I think it is misleading to speak of the output gap. It is part of what I call "hydraulic macro," which thinks of the economy as producing a single good with a single type of labor and a single type of capital...
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...I think that the simplifying assumption of homogeneous output, labor, and capital is...dangerous. My claim (which is not original with me--it is recognizably Austrian) is that a recession can be thought of as a recalculation. Imagine a central planner who decides to radically change plans. He has a huge recalculation to make in order to figure out where to allocate labor and capital. He says to some people, "Wait a minute. I am thinking. Some of you just have to stand idle while I figure this out."

The market economy is like that central planner. We are undergoing a Great Recalculation.
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In conventional, hydraulic macro, we think in terms of this one good called GDP, and the output gap is the difference between how much of this GDP stuff we could produce if everybody were working and how much we are actually producing with all the unemployment over and above "normal." We assume that "normal" unemployment, which is structural and frictional, is some roughly constant fraction of the labor force.

The way I look at things, we have a huge amount of structural and frictional unemployment these days. There is very little cyclical unemployment--limited to autos and household durable goods. If you measure the output gap using my definition of cyclical unemployment, then the output gap is tiny.

But I think it is better to drop the concept of the output gap altogether. Let us just say that we are in the middle of a Great Recalculation. Before the housing bubble popped and we figured out that our housing and financial sectors were messed up, we had something like full employment. Now, we need a Great Recalculation to figure out a new allocation of skills and jobs that gets us back to full employment. Because we got so messed up before, it will take years for the recalculation to be completed. Meanwhile, if you insist on thinking in terms of a large output gap, you are talking about an imaginary world in which the Recalculation takes place instantaneously. What you are not talking about is a gap that can be closed with government action, unless the government miraculously does the Recalculation faster and more effectively than the market.

# posted by Bob Murphy @ 11:26 PM