Growth – Donald Marron

The 3-2-1 on Economic Growth: Hope for 3, Plan for 2, Pray it isn’t 1

How fast will the US economy grow? When mainstream forecasters consult their crystal balls, they typically see real economic growth around 2 percent annually over the next decade. The Congressional Budget Office (CBO) and midpoint estimates of Federal Reserve officials and private forecasters cluster in that neighborhood.

When President Trump looks in his glowing orb, he sees a happier answer: 3 percent.

That percentage point difference is a big deal. Office of Management and Budget director Mick Mulvaney recently estimated the extra growth could add $16 trillion in economic activity over the next decade and almost $3 trillion in federal revenues.

But could our economy really grow that fast? Maybe, but we’d need to be both lucky and good. We’ve grown that fast before. But it’s harder now because of slower population growth and an aging workforce. And there are signs that productivity growth has slowed in recent years.

To illustrate the challenge, I’ve divvied up past and projected economic growth (measured as the annual growth rate in real gross domestic product) into three components: the growth rates of population, average working hours, and productivity.

The link between population and growth is simple: more people means more workers generating output and more consumers buying it. Increased working hours have a similar effect: more hours mean more output and larger incomes. Hours go up when more people enter the labor force, when more workers find jobs, and when folks with jobs work more.

Productivity measures how much a worker produces in an hour. Productivity depends on worker skills, the amount and quality of capital they use, managerial and organizational capability, technology, regulatory policy, and other factors.

As the first column illustrates, the US economy averaged 3 percent annual growth over more than six decades. Healthy growth in population and productivity offset a slight decline in average hours. Of course, that six-decade average includes many ups and downs. The Great Recession and its aftermath dragged growth down to only 1.4 percent over the past decade. In the half century before, the United States grew faster than 3 percent.

Mainstream forecasters like the CBO and the Federal Reserve expect slower future growth along all three dimensions. People are having fewer children, and more adults are moving beyond their child-rearing years, so population growth has slowed. Our workforce is aging. Baby boomers are cutting back hours and retiring, and younger workers aren’t fully replacing them, so average working hours will decline. Productivity growth has slowed sharply in recent years, for reasons that are not completely clear. Productivity is notoriously difficult to forecast, but recent weakness has inspired many forecasters to expect only moderate growth in the years to come.

Proponents of President Trump’s economic agenda offer a rosier view. Four prominent Republican economic advisers—John F. Cogan, Glenn Hubbard, John B. Taylor, and Kevin Warsh—recently argued that policy, not just demographic forces, has brought down recent growth. They claim supply-side policy reforms—cutting tax rates, trimming regulation, and reducing unproductive spending—can bring it back up. They argue that encouraging investment, reinvigorating productivity growth, and drawing enough people into the labor force to offset the demographic drag would generate persistent 3 percent growth.

Many analysts doubt such supply-side efforts can get us to 3 percent growth (e.g., here, here, here, and here). Encouraging investment and bringing more people into the labor force could certainly help, but finding a full percentage point of extra growth from supply-side reforms seems like a stretch. Especially if you plan to do it without boosting population growth.

The most direct supply-side policy would be expanding immigration, especially among working-age adults (reducing our exceptional rates of incarceration could also boost the noninstitutional population). But the Trump administration’s antipathy to immigration, and that of some Republicans in Congress, pushes the other way. Cutting legal immigration in half over the next decade could easily take 0.2 percentage points off future growth (see this nifty interactive tool from ProPublica and Moody’s Analytics). Three percent growth would then be even more of a stretch.

Another group of economists believes that demand-side policies—higher spending and supportive monetary policy—could lift growth above mainstream forecasts.

One trio of economists took a critical look at past efforts to forecast potential GDP growth, a key driver of long-run growth forecasts. They conclude that forecasters, including those at the Federal Reserve and the CBO, have overreacted to temporary economic shocks, overstating potential growth when times are good and understating it when times are bad. We’ve recently had bad times, so forecasters might be underestimating potential GDP almost 10 percent. If so, policies that boost demand could push up growth substantially in coming years. (For a related argument, see here.)

