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.

Getting growth back on track could be very rewarding

As the first chart shows, GDP growth has snapped back to "normal" following a record 4 quarters of negative growth. But as the blue and green lines in the second chart suggest, the economy today is  about 10% below its "trend" or potential level (extrapolating from the past). Stated another way, our national income is about $1.4 trillion less than it otherwise might have been if we hadn't suffered from the real estate/financial system collapse of the past few years.

Before proceeding further, I'm going to step back and engage in some "inside" thinking (see my post on this subject yesterday). We all know that the economy is facing enormous headwinds: 10% unemployment that is going down very slowly; an administration determined to ramp up government spending and tax burdens to new post-war levels; trillion-dollar federal deficits for as far as the eye can see; states and municipalities that are bitterly strapped for cash; broken credit markets; a commercial real estate disaster waiting to happen; a second wave of residential foreclosure sales; consumers retrenching and deleveraging; and a Fed that will soon have to withdraw over $1 trillion in liquidity or face an explosion in inflation.

Add all these concerns up and you have the "new normal" environment where the economy struggles to grow by 2% or so per year in perpetuity. Since the market is fully aware of these abundant "inside" facts, it is no wonder that 10-yr Treasury yields are only 3.5% despite the prospects of a multi-year, trillion-plus annual deluge of Treasury supply. It is no wonder that the S&P 500 today trades at the same level as it did over 10 years ago, even though corporate profits (per NIPA) have risen some 70% over that same period and are currently beating expectations almost every day. It's no wonder that corporate credit spreads are trading at levels that in the past have signaled the onset of recession. In short, the outlook is miserable and the market is priced to miserable expectations.

Now let's engage in some "outside" thinking. That's summed up in the purple, dashed line in the second chart. (New readers might want to refer back to this post on Milton Friedman's "plucking" theory of growth, and to this post from the Atlanta Fed that demonstrates how the strength of a recovery is largely a function of the depth of the preceding recession.) For the past 40 years, the economy has managed to grow on average about 3.1% per year: this would be the economy's "potential" growth rate. Currently the economy is about 10% below this potential, making this recession the most painful, in some respects, of any since the Depression. Let's say that because of all the headwinds out there that it takes the economy eight full years to recover to its potential; this would mark by far the slowest recovery to trend ever observed since the Depression. Yet despite being a miserable recovery, we would still see growth of 4.4% per year, and that is about double the rate of growth that many optimists are calling for.

The inside view says the outlook for growth is miserable, while the outside view says that there is a decent chance (not a certainty of course) that growth could be much stronger than the market expects, and for many years, even though the economy faces significant obstacles (headwinds) to growth. Since the market is not even remotely prepared for such an outcome, risky financial assets such as equities and high-yield debt could enjoy excellent returns even as the economy struggles to get back to its trend growth path. Imagine what could happen if some of the assumptions held by the inside view were to be challenged: what if electoral upsets next week and next year result in fiscal policies which rely more on supply-side incentives and less on Keynesian fiscal stimulus? What if faster-than-expected growth reduces the deficit and makes tax cuts possible, instead of tax hikes? The possibilities are endless, and you don't have to be a congenital optimist to see them. Just use a little "outside" thinking.

The 10% GDP output gap

With today's release of the second estimate of GDP numbers for Q1/10—which resulted in a very minor downward revision of annualized real growth from 3.2% to 3.0%—I thought I would revisit this chart, which compares the path of real GDP to a 3.1% annual growth path. My choice of a 3.1% growth rate harkens back to Milton Friedman's Plucking Model of growth, which I discussed in a post almost one year ago. In essence, his theory is that the U.S. economy has a built-in ability and/or desire to grow by a certain amount every year, and when it fails to achieve that, because of a recession-provoking disturbance of some sort, then it has a strong tendency to snap back to that long-term trend line once the economy has adjusted to the disturbance. This behavior has been documented by the Atlanta Fed: the sharper the recession, the stronger the recovery.

