Slow Road Ahead

http://www.economist.com/business/displaystory.cfm?story_id=8079134

Oct 26, 2006 From The Economist print edition

America's long-term potential rate of growth is falling, perhaps to its lowest pace in over a century

EVERYONE knows that America's economy is slowing. Thanks to the bursting of the housing bubble, overall GDP growth has fallen back sharply. The biggest short-term uncertainty for the world economy is whether American consumers stop spending and drag the country into recession. But beyond the business cycle, another slowdown has received scant attention. America's potential rate of growth—that is, the pace at which annual output can expand without pushing up inflation—is also falling. By some estimates, it could drop to 2.5% over the next few years, which would be the slowest pace in over a century.

If that happens, the consequences will be serious. Tax revenues will grow more slowly than expected. Monetary policy will become harder to manage: as the 1970s showed, inflation can get out of control if central bankers do not realise that an economy's speed limit has fallen. Financial markets will be disturbed as conventional wisdom adjusts from an assumption of 3-3.5% potential output growth, and investors downgrade their expectations.

Potential output is hard to estimate, let alone predict. That is because an economy's trend growth rate cannot be measured directly. It has to be inferred. Over the long run economic growth depends on two things: increases in the supply and productivity of labour. The growth of labour supply, in turn, depends on the growth of the working-age population, the proportion of people who work and the number of hours they put in. The pace of productivity growth depends on capital investment, improvements in business processes and technological innovation. By looking at such trends, economists can estimate future potential output.

Although it generates precise-looking forecasts, this kind of “growth accounting” is fraught with difficulty. Both labour supply and productivity growth bounce around during business cycles. The share of people willing to work may fall in a recession, for instance, as discouraged people temporarily drop out of the workforce. Once job prospects pick up, they might return. Productivity growth is usually higher at the beginning of an expansion than at its end as firms work their existing employees harder before hiring new people. As a result, potential output can temporarily diverge from its underlying trends, making it even harder to estimate.

Nonetheless, the broad post-war history of America's underlying growth rate is clear. In the 1960s potential output accelerated to around 4% a year, largely because more women got jobs. In the early 1970s, for reasons that are still ill-understood, productivity growth slowed sharply, pulling down the trend rate of growth. Between the mid-1970s and mid-1990s America's economic speed limit was about 3%. Around half that growth came from an expanding workforce; the other half from productivity growth.

Thanks mainly to higher productivity growth, but also to a rise in the number of Americans working, trend growth rose suddenly in the mid-1990s. After the 2001 recession, productivity growth accelerated again, while the growth of labour supply slowed sharply. The share of working-age Americans in jobs fell after rising almost continuously for over four decades (see chart 1). This fall was widely interpreted as temporary, a sign that the recession was deeper than it appeared. But after five years of expansion, it has not been reversed, suggesting (although the evidence is still tentative) that structural changes are afoot. These labour-markets shifts are the main reason to be pessimistic about America's potential output growth.