use of labor and capital may be picked up by the estimate of the trend coefficient during the 1970–77 period.
In brief, the rates of growth of potential output in manufacturing have fallen in Japan and in major European countries in recent years. Some of the reasons can be considered to be “structural,” such as the need for special investment to reduce pollution, or to adapt to higher-cost energy, or the desire for more leisure on the part of the labor force. In addition, however, the decline in potential output reflected the fall in the rate of investment and the increase in inefficiencies of various kinds that have been the result of the 1974–75 recession and the subsequent low aggregate demand. Thus, the rate of growth of potential output is not only a constraint that must be taken into account in setting demand management policies; it is also to some extent a variable that can be influenced by those policies. A policy that would have a lasting expansionary effect on the level of aggregate demand would undoubtedly lead to a higher level of investment and, therefore, a higher rate of growth of potential output. There is, however, always a lag between the initial investment and the resultant increase in the productive capacity of the economy. Hence the low levels of investment in 1977–78 already seem to ensure continued low rates of growth of potential output through the period 1979–80.
The amount of economic slack resulting from the 1974–75 recession is highlighted in the gaps between actual and potential output in manufacturing presented in Chart 1. The faltering recovery in Japan and the European countries in 1977–78 is strikingly evident. The size of the gaps is all the more significant in that potential output is not defined here, as it is in most published indexes of capacity utilization, as the level that reflects the intensity of use of capital and labor within firms at the peak of the cycle. It is defined as the level corresponding to the “normal” use of capital and labor within firms that tends to prevail in the long run. In the United States, by contrast, the level of economic activity in manufacturing in the second half of 1978 is already close to the level of potential output.
Output gaps in manufacturing, 1970–78
The concept of potential output
The estimates of potential output that have just been discussed need to be seen in the context of the problems inherent in defining the concepts of “full employment labor force,” “labor force available to a sector,” “capital,” and “normal intensity of use.” It is important, therefore, to examine the definitions used in the study, and to look briefly at the way these definitions were applied.
The meaning of full employment has been discussed extensively in the economic literature and in the political arena. For present purposes, it is necessary to note that: (1) the size of the labor force is positively related to employment opportunities; and (2) some people classified as part of the labor force are in fact unemployed for reasons that have nothing to do with a temporary shortfall of aggregate demand. For example, they may not be able to find a job because of the legal imposition of a minimum wage rate, restrictive practices by labor unions, or simply unrealistic remuneration requests, or they may be voluntarily between jobs. To obtain a realistic estimate of this “cyclical” unemployment, an adjustment must be made to the official series on unemployment to correct for the presence of “structural” unemployment. The full-employment labor force in man-hours can be defined as the labor force that corresponds to the employment opportunities existing when this adjusted unemployment rate approaches zero.
It is more difficult to estimate the proportion of the full-employment labor force allocated to the manufacturing sector. If labor were perfectly mobile among sectors and there was no relationship between cyclical variations in activity levels in the various sectors, such an estimate would, of course, not be meaningful. In practice, however, labor mobility is limited, in particular for skilled labor, and, even more important, the activity level in the manufacturing sector is very closely linked to activity levels in the rest of the economy. It is therefore possible to estimate a stable empirical relationship between employment in the manufacturing sector and employment in the whole economy, and to deduce from this relationship the level of employment in manufacturing that corresponds to a fully employed economy.
Basically, the difficulties that arise in connection with the measurement of the capital stock are the same as those that arise in the measurement of the labor force. What is relevant is not the capacity—that is, the capital stock—of the firms per se but the capacity that can be used by firms to meet market demand. If, because of a permanent shift in demand away from certain products, part of the capital equipment of firms becomes useless, it should be taken into account as loss of capacity. On the other hand, if the shift in demand is transitory, it should not be interpreted as resulting in a loss of capacity—if it were, potential output and actual output would become nearly synonymous. Similarly, on the production side, a temporary shortage of a specific input should not be interpreted as causing a fall in capacity, while a sharp and more lasting change in the relative input prices should be taken into account if it suddenly makes part of the capital stock obsolete. For example, one might justifiably argue that the large increase in the price of oil that took place in late 1973 and early 1974 may have rendered a certain part of the capital stock of the industrial countries obsolete. This could, for instance, be the case for energy-intensive equipment.