If this theory holds true, then currently the economy is about 10% below where it really wants to be. This would ordinarily lead to an explosive recovery. I have been arguing for over a year now that we won't get the explosive recovery (in which the economy would grow by 6-8% for a few years), primarily because of the monumental amount of fiscal "stimulus" this time around that is holding back growth by making the economy less efficient. Instead, I've been looking for 3-4% growth, and that's what we've been seeing so far. I think a cessation of fiscal "stimulus" spending would give the economy a huge boost. Note that this goes directly counter to what conventional wisdom is saying; everywhere you look these days you see people worried that the fourth quarter of this year is going to be weak because stimulus spending is scheduled to drop.

The real problem with the "output gap" we have today is twofold: on the one hand it encourages the Fed to remain hyper-easy, out of fear that the gap exerts strong deflationary pressure on the economy; and on the other, it encourages Washington to "do something," like extend unemployment benefits (which only reduces the incentives of the unemployed to seek work) and otherwise spend money (which takes money from the private sector that could otherwise be put to better use). To the extent we can cut spending, I think the economy will be better off. And if the November elections are going to be as transformative as I think they will be, then the prospect of major cutbacks in the size and role of government in coming years should be a cause for celebration, because then the economy will have a much better chance of closing the output gap rapidly, instead of over the course of many years. And the sooner the economy starts perking up, the sooner the Fed is going to have to normalize (i.e., raise) interest rates. This won't be a problem either, because current interest rates reflect the market's pessimistic view of future growth. Stronger growth and higher rates should go hand in hand.

Charts we never thought we'd see

Ten years ago we were in the early stages of what would later prove to be the most severe economic downturn since the Great Depression. We'd all seen the charts and read the history of that tragic event and its terrible impact on the country, and we hoped it would never happen again. But there were things 10 years ago that we never expected to see, which later unfolded to our lasting astonishment. Here are just a handful of charts, which I offer to remind us of the amazing economic and financial developments of the past decade, about whose nature economists are still debating.

Chart #1

Chart #2

Chart #1 shows the dramatic—and ongoing—decline in initial unemployment claims. Ten years ago the vast majority of economists would have said that claims could never decline much below 300K per week, since that was most likely the minimum amount of normal turnover in the labor force. Yet here we are today with weekly claims approaching 200K per week. And as Chart #2 (the ratio of weekly claims to total payrolls) shows, claims have NEVER been so low in recorded history, relative to the size of the workforce. The risk of a typical worker finding him or herself laid off has never been so low. Today, employers are more likely to complain that it is harder to find skilled workers than to complain about the workers they have.

It's a brave new world for workers. But it makes central bankers nervous, since they worry that a tight labor market could result in higher wages that in turn could fuel rising inflation. This worry has its origins in the Phillips Curve theory of inflation, but that theory has never found substantiation in the data—it's the economic equivalent of an old wives' tale. Today's Fed governors are aware of this, so they are not necessarily sitting on pins and needles, but it is a source of policy uncertainty nonetheless.

Chart #3

Chart #3 shows what is arguably not only the most astounding economic or financial thing that happened in the past decade but also the most unbelievable. If you had asked any economist 10 years ago what were the chances of the Fed creating over $2.5 trillion of excess reserves in the space of a few years he or she would have stated flatly: ZERO. It couldn't possibly happen, because if it did it would herald the collapse of the dollar and an inevitable hyperinflation. The consequences of such an event were so terrible that the event itself was considered to be impossible. Yet here we are today with inflation running around 2% (as it has for more than a decade) and the dollar trading pretty close to its long-term, inflation-adjusted average vis a vis other currencies.

Prior to late 2008, when the Fed launched its Quantitative Easing program, excess reserves were measured in billions of dollars, not trillions. The Fed managed monetary policy by adding or subtracting reserves (which prior to late 2008 paid no interest) from the banking system: by creating a scarcity of reserves, banks would be forced to pay more to borrow them, and that would result in higher short-term interest rates. Today, with a previously-unimaginable abundance of reserves, the Fed has resorted to pegging the interest rate it pays banks that hold reserves, and that seems to be working. Regardless, we've been sailing in uncharted monetary waters for most of the past 10 years, and economists are still debating how everything is going to work out in the years to come. 

