A commonly-held misconception is abroad in the land: cut taxes and regulation, and the economy will return to a 3 or 4 percent annual growth rate. This sounds enticing, given the anemic 2.1 percent rate since the end of the Great Recession in 2009. Who wouldn't welcome a return to the salad days of economic expansion enjoyed under both presidents Ronald Reagan and Bill Clinton?
Problem is, the situation has changed, and GDP growth is necessarily limited in its potential to expand thanks largely to demographics. Pass the Geritol.
This, of course, is not to say that we shouldn't reduce regulation and reform our antiquated corporate tax structure; readers of this column are familiar with myriad imprecations for such reforms. But it is important to understand the limits on feasible economic growth and to season exaggerated promises with a few grains of salt.
Gross domestic product is the sum total of all the goods and services produced in the United States. One way to measure GDP is to add up all sources of income including wages, rents, interest and profits. As such, it is obvious that the possible growth rate of GDP is limited by changes in the workforce. A faster-growing labor force by definition contributes to higher economic growth.
Christopher HopkinsThe second determinant of how fast the economy can grow is productivity, roughly defined as how much each worker can produce on average per unit of time and capital. Higher productivity means more production per hour and therefore more economic growth. Those two factors, labor force growth and productivity growth, determine the ability of the economy to expand.
Between 1960 and 2008, the U.S. economy increased on average at an annual rate of 3.3 percent, hence the widespread misapprehension that 3-plus percent is the norm. During that 48-year stretch, half of GDP growth came from a growing body of workers, and half from increasing productivity. Since the recession, it is clear that neither factor is likely to return soon to previous levels.
From the 1960s through the early 2000s, both the labor force and productivity grew a little over 1.6 percent annually, combining in a 3.3 percent GDP growth. Women entered the workforce in large numbers, and population shifts including the coming of age of the baby boomers relentlessly fed the workforce. Going forward, not so much. The percentage of women at work is stable, the boomers are retiring, and the fraction of eligible workers who choose to seek employment (the labor force participation rate) has been steadily declining. The president's recently-announced immigration policy will further exacerbate the decline in workforce growth. The labor force growth is expected to grow just 0.5 percent annually through 2027. This part of the equation is highly predictable: we know with certainty that the only way to manufacture a 21-year-old worker is to find a 16-year-old and wait five years.
Productivity is less predictable, but has slowed notably since 2008 (to 1.0 percent). That is troubling. Still, even if we were to return to the long-term average of 1.6 percent, potential GDP growth tops out at just 2.1 percent over the next decade. And this estimate is from the CBO; many economists are less optimistic, in the range of 1.4 to 2.0 percent. Additionally, bear in mind that threatened anti-trade protectionism will further retard productivity growth and slow GDP.
Tax reform and deregulation remain essential to improving productivity, as does continued improvement in business investment. And unexpected technological advances can beget pleasant surprises in productivity. But as the debate heats up, it is important to distinguish between facts and unattainable promises.
Christopher A. Hopkins, CFA, is a vice president and portfolio manager for Barnett & Co. in Chattanooga.