The “intensity” of the use of labor and capital stock may also vary substantially. In periods of slack demand, the intensity of the use of labor decreases; what is significant for longer-term potential output, however, is not so much whether the frequency and length of coffee breaks increases considerably, although this may play a role, but the employment of part of the labor force in menial tasks or tasks that do not directly lead to an increase in manufacturing output. In periods of economic boom, by contrast, employees may be willing to work harder than usual, but only on a temporary basis. There is, of course, no direct way either to measure the intensity of use of labor or to define a normal intensity level. The same difficulty occurs with capital equipment. The intensity of the use of capital, usually referred to as the level of capacity utilization, is one of the major adjustment variables in most economies—that is, the production system adjusts to short-term variations in aggregate demand mainly through variations in capacity utilization. In the present study, the deviations of the intensity of use of labor and capital from their long-run normal levels were measured indirectly.
Measuring potential output
There are three main methods that have been developed to measure potential output: (1) the survey of firms; (2) the trend-through-peaks; and (3) the estimation of production functions. The first method can be misleading because respondents tend to “find” capacity when output rises sharply, and “lose” it when output slackens. Under the second method, cyclical peaks in production are marked off, linear segments are fitted between successive peaks, and the linear segment between the last two cyclical peaks is extrapolated at its established slope until a new cyclical peak is established. The method, while simple, is also inappropriate under present conditions since the whole issue is whether the rates of growth of potential output that have prevailed since the last cyclical peaks (1973 in most countries) are lower than the rates of growth that prevailed before that date.
The present study relies on the third method: the production function approach. With that method, information on the evolution of available productive resources is taken into account directly to obtain estimates of potential output. First, a relationship is estimated between the observed volume of production and the volume of resources employed in the production process. This relationship is then employed to calculate the level of output corresponding to full employment of the labor force, with labor and capital being used at normal intensity.
The estimation of aggregate production functions is not, of course, without problems. Briefly, at a given point in time, numerous kinds of labor, machinery, and natural resources are used to produce a varied mix of goods. To represent the whole production process by a simple equation, it is necessary to aggregate these various inputs and outputs into a few composite variables. This gives rise to many problems. In particular, the aggregation of various kinds of capital equipment, at different points in their life cycles, into monetary measures has given rise to controversies for many years. When the production function is employed to describe the production process over a number of years, further problems arise with respect to the representation of technical progress and of changes in the quality of labor and capital inputs. As indicated above, resources within firms may also be used with various degrees of intensity, and degrees of intensity can only be indirectly measured through the use of other variables as proxies. Finally, there are difficulties in quantifying resource availability—in particular, the full-employment labor force.
In assessing the results of the study, these inherent limitations of the empirical techniques used to estimate potential output must be kept in mind. The gaps between actual and potential output in manufacturing that have been calculated must also be interpreted with caution. Clearly, they do not indicate by how much the production level can be raised on short notice or by abrupt additions to aggregate demand. In most cases, a sustained rise in the production level may be possible only gradually, regardless of the amount of spare resources available. Localized bottlenecks may also be an obstacle to an increase in the overall level of economic activity in the short run where the opportunities for imports are limited, regardless of the resources that are left idle in the rest of the manufacturing sector.
It must also be remembered that the concept of potential output is essentially a production concept. It refers to a desirable situation in which factors of production are employed at their long-run normal intensity levels. However, the production level corresponding to potential output is not necessarily an optimal level in the broader sense of the form. That is to say, it may be desirable from some perspectives to maintain the economy at a lower output level, so as to cut the inflation rate or to improve the balance of payments. This point needs to be emphasized.
The need for further work on the measurement of potential output in industrial countries is clear; national official bodies have the resources and necessary information to make particularly useful contributions. Nevertheless, keeping in mind the limits of the present study, two preliminary conclusions can be drawn. First, there has been a sharp drop in the rate of growth of potential output in manufacturing in the 1970s in most industrial countries, and particularly in Japan. Second, despite this drop, there were significant gaps in output in 1978 in the countries studied, with the noticeable exception of the United States. These results would tend to indicate that obstacles to new investment to add to a country’s capital stock do not seem to be found so much in “structural” factors as in the existence of a large output gap. The prevailing inflation rates, by contrast, cannot be explained by the existence of a low output gap, except possibly in the United States.