U.S. Long-Run Potential Growth Rate Compromised

February 17, 2009

St. Louis Fed President Bullard asserted today that the U.S. long-term potential growth rate has not declined.  I strongly disagree.

A sense of the long-term growth rate can be gleaned from the average rate of growth over very long periods of time.  Twenty-five years ought to suffice.  U.S. real GDP expanded 3.9% per annum between 4Q49 and 4Q74 and 3.3% per annum between 4Q74 and 4Q99.  That averages to 3.6% per annum during the second half of the twentieth century.  That was then.  Growth this decade — the nine years between 4Q99 and 4Q08 to be precise — averaged 2.8% per annum.  Nine years isn’t lengthy enough for absolutely definitive evidence of a potential growth trend, but it suffices to leave a compelling hint that trend already has moved lower, dropping from 3.9% per annum in the third quadrant of the last century to 3.6% per annum in the final quadrant to something below 2.8% in the first decade of the 21st century.

Several  other factors suggest that the present period will not be just a cyclical departure from trend growth in excess of 3%.

  1. A huge negative wealth effect in real estate and equity holdings will depress personal consumption and drive up the savings rate.  That rate had been below zero and has recovered to 3.6%, but the post-war norm had run 6-8%.  The unexpected evaporation of a huge chunk of wealth may require the savings rate to overshoot its old norm.
  2. Once a sustained recovery seems to be in place, it will be necessary to repair public finances.  Addressing the budget will lop off some potential economic growth.
  3. The Fed will feel compelled to normalize monetary policy, and the process will proceed more rapidly than the ill-advised 25-basis point per meeting pace from mid-2004 to mid-2006.  It will not be possible to normalize monetary policy without depressing growth to some extent.  One can only hope the trauma after the fed funds rate was doubled to 6% in the year to February 1995 isn’t replicated.  Long-term real and nominal interest rates may also rise.  Fixed income securities could be the next big bubble to burst.
  4. America spends money on healthcare inefficiently.  That sector absorbs twice as much of GDP in the United States as in other economies.  Americans do not live commensurately longer or healthier lives, however.  Healthcare funding is on an unsustainable footing.  The transition to a sustainable path will exert a drag on potential growth.  The defense budget cost of being the Western world’s only superpower will be an additional burden.  Taxes cannot be continually reduced.  In fact, the day will come when taxes will reluctantly be raised.
  5. Baby boomers will not be able to retire as young as they planned.  Working longer into life will diminish leisure time for consumer spending.
  6. Relative to other countries, U.S. primary and secondary education was once best in the world, but slippage in that regard began more than a generation ago.  Math and science skills, which hold keys to future competitiveness, are areas where standards have been most compromised.
  7. The effects of global warming are going to constrain global growth in the future.  It’s already too late to avoid any impact.  Whether the process will be reversible eventually depends on what is done form here, but that’s a story for many years from now.
  8. The U.S. manufacturing base continues to be hollowed out.  An economy comprised of only services will become vulnerable.

The factor that most convinces me that potential growth in the United States will decline further is Japan’s example.  The Japanese banking crisis last decade is the best precedent for what is happening now in the United States.  Japanese real GDP had expanded 4.0% per annum between 1Q81 and 1Q91 prior to the world’s second largest economy’s banking shock.  For the next eleven years to 1Q02 — also known as the lost decade — real GDP slowed to 0.9% per annum.  Contrary to popular belief, growth wasn’t much better after first quarter of 2002, averaging 1.1% per annum during the 6-3/4 years to 4Q08.

Some analysts will say, “Wait a minute. What about the strong U.S. productivity performance?’  Strong productivity tends to be associated with abundant business investment.  The decade before Japan hit the wall saw Japanese non-residential investment soar 8.2% per annum, twice as fast as the advance in overall GDP.  I do not take much comfort from knowing that U.S. productivity has kept growing at a robust clip or that U.S. inflation is contained.  Japan even experienced negative inflation.

Copyright 2009 Larry Greenberg.  All rights reserved.  No secondary distribution without express permission.



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