The Output Gap

Krugman blogs:

So what we want to do is compare output with what the economy could be producing. And to estimate that, it’s a good rule of thumb to extrapolate from the last business cycle peak. Why? Because at the peak of the business cycle, the economy is usually operating close to capacity -- in part because central banks try to throttle growth back when they think the economy is in danger of running too hot, leading to inflation. It’s standard practice to assess economic trends with peak-to-peak interpolation, because the peaks are a reasonable estimate of the economy’s capacity, while other points on the business cycle don’t convey anything like that information.

So I measure my trends from the last business cycle peak.

But, say some readers, what if growth at that peak was inflated by a bubble? OK, that’s confusing supply and demand. Bubbles drive demand -- they don’t increase the economy’s capacity (if anything they reduce it). They drive capacity utilization, so that a bubble may drive the economy to a peak; but that peak is still a good indicator of how much the economy can produce, no matter if it’s producing stuff people shouldn’t be buying.

So I know what I’m doing with these trend lines.

If resources hadn't been misallocated into the housing bubble, couldn't they have been allocated to something more productive and forward-looking like "CleanTech" or education, etc.? Would the capacity of the economy have been the same, just the resources allocated to different sectors?