Commentary Type

As Boomers Go Gray, Even 2% Growth Will Be Hard to Sustain

Jason Furman (PIIE)


Most of what was good in the American economy last year was unsustainable, and most of what was sustainable was not good. A decade after the financial crisis, there is still no sign the economy can generate the consistent growth of 3 percent a year many continue to hope for. The growth rate for 2017 was just 2.5 percent, and even that seems unlikely to last. Is this the new normal?

Not exactly. Instead it's a return to the old normal, a reversion that was widely expected after baby boomers began to retire. While policy makers should do what they can to increase the economy's long-run growth rate, they also need to avoid making decisions based on unrealistic expectations.

Economic growth comes from two sources. First is a cyclical rebound in demand as the economy gets closer to full capacity (or even proceeds beyond it). Second is an increase in the economy's underlying potential output—also called the supply side—driven by growth in either the workforce or productivity.

The trouble is that more than half of last year's economic growth came from the cyclical factors, which have little left to contribute given that we're at or near full employment. What this means is that absent much bigger productivity improvements, it will be a challenge for the U.S. to achieve sustained economic growth of even 2 percent.

The stock market's recent travails provide a vivid illustration of unsustainable growth. Last year the market went up 19 percent, which boosted consumer spending through a wealth effect. This surge in consumption probably accounted for about 0.75 percentage point of the growth in gross domestic product. For four straight years, consumer spending has risen faster than GDP, causing the personal-savings rate to drop to 2.4 percent—nearly the lowest on record.

Now a market correction has happened, and even with their recent rebound stocks are still 6 percent off their highs, as of close on Wednesday. Whatever may happen in the market, it's sobering to listen to the people arguing that stocks are correctly valued. The theory that today's high price/earnings ratios are justified—meaning it simply has become more expensive to buy a given return—implies lower earnings going forward. That, too, would undercut the consumption-fueled growth the U.S. has been enjoying, leaving households vulnerable after the past several years in which they took on increased debt and reduced their personal savings.

Another unsustainable boost to the economy has been the falling dollar. Last year the dollar's effective exchange rate—a measure that compares the dollar against a basket of currencies weighted by trade volume—fell 7 percent. Although the U.S. pursued a de facto strong-dollar policy through higher interest rates and larger budget deficits, this was more than offset by unexpectedly strong global growth. The weak dollar helped roughly stabilize the trade deficit, meaning net exports only subtracted 0.1 percentage point from GDP growth in 2017, compared with an average of 0.5 point a year from 2013-16.

The momentum in GDP growth could continue into 2018, especially given that tax cuts and the recent spending bill will provide about $250 billion in new demand-side fiscal stimulus this year. The unemployment rate, now 4.1 percent, could fall into the 3 percent range, a welcome development. Lagging benefits from the weakening of the dollar may arrive. Beyond 2018, however, these factors will begin to lose their force, especially since the Federal Reserve is sure to raise interest rates to offset any additional fiscal stimulus. More important, while predictions about markets are uncertain, it is a mathematical fact that the unemployment rate cannot indefinitely fall by 0.6 percentage point a year, as it did in 2017.

Growth will therefore have to come from the supply side. But a bigger workforce is an unlikely candidate. Assuming that current immigration rates continue and that employment rates by age are stable, the workforce will expand by 0.5 percentage point a year over the next decade. It is theoretically possible that people out of the workforce today could return. Betting on this, though, would be imprudent, given the steady decline in labor-force participation for men since the 1950s and for women since around 2000.

That leaves productivity growth, which is even less certain. The statistics usually reported exclude farms and the government, meaning they cover only a faster-growing subset of businesses. Instead let's look at economywide productivity, which is what's relevant for predicting overall economic growth. In 2017 economywide productivity increased 0.9 percent, slightly below its 1 percent annual pace over the past decade. If that average rate continues, overall economic growth in coming years will average only 1.5 percent. But maybe the productivity figure for 2007-17 is too pessimistic, reflecting a combination of fallout from the global financial crisis and bad luck. In that case we might look to the average economywide productivity growth of the past 50 years, 1.6 percent. That would push the baseline for overall growth to 2.1 percent.

Actual growth over the next five or 10 years could vary from this range of 1.5 percent to 2.1 percent, but there is little basis for a forecast that diverges significantly. As an analogy, imagine you're asked to predict the high temperature in Boston on Christmas Day. You might say 43 degrees (the average over the past decade) or 40 degrees (the average over the past 50 years). It could well end up being 20 degrees or 60 degrees, but those would be foolish predictions.

Slower growth is less the fault of President Trump than of his generation. Mr. Trump, born in 1946, was in the first wave of boomers. Forty percent of the people born that year have left the workforce. This was predictable, which is why in 2005 the Social Security Trustees projected that the economy would grow 1.8 percent a year from 2020-30. If anything, additional data since then would lead us to revise that forecast down. Americans simply have forgotten this basic reality. To the degree that policy and business decisions are based on false hopes for much higher growth, the result can only be dashed expectations.

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