Many of my friends cannot remember which one was Laurel and which one was Hardy. I do remember which one was Sonny and which one was Cher. And so it goes with economic growth and business cycles. In truth, growth and cycles are as different as Simon and Garfunkel but you would never know it.
Economic growth has become the Cinderella of macro. Pushed into the back room and assigned to the lowliest cleaning duties, economic growth is hardly heard of in favor of business cycles. The Fed has never been more neurotic. Are we at full employment today? Are we too strong? Is inflation too low? Should I drink JD or Scotch?
Whew. I feel a lot better now. Let’s start at the beginning. Macro has two main areas – growth and cycles. Growth is a long-run concept. It is all about how the capacity to produce changes over time. Imagine the economy as one big factory. What makes the factory able to produce more (or less) as a long-term or permanent outcome? You can imagine the kinds of things that affect the capacity to produce – better equipment, new structures, a more efficient layout, better training of the workforce, are just some of them.
The second part of macro – cycle theory – is very short-run-oriented and poses questions about why the nation’s output deviates from the capacity to produce. That is where things like recessions come into play. Most recessions are over in a matter of months. Their impacts can go on for a while, but the large and sometimes sharp turns in output are usually limited to half a year, plus or minus. Policies designed to reduce these cyclical changes are very different from those that augment long-run capacity changes. Typically the causes of such short-term cyclical events have something to do with the ever-fickle desire to buy – or what we refer to as demand changes. Suffice it to say, the things that cause short-term changes in demand are very different from the things that impact long-run capacity – and so too are the policies different.
With all that behind us, let’s think more about Cinderella -- i.e., long-term or capacity growth. While capacity growth sounds like engineering, the reason we emphasize it is that capacity growth is the key to improving both the standard and the cost of living. The evidence is around us. Whether it is a rich country like the USA or a dramatically growing country like China or Vietnam, the evidence is that producing a larger pile of goods brings permanently higher incomes and lower poverty incidence to the citizens of those countries. With those higher incomes come safer and more environmentally friendly production. While there are some who would argue against growth, most of those people are on the fringe.
We usually use sustained real GDP growth to measure capacity changes. Not focusing on short-term changes, I present some figures for the time period from 1955 to 2016 – 61 years.
Average Annual Growth in U.S. Real GDP
1955 to 1970 4.8%
1970 to 1985 4.1%
1985 to 2000 4.4%
2000 to 2016 2.0%
The US economy expanded at an annual rate of over 4% for about 45 years from 1955 to 2000. After that we saw a pronounced slowing to 2% per year. It is true that we had a major recession in 2008 and part of 2009, but it is also true there were many recessions between 1955 and 2000. If we look at shorter time periods after 2000, we see 2.7% annual growth from 2000 to 2005, slower growth of 0.7% per year in 2005 to 2010, and then 1.9% per year in the six expansion years from 2010 to 2016.
While anything is arguable, the data seem clear that something changed to permanently alter the growth rate of the US economy after the turn of the century. Left to its own course, this slowdown threatens our ability to increase our standard of living and reduce poverty.
What causes economic growth to slow? To answer that question, economists use growth models. These models ignore many things that cause short-term deviations in demand and output to instead focus on capacity-altering events. Growth models boil down to two sets of factors – those that impact the supply of labor and those that impact the productivity of labor. A retiring baby boom, global competition, government regulation, tax rates and other policies towards business are often discussed in the context of waning capacity.
The surprising thing is that most legislators ignore the bull in the china shop. Maybe it is too complicated for them. Instead they would rather spend their precious few working hours heatedly debating social policy. Policies relating to regulation and tax reform are a case in point. Such policies have the potential to raise the growth of output yet few of the public discussions focus on output, instead pointing fingers about how they might harm social goals and income distribution.
Social goals are critical to a nation. But so is growth. If we continue to relegate serious growth discussion to the background, we will suffer the consequences as we become a stagnant economy with few resources for much of anything including solving difficult social problems.