Thinking about GDP growth

If I had to venture a guess as to what the consensus opinion among economists and pundits is about the future prospects for the U.S. economy I would say it is that the economy is going to have trouble growing in the years ahead. Some people are saying we ain't seen nothin' yet, that we're headed for a double-dip recession and possibly a global slowdown of unprecedented magnitude. A lot are saying that the economy will probably start growing in the second half of this year, but at a relatively tepid pace. Some optimists like Brian Wesbury at First Trust are calling for growth on the order of 4% or more beginning right now. I agree with Brian that a recovery is now underway, but I'm not sure how strong it will be.

If there is a unifying theory for why most people are not very optimistic about the future it probably involves the unprecedented degree to which the size of government is going to expand under the Obama administration, and the sharply higher tax burdens that will inevitably result from that expansion, not to mention the burden of additional regulations and the potential for price and wage controls applied to certain industries. I consider it axiomatic that more government and higher tax burdens will give us a less efficient economy and thus slower growth. How much slower, however, is anyone's guess.

What follows is a humble attempt to come up with a projection for future GDP growth without being overly optimistic or pessimistic, and without injecting any liberal, conservative, or supply-side bias into the calculations. I do this more to establish a baseline for further discussions than to try to come up with anything that might be accurate. I draw importantly on a long-ago insight from none other than Milton Friedman to get started.

Milton Friedman in 1964 wrote a paper describing a novel theory describing how the business cycle worked, called the Plucking Model. He theorized, and the data have since lent credence to his theory, that the economy has a strong tendency to revert to trend following business cycle disruptions. The deeper the recession, the stronger the recovery; the milder the recession, the less dynamic the recovery. The economy is not a random walk: recoveries follow recessions, and the degree of recession is a good predictor of the strength of the recovery. He came up with an analogy to describe the model, which says that the path of the economy is like a string that is fastened at both ends of a board and rests on the bottom side of the board, hugging it tightly. The board is set at an upward sloping angle, with the angle being proportional to the economy's long-term trend rate of growth. Recessions occur when the string is "plucked" downwards from the board. Once the shock that caused the recession goes away, the string is released, and snaps back to the board.

A former colleague, Mike Bazdarich of Western Asset Management, uses a different analogy to describe the same theory. He calls it the "Beach Ball Theory."

If you hold a beach ball below water level in a pool and then release it, it quickly moves back to the surface and then hugs the surface without popping above it. The analogy to the economy is that GDP tends to hug closely to full-employment levels. After a severe shock, GDP can veer away from full-employment levels, but as soon as the shock subsides, the economy moves back to full-employment on its own. The farther away from full-employment it starts, the faster it will snap back, but it doesn't overshoot from recession to inflationary boom.

The chart above uses this theory to generate a forecast for growth. The green trendline represents the economy's long-term trend growth (3.1% per year) from 1966 to 2000. Note that every time the economy falls below its trend (i.e., when the string is plucked downwards from the board), it subsequently speeds up and eventually returns to trend. After 2000, however, the trend appears to have slowed down. I extrapolated what appears to be a new, slower trend rate of growth (2.3%) through 2016, as shown by the purple line. I then calculated how fast, on average, real growth would have to be over the next 8 years for the economy to return to trend: 3.1% growth per year (trust me, it is a pure coincidence that that is the same as the economy's trend rate of growth from 1966-2000). I chose 8 years because that was not overly aggressive, and it is consistent with the amount of time it took for the economy to return to trend in the 1980s and 1990s.

So, relying on Friedman's observation and the data that supports it, and making some rather conservative assumptions (e.g., the new trend rate of growth will be only 2.3% per year, and it will take 8 years for the economy to fully snap back to trend), I find that it is not unreasonable at all to expect the economy to grow a little more than 3% a year for the foreseeable future.