To this day there are still legions of observers who argue that what the Fed did starting in late 2008 was simply a massive amount of money-printing, a desperate monetary stimulus that was necessary to avoid a depression, and the economy has been running on fumes ever since. 

Others, myself included, believe that what the Fed did was not monetary stimulus at all. It was simply a rational response to an unprecedented increase in the public's demand for money and money equivalents, which in turn was the result of the near-collapse of the global financial system and the worst global recession in modern memory. The world was running very scared, so the demand for safe monetary assets was nearly insatiable. Unfortunately, there were not enough T-bills (the classic monetary safe haven) to go around. By deciding to pay interest on bank reserves, the Fed effectively made bank reserves equivalent to T-bills, and that was exactly what the world wanted: trillions more of safe, default-free, interest-bearing assets, and the Fed had the ability to create bank reserves with abandon if need be. And so it was that the Fed bought trillions of notes and bonds, and in the process created trillions of T-bill equivalents. I explained this in greater detail in a post five years ago ("The Fed is not printing money"). It did the trick, and now the Fed is beginning to slowly unwind QE, as it should, given how much confidence has returned in the last year or so.

 Chart #4

Chart #4 shows that the inflation-adjusted Fed funds rate has been negative for almost exactly the past 10 years. Never before in modern times has this occurred. Those same legions of observers that think QE was monetary stimulus in disguise argue that real interest rates have been artificially depressed by the Fed's actions. I and others, in contrast, argue that real short-term interest rates have been extraordinarily low because of extraordinarily strong demand for safe, short-term assets. If the price of a bond is bid up high enough, its yield will turn negative; it's a simple matter of bond market math. T-bills, and bank savings deposits, have been in such high demand that investors have been willing to accept zero or negative real yields. The Fed has not been artificially lowering rates, the market has driven rates to very low levels because of very strong demand for safety and very high levels of risk aversion.

Chart #5

Prior to the Great Recession, most economists would have said that the 2% yields on 10-yr Treasuries we saw in the post-Depression years would never recur, because those yields were the by-product of very weak growth and very low inflation. Yet those same 10-yr yields fell to an all-time low of 1.3% in July 2012, during a period in which the US economy grew at a 2.4% annualized rate and inflation was on the order of 2%. I believe the only way to explain these extremely low yields is to understand that they were driven to low levels by intensely strong demand for default-free assets. After all, the Fed doesn't control 10-yr yields; the market does. Today, inflation is about the same as it was in 2012, but the economy is a bit stronger and confidence is much stronger. Demand for safe assets has declined, as a result, and 10-yr yields have doubled. It all makes sense.

Chart #6

Finally, we come to what is arguably the most unexpected chart of them all, Chart #6. Prior to the Great Recession, the US economy had suffered many recessions, but after a few years it had always bounced back to its long-term trend. And in fact, the deeper the recession, the stronger the recovery. Milton Friedman formalized this observation in 1964, calling it the Plucking Model (see my discussion of this here). Unfortunately, the economy hasn't bounced back this time: growth since mid-2009 has averaged about 2.2% per year. I've attributed this slow growth to the heavy burdens of government spending, regulations, and taxes, all of which rose beginning in late 2008. If the economy had returned to its previous growth path, it would be at least $3 trillion bigger today.

Chart #7

Chart #7 shows how productivity (output per hour of those working) has been extraordinarily low for the past 10 years; this is the main explanation for why growth has failed to snap back to its long-term trend. Prior to the Great Recession, productivity averaged about 2% per year. But productivity has been much less than 2% over the past 10 years. As I've noted, the lack of productivity can easily be traced to weak business investment, which in turn is a natural response to increased tax and regulatory burdens.

Although extraordinary and wholly-unexpected things have happened over the past 10 years, there is still a logical way to understand what has happened and why. And it follows, therefore, that it is reasonable to assume that things could get a lot better in the future if the Fed continues to slowly unwind QE and the federal government continues to reduce our onerous regulatory and tax burdens.

As it has since 2009, I believe it pays to remain optimistic.