The 13% GDP gap

This chart nicely illustrates just how weak the current recovery has been—it's actually unprecedented. According to my calculations, there is a 13% "gap" between the current size of the economy and where it would be if it were following its long-term trend growth rate (3.07% compound annual growth, which breaks down on average into 1% annual growth in the workforce and 2% annual increases in productivity). The current output gap is equivalent to lost income of $1.75 trillion, and that's inextricably bound up with the fact that there ought to be at least 10 million more jobs today if the economy were on its long-term trend growth track.

The precise cause of this huge output gap will be the subject of discussion among economists for years, but most of the evidence I see points to the highly unusual expansion of government spending (mostly in the form of transfer payments) over this same period as the leading culprit. Since 2008, federal payments to individuals as a % of GDP have increased by at least one-third, to their highest level ever. Income redistribution on a massive scale like this can not only fail to create growth, it can stymie growth by creating perverse incentives (e.g., rewarding the lack of work and punishing success).

One thing about today's fourth quarter GDP report that caught my eye was the relatively weak growth (3.2%) in nominal GDP, which was entirely due to sharply lower inflation. This can be traced to the same decline in inflation that shows up in the CPI and the PCE deflator over the same period, and which, in turn, was mostly a function of a decline in energy prices, which have since stabilized. As the chart above shows, real growth has been accelerating for the past three quarters, so it's not unreasonable to think that nominal GDP will accelerate in the current quarter, as I suspect it will. Faster nominal GDP growth would also be consistent with a decline in money demand, a phenomenon which I think will be driven by the lessening of concerns over the Eurozone financial crisis. Of course, even if we do get an acceleration in nominal GDP this year, the output gap will likely remain large. Faster nominal GDP is good for corporate cash flows and debtors, but it is not necessarily a big job-creator. For more jobs we need less government and better and permanent after-tax incentives to work and invest (e.g.,  a simpler and flatter tax code) for individuals as well as corporations.

Today's GDP report also amounted to one more shot across the bow of the Phillips Curve theory of inflation: an output gap this large and this persistent should have resulted in years of deflation, according to standard thinking. Instead, the GDP deflator (the broadest and arguably best measure of overall inflation) has risen a total of 6.5% since the peak of the last business cycle.

Brian Wesbury also makes an interesting point, which is that a reduction in public sector spending was one of the sources of weakness in Q4: "Excluding government, real GDP grew at a robust 4.5% annual rate in Q4 and was up 2.6% for 2011 as a whole." In other words, cutbacks in local, state, and federal spending reduced the growth in GDP last year by 1 percentage point. That's not surprising, since we know that public sector payrolls have been declining for the past three years, and we know that our military presence in the Middle East has been winding down of late. But it's not exactly bad news, since our public sector had grown like topsy in the years preceding. A smaller government footprint on the economy means more room for the more-efficient private sector to grow.

So even though today's GDP report was bit weaker than expected, it's not necessarily bad news at all.