So where does that leave us?

Well, every crystal ball (and glowing orb) is cloudy. We should all be humble about our ability to forecast the economy over the next decade. Scarred by the Great Recession and its aftermath, forecasters may be inadvertently lowballing potential growth. Good luck and good supply- and demand-side policies might deliver more robust growth than they anticipate. But those scars remind us we can’t always count on good policy, and luck sometimes runs bad.

We can hope that luck and good policy lift growth to 3 percent. But it’s prudent to plan for 2 percent, and pray we don’t fall to 1 percent.

North Korea’s Economic Failure in One Picture

North Korea is notoriously secretive. But it can’t hide from satellites. Here are nighttime images showing the amount of light coming from the Korean peninsula.

As Donald Rumsfeld once said, “North Korea is dark”:

This image comes from “Measuring Economic Growth from Outer Space” by J. Vernon Henderson, Adam Storeygard, and David N. Weil, who demonstrate how light can be used as a proxy for measuring economic growth in places with poor economic data.

For other versions of this image, just google north south korea at night.

What Would We Need for Persistent 5% Growth?

Last week, I argued that Governor Tim Pawlenty’s aspiration for 5% economic growth over a full decade is implausible since the United States has achieved such steady growth only once since World War II.

Over at Economics One, Stanford economics professor John Taylor offers a more positive take, defending the goal and offering a recipe for achieving it: 1% from population growth, 1% from employment growing faster than the population, and 2.7% from productivity growth.

Add it all up and you get 4.7% growth, a bit short of Pawlenty’s target but close enough for government work.

That sounds great, and I hope it happens, regardless of who is president. But let’s take a moment to kick the tires on Taylor’s assumptions.

Two seem fine:

His population growth assumption is perfectly reasonable. Indeed, it matches the estimate used by the President’s Council of Economic Advisers in its most recent Economic Report of the President (Table 2-2).

His productivity growth assumption is optimistic, but realistically so. Nonfarm productivity has grown at a 2.7% pace, on average, since 1996. Few analysts see that persisting. CEA forecasts assume 2.3%, for example. But the U.S. economy has demonstrated that 2.7% productivity growth is possible for a decade or more.

Three other assumptions are problematic.

Taylor uses a very optimistic assumption about how much employment growth can exceed population growth. Today, about 58% of the working age population has a job. That woefully low level ought to rise as the Great Recession recedes. Taylor assumes that we can boost that ratio back to its 2000 level of almost 65%. But 2000 was the tail end of a technology boom that lifted America’s employment-to-population ratio to record heights. Since then, the working population has aged, so the employment-to-population ratio will be persistently lower even in good times. CEA thus forecasts that labor force changes will trim about 0.3% annually from potential growth in coming years. Getting the employment-to-population ratio back up to 65% thus won’t happen unless we have an even bigger boom than the late 1990s delivered.

Taylor assumes that workers will keep working the same number of hours that they do today. That sounds innocuous except for one thing: average hours have been declining. CEA estimates that trimmed 0.3% per year from potential economic growth from 1958 to 2007 and will trim another 0.1% per year from 2010 through 2021.

Taylor assumes that the rest of the economy will enjoy the same productivity growth as the nonfarm business sector. In reality, the other parts of the economy – most notably government – are lagging behind. CEA estimates that slower productivity growth outside the nonfarm business sector trimmed 0.2% from potential economic growth from 1958 to 2007 and sees an even bigger bite, 0.4% annually, in the coming decade.

Taylor’s scenario thus assumes that everything breaks right for the U.S. economy for a full decade, with remarkable job growth and remarkable productivity growth in the economy as a whole. Not impossible but, unfortunately, not likely either.