The growth rate of the US economy has been in the news recently, for a couple reasons.
First, economic growth in recent years has been lower than the historical average of roughly 3%. This has led some people to predict low growth as the new normal.
Second, the budget released last week by the Trump administration assumes we will achieve 3% growth. People have questioned whether this makes the budget forecast overly optimistic.
Economic growth defined
Economic growth is normally defined as the percentage increase in GDP (the value of goods and services produced by an economy). GDP growth is usually quoted in ‘real’ terms, meaning inflation has been stripped out.
Economic growth comes from two basic sources. The first is an increase in the number of workers, or really, the number of hours worked. The second is productivity gains that increase the output per hour of work.
Growth track record
The graph below shows the annual GDP growth rate back to 1951. To smooth fluctuations, the data shown is a rolling 10-year average. For example, the most recent data point (2016) represents the average annual growth rate for 2007-2016.
As you can see, growth has indeed been sluggish, averaging only 1.3% over the past ten years. This is far below the long-term average of 3.25%.
Reasons to doubt 3%
So, can we get back to 3% growth on a sustained basis? There are reasons for doubt.
First, workforce demographics argue for lower growth. Since 2000, the size of the workforce has increased by 0.7% per year, only half of the post-WWII average. But that period includes a large expansion of the workforce from 1963 to 1985 as a wave of Baby Boomers and women entered the workforce. Those demographic shifts are unlikely to repeat, making it unlikely that future workforce growth will even reach the post-WWII average.
Second, productivity in recent years has been historically low. Productivity increased only 1.2% per year over the past decade, just over half of the post-WWII average of 2.2%. Many economists believe that low productivity gains are destined to continue. For example, an article in the May 16th Wall Street Journal reports that the CBO expects future productivity gains of only 1.3%. However, there is less of a consensus on this issue.
Many respected economists believe that future economic growth will only be 1.75% to 2.0%.
Reasons to believe 3%
On the other hand, there are also reasons to believe 3% is doable:
- Let’s start by noting that growth averaged 3.25% over many decades, through thick and thin. Do we really have to throw in the towel and expect future growth to be only half or two-thirds of that?
- Something called ‘recency bias’ describes a tendency for people to be influenced too much by recent events when forecasting the future. Recency bias is real. Perhaps the weak growth of the past dozen years has caused people to be overly-pessimistic in their assumptions that low growth will continue.
- There is room to increase total hours worked. The labor force participation rate for 25-54-year-olds is still more than one percentage point lower than it was prior to the Great Recession, so more people might go back to work. Immigration could also provide a source of needed workers, especially if visas are granted based on skills rather than family relations (like Canada).
- There is room for optimism on productivity. Productivity is all about having new ideas and converting them into tangible improvements. Surely the explosion of the internet will be good for future idea-sharing and collaboration. Also, capital investment by businesses has been low for a decade, so investment might bounce back and improve productivity.
- The human desire for more products and services is pretty much unlimited. Likewise, there is no real limit to human creativity and ingenuity that can be harnessed to supply those products and services. This implies that potential exists for strong economic growth for years to come. The key is to unlock the potential.
I guess I fall somewhere in the middle. I think 3% growth is certainly possible for a year or three. With the right policies, growth could even hit 4% for a year or so.
But averaging 3% on a sustained basis does seem like a stretch, primarily due to the workforce demographics mentioned above. Possible, but less likely than in the past.
But we should be able to grow by 2.5%, or a bit more. The chart below shows some possible scenarios:
The first scenario represents the 1.8% CBO forecast mentioned in the WSJ article. The middle scenario represents 2.6% growth that I think is realistic. The third scenario represents my optimistic scenario of 3.3% growth if everything comes up roses for both workforce and productivity.
Again, I doubt that we can hit the optimistic growth rate on a sustained basis. But we should be able to achieve 2.5% growth. And if we do, our future will be much brighter than with growth of only 1.5% or 2.0%. A difference in growth rates of only 0.5% or 1.0% may not seem like much, but over decades it will mushroom to substantial differences in our standard of living.
Growth is important!
The compounding power of growth just mentioned illustrates why growth is so important. Economic growth is crucial for increasing future prosperity, eliminating future poverty, and being able to afford future government spending from national defense to food stamps.
It therefore makes abundant good sense to do all we can to encourage growth.
How do we get more growth?
How do we encourage growth? Regular readers (can I even have regular readers after 3 months?) will not be surprised to hear that I think we can encourage growth by expanding economic freedom. That is, by pursuing more free-market capitalism while limiting the power and reach of government.
Reducing taxes could help expand the workforce, because taxes shrink the incentive for workers to work and for job-creators to create jobs. Reducing the benefits of government programs that pay able-bodied people to not work could also help, because that would reduce their attractiveness compared to work.
Reducing taxes and regulations would also reduce barriers to productivity. The lighter yoke of smaller government leaves people with more time and resources to pursue productivity. It gives entrepreneurs more confidence to start up innovative new businesses. It does less to discourage the capital investment that is essential for productivity. It leaves market participants freer to act and react in pursuit of that which makes the most economic sense.
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