HOW big can the American economy grow? This week's Free exchange column tackles the critical question of America's potential: the maximum output it can sustain given its endowments of capital, labour and technology.
The article notes that economic growth since the recession ended three years ago has averaged 2.5% a year. That is roughly the trend rate of an economy already at full employment. Given that America is still in a deep post-recession hole, such a rate should not be enough to reduce unemployment, and should have left so much spare capacity that inflation ought to have fallen sharply. Instead, unemployment has dropped nearly two percentage points in that time and underlying inflation, after dipping below 1%, is above 2%.
While various idiosyncratic factors can explain this behaviour, it could also be a sign that the crisis has significantly eroded potential GDP, and the output gap is much smaller than generally realised. (This is a topic on which I've blogged before, here, here and here.) Since 2005 the Congressional Budget Office has revised down its estimate of potential GDP in the year 2012 by 5%.
Doing this exercise for the late 1990s, a completely different picture emerges. As the accompanying chart shows, in 1997, the CBO estimated potential in early 2001 would be $8.3 trillion (in constant 1996 dollars). By 2001, it had revised that up a whopping 12%, to $9.3 trillion, a figure that looks more reasonable given what we now know GDP actually did.
The CBO's shifting estimates of potential illustrate two things. One is that potential is almost impossible to pin down in real time since the economy's equilibrium long-run stock of capital and labour are so difficult to estimate with precision; so we look at what GDP actually did as a hint of what it can do.
Second, and more important, is that supply (i.e. potential) is itself affected by demand. Potential output is the product of capital, labour and innovation. Since economic booms bring more investment, more risk-taking, and higher labour force participation, they push up measures of potential. The opposite is true of busts. If overall spending is depressed long enough, many workers will experience prolonged unemployment that degrades their skills, making them unemployable; they may eventually quit the labour force altogether. Depressed sales also discourage investment in new technology and research, which can degrade productivity and efficiency for years to come. (A counter argument is that depressions may hasten the migration of capital and labour from dying, low-productivity sectors to growing, high-productivity ones. Apparently, scholars are still arguing over whether this happened in the 1930s.) Powerful evidence for this phenomenon comes in a paper that my colleague A.C.S. discussed Monday which found most structural unemployment begins during recessions.
It follows that efforts to preserve demand can also preserve the economy's supply-side potential. That, too, seems to be one of the lessons of international experience. It is not too late for America to limit most of the long-run damage of its crisis; but it may soon be.
(Note: special thanks to Brent Moulton of the Commerce Department's Bureau of Economic Analysis for technical advice on how to convert real GDP figures to a common base year.)
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Stop distorting the economy with government spending, stimulus, and suppressed interest rates, and will see how much of that "capacity" is actually focused on real wealth creation.
Conservative Thought, what a grab-bag of rubbish! He inherited the wars in Iraq and Afghaistan from your conservative predessor and is winding them down, and Libya is pretty much history. As for keeping oil prices high, are you assuming tht he sits on the Board of Saudi Aramco, Rozneft et al and can command their pricing? Wake up guys, we're on a planet named Earth and the markets you so blindly tout have a lot more to say about things than a guy sitting in Washington being bayed at by uninformed zealots. Let me suggest changing your handle by subtracting the word Thought and substituting it by Daydreaming.
No of course he's not on the board of Saudi Aramco. Instead he wants to eliminate oil subsidies, stop the creation of the Keystone pipeline, and move against the shale oil and gas industry. All leading economists (including this newspaper) agree with these points.
Clearly Obama's masssive wasted corrupt spending on insanity like Solyndra, anti-business policies, trillions in printed funny money, and truly nation destroying levels of debt has inflicted terrible damage on the U.S. economy. Damagage that will get harder and harder to reverse as Obama continues to inflict more and more damage! As the article mentions its still not too late. The U.S. has until Nov to reject Obama and change course. If Obama is reelected the nation will never be able to recover and the future will one of decline and despair!
Finally someone talking sense. Obama ludicrous spending habits on Obamacare, the car manufacturing bailout, the wars in Iraq, Afghanistan, and Libya have bankrupt the nation. Not to mention the fact that Obama has kept Oil prices has high as possible in order to advance his environmental policy.
