The mood surrounding the U.S. economy is finally picking up. The housing market is recovering, consumer sentiment is getting off the floor and, most importantly, unemployment is falling. However, Ben Bernanke, ever the dismal economist, has managed to find the cloud at the end of this silver lining. In a speech this week, Bernanke pointed out that falling unemployment in a period of sluggish growth has worrying implications for the future. Bernanke said:
Output normally has to increase at about its longer-term trend just to create enough jobs to absorb new entrants to the labor market, and faster-than-trend growth is usually needed to reduce unemployment. So the fact that unemployment has declined in recent years despite economic growth at about 2 percent suggests that the growth rate of potential output must have recently been lower than the roughly 2-1/2 percent rate that appeared to be in place before the crisis
In other words, what everyone sees as good news (falling unemployment) is actually a sign that the economy is set to grow at a slow pace over the next few years.
If you find that thought a bit depressing then don’t read the rest of this article.
Bernanke pointed to a number of ways in which the financial crisis may have slowed the potential growth rate of the economy but he seems to believe the economy will recover to its normal growth rate once the financial sector has sorted itself out. However, there are there are reasons to believe that slow rates of growth are perhaps here to stay.
Economic growth comes from two sources: Growth in the number of workers and growth in the average amount of output these workers produce (i.e. productivity growth). The news on both fronts is bad.
Start with productivity growth. Normally at this point in a business cycle, productivity is growing at a fast pace as under-utilized workers get busier and businesses increase their investment in productivity-enhancing equipment. However, average productivity growth over the past two years has been under 1 percent.
Traditionally, productivity growth has been driven by the invention of new technologies. When I worked for Alan Greenspan at the Federal Reserve in the late 1990s and early 2000s, he and other Fed staff believed that new computing technologies were driving increases in productivity growth (with good reason – my own research at the time suggested these effects were real).
It may appear that we still live in a world where new technologies are being developed all the time, with smartphones, computing tablets and lots of other new devices coming on stream all the time. However, some of those who know the technology industry well are sceptical about whether the true pace of advance is a fast today as previously. Peter Theil, founder of Paypal, points out in this article in the Financial Times co-authored with Garry Kasparov, that technological innovation is now confined to a very small part of the economy and that people are missing the stagnation of innovation in the rest of the economy.
In a recent paper, Northwestern University economist Robert Gordon, perhaps the profession’s sharpest observer of technological history, offers a telling thought experiment that provides a comparison of the true value of recent innovation compared to the advances of the past:
You are required to make a choice between option A and option B. With option A you are allowed to keep 2002 electronic technology, including your Windows 98 laptop accessing Amazon, and you can keep running water and indoor toilets; but you can’t use anything invented since 2002. Option B is that you get everything invented in the past decade right up to Facebook, Twitter, and the iPad, but you have to give up running water and indoor toilets.
No prizes for guessing which option most people pick. Gordon warns that “Future growth in real GDP per capita will be slower than in any extended period since the late 19th century.”
Looking beyond productivity growth, the trends for the other element of economic growth, increases in the numbers at work, are perhaps even less encouraging. While employment may be growing because of the falling unemployment rate, there is little to suggest there is enough momentum to produce a fast pace of increase in employment over the next decade.
After many years of steady growth, there has been almost no growth in the labor force in recent years. This is partly driven by slower population growth but also by the reversal of a long trend of rising female participation in the labor force.
Another factor restraining the growth in numbers at work is the aging of the U.S. population. Projections from the Census Bureau show there will be a large increase in the dependency ratio (i.e. the ratio of people not working to people working) over the next decade because of the large increase in numbers of retired people as the baby-boomers step out of the workforce.
Taken together, these calculations suggest a future average growth rate for the U.S. economy that is far lower than people have been used to.
If this scenario comes to pass, it would have serious implications for future political decisions. As in most countries, political tensions in the United States often come down to arguments about how to divide up a growing economic cake. If the economic cake stops growing, these tensions would become more severe. Even more complex is the question of what to do about promises made to future generations that are premised on the assumption of years of strong growth if that growth never shows up.