Economic Growth Confusion

Mixing apples and oranges doesn’t sound too bad until you start making an apple pie. That’s the way I feel about the careless use of terms like "economic growth". Economic growth has so many meanings that it is easy to confuse people. These misunderstandings are particularly troubling today, because of the implications for growth-caused inflation and interest rates.

It is common to discuss the growth of the economy. You can talk about national growth last quarter or last year. Or you can average it over many past years. Forecasters discuss economic growth in the coming year. All that is fine.

What is not fine is mixing these popular uses of the term economic growth with the outcomes of an economic growth model. An economic growth model’s output is probably misnamed. What it ought to be called is JD. No, that’s not right. It ought to be called "long-run economic growth". 

A growth model is a simple mathematical expression that posits that economic growth is equal to the sum of the growth rates of the labor force plus the growth of labor productivity. (Note there is something called a two-factor economic growth model but that complicates matters beyond my meager goals today). Let’s write the economic growth equation:

  Long-term Economic Growth Rate = 

  Growth Rate of the Labor Force

                         

  + Growth Rate of Labor Productivity

Don’t you just love equations?

I use the word "long-term" to make a point. This equation is NOT meant to explain or predict changes in a nation’s output (real GDP) from day to day or from year to year. It is meant to explain how our permanent or sustainable capacity to produce changes over fairly long periods of time.

You could ask, How will economic growth in the next 10 years differ from the previous 10 years? That would be an acceptable use of the growth model described above. When answering that kind of question, the growth model ignores lots of short-term distractions and focuses on what it takes to permanently alter the capacity to produce goods and services. It is inherently supply-side-oriented. Clearly how much labor you have available is critical to sustain an ability to produce. The productivity of labor matters too, and that productivity is very much influenced and determined by how the quantity and quality of capital (plant, equipment, software, etc) change.

The trouble comes when people use discussions of the economic growth equation to talk about the next year or two. Capacity growth is important to next year but so are a lot of other things. For example, low labor force participation might endanger economic growth in 2018 but to focus too much on that one indicator is to not be playing with a full deck of cards.

What is the full deck of cards? Macroeconomic models we use to explain and forecast short-term changes in output (and prices) generally focus on events and factors that impact both the demand and supply of goods and services. A tax cut for moderate income people might encourage them to spend more and therefore impact demand. An increase the energy prices in 2018 might cause the cost of running factories to increase and lead to impacts through the supply of goods and services.

The full deck of cards includes Jokers, Queens, and Kings – and anything and everything that might influence our desires to buy and to sell. Thus, it is possible and desirable to intertwine long-run supply-side factors with the many short-term factors that will impact economic growth. To ignore the short-term changes is to imperil our judgment about the short-run.

The upshot of this is that output growth next year could be much faster or much slower than the long-run model predicts. When we hear the words "capacity output", we think of some kind of physical wall or constraint. But the truth is that for a year or two, output can grow much faster or much slower than capacity. How is that possible? 

Think of a distance runner who knows his sustainable pace for the long race. Call that long-run capacity growth. But think what happens at mile 17 when his arch rival moves ahead of him. For a time, he may run much faster than his overall pace to psychologically attack that rival. If he tries to sustain this high rate, he will run out of gas. But he can dig deep for a little while. Similarly, capacity might be growing at 2% per year but the economy could grow faster than that for a little while.

In the economy, labor force and productivity determine the sustainable long-term pace. But in the short run you can jam more workers into stores and factories than can be sustainable. Think of December when so much output gets sold. That’s not sustainable over the whole year.

The main confusion today is about how faster economic growth might influence such things as inflation and interest rates. Suppose spending kicks into higher gear while capacity moves like a snail. In that case, one might predict stresses leading to higher interest rates and inflation. Instead, suppose spending grows faster while short-run supply does the same. In this case, the economy is not stressed and there may be no additional pressures on inflation and interest rates.

Energy, business deregulation, some of the elements of tax reform, as well as the residual impacts of a global surplus suggest a national supply response that will not bring along the usual increases in wages, interest rates, and inflation. At least not right away. All this could change in a year or two and then we have plenty to worry about. It might be a good idea for policymakers to goose the long-run growth model faster. We will need that extra permanent capacity to keep the economy from strangling itself. 

Notice this implies nothing for the usual monetary and fiscal policy and everything about how a country improves its labor force –  its size, its quality, and its productivity.