I beg to disagree. It is you repulicans who have caused this problem. Your senselss wars on the other side of the planet have ruined America. Let us look at the words of the conservative republican president General Dwight Eisenhower:
"Now this conjunction of an immense military establishment and a large arms industry is new in the American experience. (This was 1959) The total influence — economic, political, even spiritual — is felt in every city, every Statehouse, every office of the Federal government. We recognize the imperative need for this development. Yet we must not fail to comprehend its grave implications. Our toil, resources, and livelihood are all involved. So is the very structure of our society.In the councils of government, we must guard against the acquisition of unwarranted influence, whether sought or unsought, by the military-industrial complex. The potential for the disastrous rise of misplaced power exists and will persist. We must never let the weight of this combination endanger our liberties or democratic processes. We should take nothing for granted. Only an alert and knowledgeable citizenry can compel the proper meshing of the huge industrial and military machinery of defense with our peaceful methods and goals, so that security and liberty may prosper together."
The taxes in the 1950s were 7%, now they are 35% unless you are Mitt Romney who earns over 20 million a year, but pays only 14.9% His secretaries who earn one thousand times less than him pay over twice as much in tax rates.
Potential GDP, there is no such thing. Only a gambler that wins today and imagines he is a potential millionaire this time next year.
I don't buy into all that "Oh my, how terrible is America's misfortune." True, Americans occassionally like to whine like spring-silly women and one would go crazy to follow their mood oscillations. But they are made from a tough fiber, those Americans. More so than they themselves sometimes remember.
The reference to potential supply being limited by demand is a good realization that Say's Law partially neglects. When the capital stock moves into a surplus (labor as well), and limited avenues of exchange through the domestic economy leads one to the external sector, one would be surprised to note that there is a wrong trade off that America made in exporting capital while importing labor.
Once I remember a small European country member telling me that their people are always willing to pay more for the goods made in their own country!!
Procyon Mukherjee
In theory, their must be a point where the U.S can no longer grow as it is at maximum capacity. One thing I cant get my head around is the idea that any economy can continue to grow FOREVER...it's ridiculous...america and the world is only so big.
Bank Exchange Rate Blog
I believe the important fact here isn't that the economy can grow 'bigger' but if we accept that this is impossible beyond a certain point in the foreseeable future, which it is. Then what I as a first year Economics university student then assume is that we will focus on Total Factor Productivity (TFP) which is in essence the driving force of many investments in the current economic world. If we assume that such investments can lead to research and subsequently we have reached an improvement in our current position that utilises new technology and processes that can produce a larger quantity from a process that we used before with the same resources. There are limitations to such an assumption such as the time path of natural resource depletion as this will severely limit our destination.
Overall what I feel will happen is that we will continuously move forward at a decreasing rate, that a convergence of what can be harvested from existing resources is ever increasing in the short term but on a long term scale this is a increase of produce at a slight decreasing rate. Although this can be argued as irrelevant if the proper funding can be supplied to our scientific institutions to expand our horizons but in the current pathetic climate with petty governments and their lack of recognition for what is Important to societies welfare; scientific progress and not a silly percentage showing growth
That is the essence of growth, once we are done with this folly and this useless measure of growth that we currently use that is known as GDP then hopefully the world governments can come out of their shells and invest heavily in science to help limit environmental destruction and increase TFP to heights that actually cause benefits for the planet and not costs.
America and the world continue to grow in population. As long as human capital continues to be productive (and America, in particular, has become more productive over the last 20 years - i.e. value of goods per work hour), then the long-term trend will be for growth. In an absolute sense, sure, nothing can grow "FOREVER." However, as long as humans exist and have adequate resources (a real mitigating factor) there is no practical limit to their capacity to grow.
America and the world are not fixed elements with a theoretical growth limit. Humans are dynamic and resourceful. Every time someone predicts our demise (think Malthus), they've been proven wrong.
We are a creative bunch, let's just hope this thing called growth comes back soon. I for one am sick of watching stock prices plunge.
Bank Exchange Rate Blog
Wealth increases with the discoveries of new technologies. To say that we will quit growing some day means only that some day we will quit learning and quit discovering new things.
I see a few things coming in the future that will dramatically increase wealth. Nano tech holds enormous promise. But the biggest will be new forms of energy, such as cold fusion, and more energy efficient transportation. We will probably double the fuel efficiency of cars and truck in the next few decades as we learn to use lighter but stronger materials and more efficient engines.
