$2 trillion GDP shortfall

Third quarter real GDP grew somewhat faster than expected (3.5% vs. 3.0%), and on top of the 2nd quarter's 4.6%, that gives us annualized growth of just over 4%. Wow: has economic growth really ramped up than much? I'd like to think things have improved a bit of late, but in any event it's premature to reach that conclusion—we'll need to see at least another quarter's worth of stronger growth to be sure.

Abstracting from the quarterly numbers, which are always volatile, real GDP growth over the past two years has been 2.3% annualized (see chart above). It's also been 2.3% annualized since the recovery began in mid 2009. This has been a 2.3% growth rate recovery for over 5 years. Nothing much has changed, at least so far.

As the chart above shows, this has been the weakest recovery in history. The economy is now about 10% below its long-term trend growth potential. In other words, nominal GDP today would have to be $2 trillion higher to get us back on the economy's long-term trend. Due to a variety of factors (e.g., too much income redistribution, high marginal tax rates, too many additions to regulatory burdens, Obamacare, geopolitical uncertainty, unusually strong and persistent risk aversion, the retirement of the baby boomers), we are missing out on $2 trillion of annual income and 10 million or so jobs.

This is a big deal, and this is why the electorate is upset. We've made some terrible decisions and left an awful lot of money on the table.

But I do think it's likely that the economy is gaining strength on the margin. One reason for that is the big decline in government spending relative to GDP, which has dropped from a high of 24.4% to 20.3% in the past five years (see chart above), mainly because spending has not increased at all during this recovery. Spending is taxation, so what we've seen in the past five years is a huge decline in expected tax burdens. A considerable amount of weight has been lifted from taxpayers' shoulders. The private sector now has more breathing room. The private sector is now spending a larger share of its own money, and that means that spending in aggregate will be smarter, more efficient, and more productive. (Keynesians, by the way, get this all wrong: they think the economy has suffered because the government has not spent more and because the deficit has declined—that fiscal austerity is the culprit behind weak growth.)

Meanwhile, it seems increasingly likely that the electorate next week will repudiate the current administration's policies. At the very least we are likely to see congressional gridlock, which could keep spending from growing and reduce the burden of government further. More likely, we'll seen Congress make progress on reducing our onerous corporate tax rate, which could result in more new investment and more new jobs. We might even see some much-needed reform of our absurdly distorted tax code, and some sensible, market-based reforms to healthcare.

You can already feel the policy winds shifting. Instead of headwinds, we are starting to get tailwinds. This is very good news. There is a lot of ground to make up, and a lot of upside potential if we get things right in the next few years. It pays to remain optimistic.