David Ruffley MP has questioned whether the Bank of England knows how much spare capacity is in the UK economy.

Spare capacity is important because any measures to get the UK economy going by stimulating demand- such as quantitative easing (the creation of new money)- will only work if there is enough supply capacity to meet the demand. If there is not enough spare capacity, then extra demand will simply cause inflation without doing anything for growth. The inability of small and medium-sized firms to access financing from banks- on which David grilled the Chancellor in January - means that many of them actually cannot expand even though they want to. Here is David's exchange with Charlie Bean, Deputy Governor, and Adam Posen, Member of the Monetary Policy Committee.

Q74 Mr Ruffley: From one kind of uncertainty to another: the output gap. You were very candid in your last press conference early this month when you said, 'It is almost impossible to judge what the output gap is'. Mr Bean, you said at that same press conference, 'We see the impact of the crisis as being one that is temporary on the rate of growth of productivity. We don't anticipate a permanently lower rate of productivity growth, as a result of what has happened in the last few years'. That would seem to support the argument that there is not much slack in the economy. You also point out in your charts that other data point to there being quite a lot of slack in the economy. What I would like to know is why would you assume that productivity is going to snap back to its long-term average?

Charlie Bean: There is an important distinction between the levels and rates of change. The big unknown is how much damage the financial crisis and the recession have wrought on the level of potential supply now. The comment I made at the press conference was about the rate of productivity growth, going forward into the medium term, not necessarily even over the next year or two but a longer run view. As I said there, I do not see a compelling reason why that rate of productivity growth should be very markedly different from what it has been in the past.

One of the big things that stands out, if you look at long runs of historical data, is how constant the rate of productivity growth is; you do not get big variations from decade to decade, by and large. Personally, I am reasonably confident that the rate of growth of productivity, out in the medium to long term, will probably go back to where it was pre-crisis. What is very unclear is, firstly, how much margin for spare capacity there is now, and how much of that loss is really permanent, or if some of it might come back. If you have mothballed some production lines you might be able to bring them back into action. On the other hand, if workers have been unemployed and not been able to gain skills on the job, it may have a much more lasting impact. That is the area where we feel very uncertain.

Q75 Mr Ruffley: On that point, Dr Posen, the last minutes note that there were concerns that 'persistently weak growth might impair the future supply capacity of the economy through hysteretic effects'. Do you think we should attach quite a lot of weight to the output-destroying aspect?

Dr Posen: Mr Ruffley, we should attach weight to that because it would be a shame to let it happen. If we are convinced that the output gap exists and is non-trivial, which I think there is good reason to believe, and all observers, including the OBR, admit, then any lackadaisical attitude we take to try to bring demand back up to where it should be carries with it the risk you just identified, about eroding the supply capacity. As other colleagues of mine on the MPC have said, we want to be in a position where we are going to have to some day raise rates because inflation is coming back, but we want it to come because the gaps have been closed by demand and not by supply shrinkage.

When you say take it seriously, the point I would add is that I think take it seriously does not mean we have to believe that the supply capacity of this economy either has eroded quickly, or will erode quickly. My views on this have shifted slightly. A year and a half ago, roughly, I gave a speech in which I talked about the hysteresis effects, and even though broadly my basic instincts were in line with what Charlie just said, that is one of the lessons from Japan, frankly, that I did not state. Japan went through this terrible process, a prolonged recession, but when they had recovery they returned to the rate of productivity growth they had in the immediate pre-crisis; not the 1970s, not the glory days, but they did return without inflation to a 2.5% growth for several years.

I am doing research right now with some members of the Bank staff on this, trying to put numbers in the same way you were asking for the European numbers on these processes, and I think it is much more tractable to do estimates of this than the European issue, frankly. There certainly is erosion; when young people are in long term unemployment and cannot find jobs there certainly is erosion. When businesses fail, as Mr Mudie was talking about, there certainly is erosion.

The scale and pace of this erosion, though, is slower and smaller than I would have worried about. In particular, given how well our labour markets function, as bad as youth unemployment is right now-there are reasons to be concerned about that-we are not adding to long-term unemployment, and what I and a lot of people would consider the structurally unemployed, as quickly as, say, we were in the 1990s. It looks more like the 1980s; the trade-off is not that steep. That is one example of why although I think it is something to be very concerned about, and we should not let it happen, I am not worried about the supply capacity eroding the output that quickly.
Similarly, if I may make one other preview of this research-the staff member at the Bank with whom I am working, Neal Hatch, who deserves a lot of credit, and some other staff and I have been working on this-you find that if you break down the economy into sectors, most sectors in the economy have returned to their pre-crisis growth trend as well, which does not prove anything one for one but it is consistent with the view that we have not had a structural disruption in this economy; it was not that we had trouble adjusting, say, putting more employment into manufacturing. That does not mean all sectors are doing great; extraction in the North Sea is still declining in productivity, but it is not declining any faster than it was pre-crisis.
To me the picture is broadly, as Charlie says, that I do not think our supply capacity is eroding very quickly and, therefore, we do not need to worry about the output gap in the near term being closed by supply constraint. But I completely agree with where you started the question; this is something we have to take very seriously. That is one of the reasons, until the present, I was advocating more aggressive policy, because it is a waste to let it happen.