GDP gap: 10% and growing

Real GDP growth in the first quarter was weaker than expected (0.2% vs. 1.0%), but it wasn't much of a surprise. It's now been almost six years that the economy has managed only meager growth—about 2 ¼% per year on average. As a result, by my calculations, real GDP is a little over 10% below its long-term trend potential. That's more than $2 trillion in lost income every year, and it's getting worse. 

Weak quarters happen from time to time, as the chart above demonstrates. First quarter growth this year was negatively impacted by West coast port strikes (which reduced exports), terrible weather, and fallout from a sharp cutback in oil drilling activity. Nevertheless, we'll most likely see a pretty decent rebound in the current quarter, much as we did last year, as those temporary factors disappear. 

The chart above shows the 2-yr annualized rate of real GDP growth, in order to abstract from quarter-to-quarter volatility. By this measure, the economy looks to be growing about 2.5% per year. Since the recovery began in mid-2009, the economy has posted annualized growth of about 2.25%.

The chart above compares the level of real GDP to a long-term trend growth rate of 3.1%. This confirms once again that we are stuck in the slowest recovery ever. It's my belief that the persistence of slow growth is largely the result of bad policies, though demographics likely plays a part too. Corporate profits have been very strong, but business investment has been very weak. Without new investment and risk-taking, we are not going to see a pickup in productivity which is, at the end of the day, what drives stronger growth and higher living standards. Investment has been weak probably because marginal tax rates and regulatory burdens have increased significantly in the past six years. In a sense, and expansion of government has suffocated the private sector.

Things are not going to change much for the better until policies become more pro-growth.

Whether the persistence of relatively weak growth is a reason for the Fed to continue to keep short-term interest rates extraordinarily low is one of the key questions of our time. I don't see how low interest rates stimulate investment or enhance productivity. Only private initiatives can do that.

On the bright side, if policies do become more favorable, there is tremendous upside potential to look forward to. Closing the GDP gap would be nothing short of exhilarating.