That is 100% correct. I for one scoff at the notion countries need to grow, as I believe they need to retract. When they talk about how one generation needs to have a bigger generation to support it I wonder "well then how big does the next generation have to be?"
The world is only so big and it is a hell of a lot smaller now then it was in the eyes of Ceaser.
That is 100% correct. I for one scoff at the notion countries need to grow, as I believe they need to retract. When they talk about how one generation needs to have a bigger generation to support it I wonder "well then how big does the next generation have to be?"
The world is only so big and it is a hell of a lot smaller now then it was in the eyes of Ceaser.
They can still grow, if they take their lifes back in their own hands. By losing hundreds of billions a year to other countries they are doomed. They have to get less depended for natural resources . Bring production back to their own country, in one or the other way. How can you talk about growth if you lose money every day. And how langer they wait how harder it will get.
The problem with the US economy as with Europe is completely Structural. The US and Europe must implement necessary structural reforms to increase competitiveness and efficiency.
financial gimmickery (printing money, debt borrowing, bailouts) is never a long term solution for growth.
Name those structural reforms!
see my post below.
Structural problem is structural problem. The only way to overcome it is by replacing the economic system (in USA's case, capitalism) for another economic system (according to Marx's model, it would be socialism - note that Marx's socialism is completely different than the Soviet model).
It's a natural course of human history: ancient slavery colapsed in Roman Empire and gave place to Feudalism, which evolved until colapse to give place to capitalism (merchant capital, after industrial capital). Now it's time of capitalism to show it's first signs of structural contradictions.
The Soviet model was not different from Marx's model. That's a lie Marxists made up to keep the USSR from discrediting Marxism. Marx was very vague about the details of implementing socialism because he was less concerned about building his socialist utopia than in tearing down capitalism. The USSR was the best implementation of Marx's ideas ever.
Good luck selling Marx to the US voter --
Those of us who know fundy - even if we disagree at times - know he's not "selling Marx to the US voter."
Seems things have deteriorated around here since adding the Facebook/Twitter/LinkedIn junk.
NPWFTL
Regards
I don't need to sell Marx to US voters. Americans embraced most of Marx's principles under the banner of "Progessivism". Here are Marx's ten principles (from http://www.historylearningsite.co.uk/karl_marx.htm)
1) The abolition of the property/ownership of land.
2) Income tax to be graded to income – the more an individual earned, the more they paid. The less you earned, the less you paid.
3) Abolition of all rights of inheritance.
4) The confiscation of all property of immigrants and rebels.
5) The centralisation of all credit into the hands of the state by means of a national bank with state capital and an exclusive economy.
6) Centralisation of all means of communication and transport into the hands of the state.
7) The extension of factories and the instrument of production owned by the state. Bringing into cultivation all land not being used that could be and an improvement in the fertility of the soil.
8) The equal obligation of all to work and the establishment of an industrial and agricultural armies.
9) The combination of agriculture and manufacturing industries with the gradual abolition of the distinction between town and country by the more equable distribution of the population over the country.
10) Free education for all children in public schools. The abolition of child labour in factories; an educated child would be better for society in the long term, than a child not educated.
The US hasn't abolished private property because that angers the middle class, so it has gone the route of German socialism and taken control of property without taking the paper title. That fools people into thinking they still own the property.
The US hasn't abolished private property because that angers the middle class
I think it would anger state and local gov'ts more.
Losing tax revenue.
Did you see Pt. 1 of Ferguson's "Civilization"
Private property is one of his reasons for the West being far ahead of other nations.
http://www.pbs.org/wnet/civilization-west-and-rest/watch
NPWFTL
Regards
But they would keep all of the profits instead of just 50%.
I didn't see Civilization, but have seen other series by Ferguson. He's not a bad economist for a historian. Economics rediscovered the importance of property with the rise of the New Institutional School under Douglass North. That's where Ferguson learned the importance of property rights.
The problem is that we have separated property from control. You can't do that and succeed. Property is control. Take away control and you have the same effect as eliminating property completely. But socialism has fooled Americans into thinking that taking away control of property through regulation and taxation, while leaving them with the paper title, is harmless. It ain't!
" note that Marx's socialism is completely different than the Soviet model)."
