Thursday, June 11, 2009

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.


seekingtraceevidence said...

My regression of Real GDP from 1930 to present shows a slowly declining pace from 3.9% in 1930 to 3.15% today as the economy becomes larger. I lean with Wesbury that after a GDP decline you get an above avg period to bring the near trend in line with the long term.

Donny Baseball said...

Excellent. Thanks. And yet this theory is, IMO, predicated on the durability of our legal system and the protection for contracts remaining constant. Weaken the rule of law and the string lengthens and sags. We still don't know what reverberations the administration's handling of Chrysler and GM bankruptcies will have on investors' confidence in legal protections. Maybe none, maybe alot. Ditto the corporate tax proposal Obama has put forth. I don't think the major debate is where we are in the economic cycle, but where we are in the policy cycle - how deep will anti-growth policy run and how long will the trough be? Those are the hard variables to get a handle on.

I've been meaning to ask your thoughts on your state's fiscal mess. What do you see happening? What effects might things have on the broader economy and markets? We here in NY are watching CA closely as we are next in line to hit the fiscal wall (or maybe NJ).

Scott Grannis said...

All the things you mention are reasons to expect that trend growth going forward will be less than it has been in the past. All but the hard-wing lefty Obama supporters have come to that conclusion. I think the market is coming to believe it also (though not fully yet). I hate to be in the middle of the consensus.

As for CA, the propositions went down to a big defeat and that was incredibly positive. The people are not stupid, and they definitely don't want higher taxes. Politicians have no choice but to cut spending. Hasn't happened yet, though. We're all waiting to see what those idiots in Sacramento are going to do. Meanwhile they are passing bills regulating what pre-school kids can and can't eat for lunch.

Mark A. Sadowski said...

This post made me organize alot of thoughts for what it is worth. I actually spend much of my time thinkng about factors affecting long term growth as well as deviations from that path.

Let me start by asking a few questions about your calculations. Based on the numbers I backed out what I think are your calculations. Correct me if I am wrong. It seems to me that you are actually using 2007 as a base year assuming that we were at potential. Then you assumed a trajectory of 2.3% on potential GDP and (given that 2008 GDP growth was 1.1%) assumed a 2.0% decline in GDP in 2009 and a constant rate of growth thereafter.

If this is true, my major criticism is that you are assuming too small of a decline in GDP this year. The Survey of Professional Forecasters currently has a prediction of a decline of 2.4%. The OECD is currently predicting a decline of 4.0%. I personally predicted a decline of 2.8% as of last last quarter. I think you're a little optimistic. On every other score I have little disagreement.

I think we will get back to potential GDP as early as 2015. I also believe that potential GDP is growing at about a 2.4% rate through then. And by my calculations we were about 0.4% above potential in 2007. Given my more pessimistic forecast about this year and my more optimistic forecast going foreward I come up with a figure of 3.7% average growth for the years 2010-2015.

I have much more to say about this topic but I think I'll divide it into separate comments.

Mark A. Sadowski said...

I commend you for bringing up Friedman's 1964 paper. It is seminal in some ways. I also recommend his subsequent paper (only seven pages) in 1993 in Economics Inquiry. Good reading.

There have been many empirical paper done on the "plucking model."
The support for this model's description of macroeconomic behavior is very strong (but almost all of this research is based on post-World War II data).

One of the big lessons I take from it is that the worse the economic decline the faster the economic recovery. But one must be careful in interpreting the model's empirical conclusions in terms of policy. Not even Friedman attempted to draw those conclusions.

In fact when taken in the context of all of his writings I think it is implicit that one of the main reasons that growth is stronger following major recessions is that policy makers are more proactive. In fact that is one of the reasons why I think that the recovery from the current great recession will be so swift (once it is over).

More on this subject later.

Mark A. Sadowski said...

I think this will be my last (or next to last) comment.

I've studied the history of potential GDP growth extensively. The one thing that I think is universal about eras of fast growth versus slow growth is whether unempoyment was relatively low or high. It seems that when it is low that potential GDP growth (particularily GDP per hour worked) is high. In the opposite case it is relatively low. I think a major part of this is due to hysteresis. When people are unemployed they lose valuable skills. Thus it is better to keep the labor force as fully employed as possible.

Let me feed you some data as examples. FRED keeps data on potential GDP growth in the US dating back to 1948. Here is what I have observed.

If you look for long periods of above average and below average periods of growth on record four periods in particular stand out.

The two high growth periods were 1949-1952 and 1963-1969. They had potential GDP growth rates of 4.7% and 4.9% respectively. The two low growth periods were 1991-1996 and 2004-2008 (so far). They had potential GDP growth rates both of 2.6% each.

Both of the high potential GDP growth periods were characterized by low unemployment relative to NAIRU. They were 4.9 and 5.4 on average versus 5.3 and 5.7 on average in order temporaly. Both of the low potential GDP growth periods were characterized by high unempoyment relative to NAIRU. They were 6.4 and 5.1 versus 5.5 and 4.8 on average in order temporaly.

Note that the two periods of high periods of potential GDP growth were characterized by high top marginal federal income tax rates (70-94%) and that the two low periods of potential GDP growth were characterized by low top marginal federal income tax rates (15-39.6% depending). This is the opposite of what Supply Side theology teaches.

When one actually looks at the data one reaches different conclusions than you.

Scott Grannis said...

seeking: Try drawing the trend line so that real GDP never exceeds it. That's how Friedman specified his Plucking Model. I think you will find that the recent trend is less than 3%, as suggested in my chart.

Scott Grannis said...

Mark: I'm assuming a modest decline in real GDP in the second quarter. As for proactive policies driving a rebound, I've mentioned before how I think the recovery from this recession has been delayed by Obama's wonton fiscal stimulus and the prospects therefore for much higher tax burdens. I think the recovery could have started months earlier if not for this.

As for potential GDP growth I don't have any confidence that it can be measured correctly or even observed. My estimate of trend growth, and any other's, is purely guesswork and done after the fact.

Finally, be careful of mistaking correlation (hi/lo GDP growth and lo/hi taxes) for causation. You are ignoring a plethora of other variables that enter into the equation.

Bob said...

Simply Mark, there is a lag between cause and effect. High tax rates lead to less productivity and eventually less tax revenue. Lower taxes lead to more income and hence more taxes. It is not a difficult thing to understand. The Bush tax cuts took about a year and half to start taking effect. Subsequently the U.S. had a number of months that had record Federal tax receipts and a budget deficit that was on the decline even as a corrupt Republican Congress overspent in every arena and an Administration that was in effect domestically and economically liberal, spent to oblivion.