One is that the idea might not make sense. A study of a US steel mill by Yossi Spiegel of Tel Aviv University and Igal Hendel of Northwestern University shows why. They show that even though the mill didn't much change its workforce or technology over a 12-year period, output doubled in that time. This wasn't because the mill was initially operating at half capacity, but because management made endless tweaks to production to eke out more output from the same inputs. "Capacity is not well defined," they concluded.
If capacity isn't well defined for a single simple factory, it's even less likely to be measureable across the whole economy. Doing so requires the macroeconomist to second-guess the technical production decisions of tens of thousands of managers confronted by the question: can we raise production without raising costs? Such second-guessing is probably impossible. For this reason, Paul Ormerod of Volterra Consulting has described the notion of the output gap as "mumbo-jumbo".
You might object here: maybe the output gap is a daft idea, but we do know the number of unemployed and surely this affects inflation as the Phillips curve tells us.
Not in an open economy, it doesn't. The best modern macroeconomics textbook - Carlin and Soskice's Macroeconomics: Imperfections, Institutions, and Policies - says: "in an open economy, there is a range of unemployment rates consistent with the absence of inflationary pressure".
To see this, imagine that an economy is booming so that companies would like to raise prices but that its main trading partner is in a slump. Domestic companies could not then put up prices for fear that they would be undercut by overseas companies keen to enter their growing market. Inflation would then stay low even though the domestic economy is booming.
Of course, you don't have to imagine this at all. It's what's happening to the UK now. Our biggest trading partner has inflation of just 0.4 per cent. This puts a tight limit upon how far UK companies can raise prices.
Of course, many UK companies aren't competing with European ones and so aren't directly affected by this: nobody goes to Greece to get their hair cut. But they are indirectly affected. If the companies facing European competition hold down their prices they must also hold down wages, and this limits demand for the services provided by companies that don't face foreign competition. For this reason, even in the US - which is a much more closed economy than the UK - economists agree that the Phillips curve is quite flat; inflation doesn't respond much to variations in unemployment.
Which poses the question: why, then, does the Bank of England devote so much time to thinking about spare capacity? For years, I've had a suspicion here. It's because the Bank is also trying to stabilise output - a job which, for various reasons, has not been adequately done by fiscal policy. In a weak economy, the Bank cuts rates to try to protect jobs, and in a stronger economy it raises them to protect savers. In appealing to the notion that the output gap heavily influences inflation, the Bank can reconcile output stabilisation with inflation targeting.
Personally, I think this is wholly reasonable. As Plato recognised 2500 years ago, sometimes policy-makers need to use a noble lie.