If we were buddies growing up back in the home country, you'd get 10 years hard labor in Siberia for saying that. Yay GULAG!
Soviets were totally serious about that - we were building Communism through Socialism via Marxist-Leninist principles. USSR had plenty of academic think tanks dedicated to this very issue. Now, whatever issues you may have with capitalism, socialism is definitely NOT the way to go.
Most people recognize that structural unemployment happens when specific skills are no longer in demand and workers need to be retrained. What they don’t see is that the same thing happens to capital equipment. Just as work skills become obsolete due to changes in the economy, so capital equipment dedicated to those same jobs becomes obsolete. It’s difficult to make pizzas with equipment used to make cars.
Capital and work skills become obsolete when consumer preferences change. Consumer preferences changed in the latest crisis when consumer could not or would not borrow to continue living beyond their means.
Much of the equipment and plants used to make cars and stuff for housing are now obsolete in an economy that demands far fewer of each. The loss of that capital reduces the potential output of the economy. So projecting potential output from the peak of output during the latest unsustainable boom is just stupid.
But there's no consumer if there's no employees in your model. The cicle of capital must begin again indefinitely. For capital in it's global picture, there's no difference between a thousand middle class people spending US$ 1 million dollars in 100,000 different itens and 1 person spending US$ 1 million in the same 100,000 itens. For these other 1,000 people can die of inanition as long as it can continue to begin it's cicle again.
For a individual capital to continue to grow, it must extract more value from the lesser workforce possible. The most viable way is through automation: a machine lays off x workers because it can do their work. But by extracting more value from less salaried workforce, it increases it's profit at the cost of the new unemployed and by the relative empoverishment of the few ones that retained their jobs (they now receive the same salary, but produce more for the capitalist): that's why we produce food for 9 billion people but more than 1 billion suffers from hunger. The creation of wealth is the creation of misery.
Your utopian society can only exist if it has no competition.
Wealth creation by individuals and localised capitalist enterprises is the only way forward as world charity and neo marxist African states have failed so badly.
The average African peasant farmer is worse off than his grandfather because of centralised govt interference contrasted with the market system his ancestors enjoyed.
Localised capitalism with a light benign State works -- Marxism does not
(they now receive the same salary, but produce more for the capitalist):
You are assuming it is an easy machine to run, requiring no special skills.
Machines break and/or need maintenance. The person who troubleshoots, maintains, and repairs has to be skilled.
Some companies go with a maintenance contract.
NPWFTL
Regards
Throughout history, emperors used to forbid inventors from using labor saving equipment out of the same fears that you express. It's an ancient fear that machines replace people and leave greater unemployment in their wake.
But history has proven that fear to be false. People in 1600 were as poor and backwards as people who lived 5000 BC because no one was allowed to use labor-saving equipment. No new wealth was created. Each empire stole its wealth from those it conquered.
Then the Dutch Republic in 1600 removed those restrictions and the industrial revolution began. For the first time in human history new wealth was created. And for the first time in human history per capita income and wealth began to grow. The West became wealthy by increasing its use of labor saving equipment. Recently, China and India have done the same and lifted over 500 million people from starvation in one generation.
Capital equipment does destroy jobs in the short run. That's pretty obvious. But in the long run, capital equipment reduces the cost of goods it produces and that lowers the cost of living for consumers. A lower cost of living makes consumers wealthier and they spend that extra wealth on other goods that they couldn't afford before. That extra spending creates jobs that never existed before and replace the original jobs lost.
New wealth created by better capital equipment gets divided three ways: of course, the owner gets a share; the worker gets higher wages; and the consumer gets better goods for a lower price.
The other day somebody was shouting about US sovereign debt and noted that it was up around 126% of GDP and how if he ran his family finances like that, he'd be living on the street. Normally I just tell myself that sovereign debt is different than personal debt. But got to thinking, well, if I made $100k a year and went to the bank with $26k in car loans and credit card debt and wanted to borrow $100k on a house, that would probably be no problem at all. I would even imagine that it is not all that unusual in many parts of the country to have a mortgage or total debt of more than three times yearly income.
Not that I think there is no problem, or that we shouldn't start reducing debt, but there is also the argument that confidence works both ways.
