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.