The problems with escalating rates of growth become evident immediately if a particular industry, or the economy overall, starts to overheat. You have heard that expansions don't die of old age. They die because high levels of confidence eventually turn into overconfidence, and overconfidence causes mistakes. Investors start to speculate excessively, real estate developers overbuild, businesses take on too much debt, and households overextend themselves. This process has preceded every recession in recent decades, and it will likely be the process that precedes the next recession.
The rhetoric coming out of Washington regarding GDP growth greater than 3 percent per year is necessary for political purposes, but it is not necessarily a good idea. This talk is fueled by the fact that the recent tax cuts will result in a significant increase in the federal budget deficit that will only be offset if economic growth exceeds 3 percent per year.
The problem with this scenario is that economic growth in excess of 3 percent is faster than the long-term potential for the U.S. economy. Roughly speaking, a country's long-term potential is the rate of population growth added to the rate of productivity growth.
For many years the rate of U.S. population growth has been well below 1 percent per year. It is more difficult to measure the rate of growth in productivity, but since the end of the last recession, official measures of productivity gains have also been below 1 percent per year.
This gives us a long-term potential rate of 2 percent per year. There just has not been enough investment during the past decade to push productivity rates higher. Whether it is infrastructure, capital equipment or workforce development, all have suffered in recent years from underinvestment.
So growth that exceeds 2 percent creates a high risk of unacceptably high rates of inflation. If this happens, the Federal Reserve Board will raise interest rates more quickly than currently planned to slow the economy.
The difference between an economy's long-term potential rate and one that is higher is called the "output gap." Economies can run for a while with an output gap, but not forever. Historical data suggests that three years is about as long as an overheating economy can go. After that, it enters a recession.
This economy functioned for eight years growing by 2 percent per year without causing any signs of overheating. Time will tell whether we can sustain a higher rate of growth.
The United States may be able to spur productivity growth in the coming months to a level that will sustain 3 percent growth. But business owners and managers should pay close attention to the inflation data this year and not get blindly caught up in any euphoria that may potentially be created by faster economic expansion.