To take the Ron Paul extreme, (though the mainstream party is getting out there too) if I went to see a banker about refinancing and borrowing a bit more on a mortgage so that I could build an addition for my aging mother, and was calm and collected and had a plan then I would expect it would work out. If I went in rending my hair and gnashing my teeth and bewailing my financial incompetence, and then informed the banker that I wasn't all that much into the whole fiat dollar thing and asked if he would except organic chickens like my papa used to barter back in Texas, then I would expect that the extra cash would not be forthcoming.
To make the analogy more realistic, you need to ask your kids if they would make the payments on the debt you want to take out so you can retire in Hawaii for the next 25 years.
Nations are indeed different - they have vast quantities of liquid debt mutualised over diverse income steams.
Yet, that doesn't make the situation prettier. Government tax income isn't 100% of GDP.
Actually, 2011 tax revenue was 32% of GDP. Sure, debt at "3x annual income" sounds modest. But American federal and state governments have vast spending obligations across Medicare, pensions, payroll, the military, maintenance of infrastructure, bailing out banks, etc. Government expenditure is running at 40% of GDP. "Government liabilities" properly measured would be a very large multiple of GDP.
http://www.imf.org/external/pubs/ft/weo/2012/01/weodata/weorept.aspx?pr....
There's no pretending this is sustainable - the American fiscal deficit is worse than Greece's. The only saving graces are America's sheer economic scale, its lower starting debt levels and fewer structural shocks - but America will require a vast and painful fiscal correction - probably sooner than anyone would want from an aggregate demand perspective.
Not realistic.
Boomers never asked.
And be sure to also ask them if they want to inherit the house as well as the debt on the house, esp. if the house is in Hawaii.
if I made $100k a year and went to the bank with $26k in car loans and credit card debt and wanted to borrow $100k on a house, that would probably be no problem at all.
Of course not.
But if you lost your job, the bank could take the house.
Your car could be repossessed.
The lenders would probably not make back all of the money.
But you'd probably be liable for the difference.
(At least that's how things used to work.)
Now if the gov't defaults, will lenders get a piece of Mt. Rushmore, or the Grand Canyon?
...if I went to see a banker... ...If I went in rending my hair and gnashing my teeth and bewailing my financial incompetence...
Why go to a banker?
There are many mortgage/finance companies that will lend you money, fewer questions asked. The bank or finance company will probably sell you debt to a 3rd or 4th party anyways.
NPWFTL
Regards
They aren't buying a house. They're staying in a nice hotel. Buying a house would imply that money the Federal government borrowed and spent has gone to some lasting legacy for the next generation. It hasn't. Most of it was nothing but a transfer from younger workers to old retirees. Another big chunk was wasted on military adventures around the world. In other words, it was all consumed.
Of course, the house analogy does apply if we consider that the government can pay off some of that debt by selling its gold and its vast land holdings west of the Rocky Mountains.
What do you mean by consumed? Like it went down a black hole somewhere? When my Mom collected social security and Medicare she spent it at the local supermarket, paid her electric bill and paid down her mortgage. It was mostly young people working at the supermarket, and I don't know who was working at the electrical utility. When she passed away, I inherited her house. So ultimately these transfers to the older generation work their way back to the younger generation. Where else are they going to go? I get your point about passing on the debt to the next generation, but let's factor in also the assets that the next generation inherits. And I agree with you that borrowing money today to pay for infrastructure that pays off long-term is a prefarable use of debt, and one where you usually come out ahead.
Comparing "Government liabilities" to GDP is, again, like comparing your annual income to your mortgage. One stretches out many years into the future, while the other is for a relatively short time. Most people with a mortgage aren't upset that it's many times their annual income, because they know they make a lot more in 30 years than their mortgage, and their monthly payments are well within their means. It's not so much the total liability that counts, but the timeframe over which it is paid and the ability to make payments.
What matters is that:
1) That the cost of debt finance is easily affordable. Note that mediocre growth and high real interest rates are possible responses to realistic economic events. If interest rates rose in Japan, Japan would have to choose between default, hyperinflation, massive confiscatory taxes/ wealth appropriations and/or extreme capital controls. Sweden, Finland or Estonia are safe from such risks. Italy wasn't safe when interest rates rose in the '80s - and now has to run a primary surplus above 3% of GDP just to run an unsustainable deficit. America is perhaps no longer safe. The debt is easily affordable now - real rates are negative now. But the US government is assuming non-trivial fiscal exposure to interest rate risk, bond liquidity risk and growth risk.
