There is currently an interesting debate in the US about what the trend rate of growth is, and how it could be raised, alongside a broader anxiety about the relative performance of the US economy. The recovery in output from the Great Recession has been much slower than those following previous recessions: the rate of GDP growth has averaged 2 per cent a year since the recovery began eight years ago. Meanwhile, the rate of labour-force participation is at its lowest since the 1970s, and productivity growth has been weaker than expected.
The hangover from the banking crisis
Part of this disappointing economic performance can be attributed to the cause and character of the recession itself. Slumps in output brought about by financial and banking crises are associated with protracted periods of economic weakness post-crisis. That was the lesson of the 1990s’ Japanese and Swedish banking crises, along with many others discussed by Kenneth Rogoff and Carmen Reinhart in their book This time is different. Examining banking crises over several hundred years, the authors show that serious examples are usually followed by protracted periods in which banking and credit systems remain impaired, and restrict the pace of economic activity even as the economy recovers. Dr Henry Kauffman — the doyen of Wall Street interest rate analysis and the Dr Doom of the Bond Market — has asked whether part of the explanation of slow growth in the US economy is a credit system that simply does not have the liquidity and capacity to support a trend rate of growth of over 3 per cent.
America’s structural economic problems
Yet aside from the legacy of the Great Recession and the banking crisis, the US economy appears to exhibit structural challenges that cannot be tackled by monetary policy or the policy instruments available to a central bank. A paper published by four economists who have served in Republican administrations — John Cogan, Glenn Hubbard, John Taylor and Kevin Warsh — on the prospects for higher economic growth, argues that the weak productivity growth and disappointing labour market performance are the product of defective policy and the neglect of the supply performance of the economy.
Its authors identify high marginal tax rates, costly recent labour market regulation, the accretion of antiquated federal rules and regulation, and the introduction of new regulation without proper cost-benefit analysis. These features often have the effect of protecting incumbents, hindering competition, and discouraging investment and employment.
They also point out that the US has a public spending problem. Referring to the House of Representatives Budget Committee’s 2018 Budget Resolution, they draw attention to the estimate that, on unchanged policies growth in demand-led entitlement spending on health care, pensions, and government debt service charges, federal government spending will rise by 60 per cent in the next ten years. This would add about 12.6 per cent to the General Government to GDP ratio, taking it from the OECD’s estimate of around 38 per cent to something over 50 per cent. (This ratio also includes the spending of state governments and local government authorities that accounts for around 16 per cent of US GDP.) As the authors of the paper note, this increase in the ratio of public spending would eventually crowd out private investment and further constrain productivity growth.
A need for realism about growth under present policies
The authors argue that the growth rate could be increased to something like 3 per cent. This is significantly higher than the Congressional Budget Office’s estimate of a trend rate of growth of 1.8 per cent. The CBO’s estimate assumes the continuation of current policy with little change to the structure of taxation, the framework of regulation, and a budget reform that would constrain growth in public spending on entitlement programmes to the rate of inflation and the growth in population.
The debate in the US needs to focus on greater realism about the federal government’s present spending plans, in the context of the plausibly realistic growth forecasts produced by the Congressional Budget Office. The reason to constrain the growth in federal government spending is more to do with avoiding further crowding out of the private sector than how it may stimulate stronger future trend rate growth. The US faces some very awkward choices about public spending, taxation, and borrowing. Decision-making should be informed by a cautious realism that avoids wishful thinking.
America’s inherent strength
The US has fiscal challenges and problems with the supply performance of its economy that are common to most of the advanced economies in the OECD. Most of those countries face awkward fiscal choices, and it would be an error to lose sight of the great economic advantages that the transcontinental US economy still possesses. Martin Feldstein, who served as President Reagan’s chair of the Council of Economic Advisers, rehearsed this point recently in the Harvard Business Review by addressing why the US is still richer than every other large country.
Its advantages are: an entrepreneurial culture; a financial system that supports enterprise , innovation, and start ups; a developed venture capital market and a decentralised banking system; world class universities; a labour market unimpeded by powerful trade unions, state enterprises, and excessive labour market regulation; an expanding population; a culture of tax incentives that encourage and reward long work hours; an independent and inexpensive supply of energy as a result of natural gas fracking; a framework of regulation that is less hindering than that of the EU; a smaller public sector than that of European countries — the state spends around 38 per cent in the US, compared to 44 per cent in Germany, 51 per cent in Italy, and 57 per cent in France; and a decentralised political system in whihc state governments can experiment and compete with different policies attracting and repelling both business investment and labour.
The concerns of Cogan, Hubbard, Taylor, and Warsh are that many aspects of these advantages have been eroded. An erratic income tax system has created a ‘Manhattan skyline’ of marginal income tax rates, and tax credits phase in and out across the earnings distribution. Employment regulation and after-tax work incentives have begun to blunt the demand for labour and its supply — with the consequence that the labour market participation rate has fallen, not just in this cycle but over a longer period.
An economy that may yet remain underestimated
Yet the US economy weathered the Great Recession better than almost all other major economies. As Martin Feldstein points out, each year the US produces more per person than most other advanced economies. In 2015, real GDP per capital was $56,000 in the US, compared with $47,000 in Germany, $41,000 in the UK and France, and $36,000 in Italy, when taking account of what incomes would actually buy on a purchasing parity basis. Moreover, as Professor Feldstein has argued elsewhere in the Journal of Economic Perspectives, the current data reporting productivity and real growth of personal incomes and GDP may be under reported. Changes in the quality of existing goods and services and new introductions cause great difficulties to national accountants measuring prices and output. Despite the efforts of the Stigler Commission in 1961, the Boskin Commission in 1996, and the Shultz Commission in 2002, official estimates of improvements in quality and their implications for price deflators remain imperfect. So, the $18.5 trillion cash GDP figure scored by the BEA and deflated into constant prices based on 2009 prices may be of greater real value than the $16.6 trillion figure that US national accounts presently report.
The US economy retains great relative strengths. But it is not immune from the structural impediments that hinder other advanced economies with developed welfare states. These have accumulated over many years, and their resolution is not always within the control of the federal government. Given that many of the rub points arise from the clumsy interaction between federal and state benefits — particularly in relation to Medicaid — and tax rules. Before policy makers assume an increase in the trend rate of growth, they need to demonstrate that that the supply performance of the economy has improved. If they simply assume it will happen, policy will be made as a form of wishful thinking. In planning and financing public expenditure, the lesson of the 1970s — and from UK experience under New Labour in the 2000s — is that wishful thinking lands economies in trouble. Rigorous realism needs to be applied to the programmes of the right as much as programmes from the left or governments offering a third way.