Economy needs to incentivize investment

It's that time of year when economists are called upon to provide guidance on likely economic conditions going forward. If properly done it eschews crystal ball gazing and ideology. Economists have a vast toolkit and a rich database.

There are long-term, medium-term and short-term trends of U.S. economic growth. It's comforting to observe that in the long term periodic recessions have always been followed by recoveries; the business cycle has never been banished. However, the trend of growth of U.S. real GDP, portrayed in Figure 1, suggests a step-change in recent decades. In the decades after World War II, growth was of the order of 3.5 to 4 percent. From the 1970s through the 1990s growth of 3 to 3.5 percent was the norm. Yet since the turn of the century the U.S. economic growth dynamic has slowed down to around 2 percent. Is this the new normal, and if so why?

Boiled down to its essentials economic growth is a function of two vital variables: the growth of the labor force and the growth of labor productivity. The annual growth of the U.S. labor force peaked in the 1970s at 2.4 percent. It has declined steadily since then. The U.S. Department of Labor predicts 0.6 percent average annual growth of the labor force from 2014 to 2024.

Academic economists, including Robert Gordon at Northwestern University, have studied the long-term trend of U.S. labor force productivity. It appears to have peaked at 2.5 percent in the 1950s and 1960s, and since then it too has steadily declined. Since the end of the Great Recession, it has only grown at a rate of around 1 percent.

In Table 1, I combine the recent trends of these two variables. This yields a proxy for the trend of potential real GDP growth, and I compare it to the trend of actual real GDP growth. There's a fairly close correspondence between these two data-sets.

What do the data in Table 1 tell us? First of all, regardless of future immigration policy, the slow growth of the U.S. labor force is already locked in. Thus, in order to restore the former growth dynamic of the U.S. economy, we need policies that raise the productivity of our workforce. That means increased investment.

In the long term our priority must be improving the productivity of students emerging from our high schools, colleges, universities and vocational schools. However, in the long run, as John Maynard Keyes once quipped, we'll all be dead. We need more immediate solutions.

How do things stand at the moment? In December the Federal Reserve Board raised the targeted range for the federal funds rate by 0.25 percent. This was purely a symbolic and probably largely ineffectual gesture. On the one hand the Fed should have taken this step long ago. On the other hand it is a bizarre time to be tightening monetary policy when inflation is dormant and economic growth is tepid. It certainly won't stimulate investment.

Table 1 provides a supply-side perspective on economic growth. The alternative demand-side perspective reaches the same conclusion. The Department of Commerce publishes data on net contributions to U.S. economic growth from the four primary sources of spending. It simply multiplies the growth of these segments by their shares of GDP. Table 2 portrays the pattern over the period 2010-2014.

How will these four components of GDP fare in 2016? Bear in mind they are all inter-connected. Consumer spending is by far the largest component of GDP, and it has been tracking in the range of 1.5 to 2.7 percent since the end of the Great Recession. International trade has been a net negative, and the recent rise of the U.S. dollar has taken a toll on U.S. exports. The revolution in the oil and natural gas industries will reduce our import bill. Yet the collapse of oil and natural gas pricing should have enhanced discretionary income and spurred consumer spending. That mechanism hasn't materialized yet.

In effect the decline in energy pricing hasn't provided a cure for the U.S. economy. Rather it reveals the extent of the deficiency in overall demand.

The sequester bill of 2011 led predictably to a cutback in government spending. At the end of 2015 Congress began loosening the fiscal policy purse strings somewhat. Yet the overall political economy has been mired in a slow/no growth mindset, and there will be no change in an election year. The feeble attempt at stimulating infrastructural spending in 2009 takes any new attempt off the table.

In my view the restoration of economic growth in 2016 hinges on renewed capital formation and investment. The focus on war since 2001 and the new concern over homeland security has weakened the normal animal spirits of entrepreneurs and investors. Real gross investment in 2014 was only back to the level of 2007. Non-residential investment only grew 1.4 percent over that period whereas residential and government investment levels have yet to return to 2007 levels.

In the end I hold to the Latin adage, “Natura non facit saltum” (Nature doesn't make a leap). The annualized growth in U.S. real GDP slowed down from 3.9 percent in the 2nd quarter of 2015 to 2.0 percent in the 3rd quarter and then to 0.7 percent in the 4th quarter. In effect the carryover of economic growth momentum heading into 2016 was half the momentum heading into 2014 and 2015. We would need a fair amount of intra-year growth in 2016 simply to attain the “new normal” growth rate of 2 percent.

The only hope for raising growth above this new normal is a new pro-growth administration focused on incentivizing investment, raising labor productivity and ultimately improving living standards.

Mooney is president of Advanced, N.C.-based Plastics Custom Research Services.