2) The long run quantity of annual debt issuance must not grow faster than the long run rate of GDP growth. We can have a rapid debt expansion from 40% to 200% of GDP - fine if taxpayers are happy and committed to their obligations, and if bondholders have confidence that the rate of expansion in debt issuance will again return to the long run GDP growth rate. If there were fear of a political bias towards issuance growth overshoot, the system is extremely vulnerable to a general loss of confidence and loss of liquidity (hell - that's what happened in Greece).
3) There must be complete market confidence that politically motivated default will never happen. Even if debt interest is costing the federal government 20% of tax revenue - with sacrifice in education, health, payroll, higher tax rates, etc - there must be complete confidence that debt repayment is always the top priority (however politically attractive an engineered political default could possibly be).
On the latter two counts, US institutional arrangements help considerably. On the first, note that America's reserve currency benefits are likely to diminish somewhat. When real interest rates rise (and they will when the economy recovers), the federal government will have to raise taxes (to levels unseen since the early '80s/ '70s) both to close the present deficit and to cover the costs of debt finance. Because of the costs of debt finance, the primary deficit (for debt to grow only in proportion with GDP) will have to be smaller than any time in recent history.
shaun39, excellant analyses! I appreciate your thoughtful input. Thank you.
As I said, I think we do need to reduce debt. And sure, taxes are not 100% of GDP. But we don't spend all our money on housing and transport either, in my example. Also if one took out a 30-year loan for $300,000 at 5% say, one is not on the hook for $300,000 but rather for more like $650,000 all in.
Will TE's bloggers never run out of new and ever creative justifications for "spend yourself rich" cool-aid?
You have to admire their persistence. No matter how many times federal stimuli fail to stimulate, they never give up.
Yep - it's like fuc.... Japan is on another planet or something.
Japan is your example of Fiscal Stimulus? That's a pretty weak example.
Mr Fox Thinking the exact same thing, the Economist always advocates Spending and other financial tricks to try to induce economic growth, they never tackle the hard questions of structural reforms, but then again maybe thats beyond the scope of this magazine.
Japan's debt to gdp is about 200% as a result of many rounds of stimuli.
"It follows that efforts to preserve demand can also preserve the economy’s supply-side potential. That, too, seems to be one of the lessons of international experience. It is not too late for America to limit most of the long-run damage of its crisis; but it may soon be."
Yup, but the GOP has no interest in doing anything to improve the economy until November, and then only if Romney wins.
Maybe the GOP is tired of throwing good money after bad with nothing to show for it.
When Republicans attack the stimulus as ineffective, they undercut the prime article of their faith, for much of it was tax cuts. There is always the risk that some fiendish Democrat may point this out, and sow doubt among the as-yet unconfirmed.
Republicans are wrong that tax cuts stimulate the economy in the short run. They're especially ineffective in a recession. Tax cutting is a long term strategy.
Maybe the GOP is tired of throwing good money after bad with nothing to show for it.
Nah, they keep wanting to increase spending on defense.
NPWFTL
Regards
That's true!
America’s potential: the maximum output it can sustain given its endowments of capital, labour and technology.
You forgot debt.
At the end of 1989 the Total US debt - as a country - was 234% of GDP.
At the end of 2004 the Total US debt - as a country - was 326% of GDP.
---
Let me have your credit card and I'll get the economy rolling.
NPWFTL
Regards
hedgefundguy, I'm having a hard time following your math. Here's what I found for 2004. According to the Treasury (http://www.treasurydirect.gov/NP/NPGateway) the total U.S. Debt at the end of 2004 was $7,397B. According to the Bureau of Economic Analysis (http://www.bea.gov/newsreleases/national/gdp/2005/gdp404f.htm) the U.S. GDP in 2004 was $11,735B. That yeilds a Debt/GDP ratio of 62.9% - a far cry from 326%. Am I missing something? Thank You.
He includes private sector debt as well as debt from all levels of government, not just federal. Ultimately this matters as the recession in the USA, Ireland, Iceland, & Spain among others was caused by too much private sector debt, not government. Both are equally dangerous.
guest-iewaias, thanks for the clarification. That makes much more sense.