Who Believes In China’s Output Gap?
There are two statements about China’s economy that receive broad agreement today. One is that China faces a long-term structural slowdown in its growth rate, due to a laundry list of factors including the law of large numbers, changing demographics and less catch-up potential as an upper-middle-income country. The other is that China’s economy has recently been underperforming, suffering from extended deflation and weak employment, and would benefit from more aggressive cyclical stimulus. It’s not contradictory to believe both of these things, but there is some tension between them—and it’s in that tension that a crucial debate is playing out.
What you think China should be doing in terms of economic policy depends on which of these beliefs you hold most strongly. And that in turn depends on what you think about China’s output gap: whether growth is above or below potential, and by how much. If you think growth now is well below potential (the output gap is large), then you would advocate aggressive stimulus; if you think growth is closer to potential (the output gap is small), then you would be cautious about stimulus and favor structural reforms instead. (Not many people would currently argue that China’s growth is above potential, i.e. that demand exceeds supply and is putting upward pressure on prices.)
While the output gap is a simple concept that is fundamental to economic policymaking, it is difficult to put into practice. The potential growth rate of GDP at any given moment is impossible to know, and can only be approximated. One way is to take a top-down approach, analyzing the historical pattern of GDP growth and using that to model its future potential. Another way is to take a more bottom-up approach, analyzing the current behavior of economic variables, particularly unemployment and inflation, to see whether they imply growth is above or below potential. What makes the assessment tricky for China is that these two approaches, at the moment, point in opposite directions.
