Is This the Best the Economy Can Do?
The belief that U.S. economic output is less than it could be -- an idea that's driven post-recession policy at the Federal Reserve -- is increasingly challenged by the data, as I described in my last post. That suggests a drop in the country's productive capacity, which leads to an even more vexing question: What's behind that drop? And how should the Fed respond?
It's not hard to see why economists' instinct is to view our current low growth as an anomaly. The U.S. economy has long been a predictable growth machine. For decades, you could count on it growing about 3 percent a year after accounting for inflation.
And then the recession happened. The U.S. has grown an average of just 1.6 percent a year over the last decade. Whether the U.S. can recapture the growth it has lost depends on what slowed growth in the first place.
If slow growth has left the U.S. economy with lots of excess capacity -- slack, in other words -- we could still hope to make up for that lost growth. But there's another possibility: that slack might not exist. Maybe we're running near full speed but don't know it.
What would explain the slowdown in growth, if the culprit isn't some version of unused capacity? It's not as if the entire U.S. woke up one morning in 2008 and decided, "I'm going to be less productive today and every day going forward."
The best explanation might come from thinking closely about the U.S. housing market. Amid the bubble in home prices, homebuilders glutted the nation with new homes, which sat vacant when the bubble popped.
That slack capacity was expected to hold down home prices, but when the recovery arrived, little slack turned out to exist. With few homes built in the recession, there were few to sell when the recession ended. Extraordinarily slow construction had drained the slack away.
If slack doesn't exist in the rest of the U.S. economy, it could be for a similar reason. Investments to expand capacity don't happen when the capacity that already exists isn't being used. And it's not as if one can clap those investments instantly into existence once the slack goes away -- the time required to invest has already been forfeited. This lack of investment during the recession probably reduced the country's economic potential and, with it, the amount of slack it has left.
What's the evidence that U.S. capacity hasn't grown much since 2007? To start with, productivity growth is crawlingly slow -- averaging just 1 percent over the last few years. That's a far cry from the late 1990s, when it ran at 3 percent. That underperformance was enough to garner attention in Ben Bernanke's farewell speech as chairman of the Federal Reserve:
The reasons for weak productivity growth are not entirely clear. It may be a result of the severity of the financial crisis, for example, if tight credit conditions have inhibited innovation, productivity-improving investments, and the formation of new firms; or it may simply reflect slow growth in sales, which have led firms to use capital and labor less intensively, or even mismeasurement.
Estimates of industrial capacity from the Fed's Board of Governors show just as little progress during the recession. The result: Factories are reporting they are near full capacity even though production has just recovered to prerecession levels.
Economic theorists wouldn't be surprised by the possibility that the recession sapped the American economy's potential. In fact, many warned us about it. A much-discussed paper from J. Bradford DeLong and Lawrence Summers, for instance, argued that an economy's potential output falls when that potential goes unused for an extended period of time. Their estimates of how quickly that process happens would imply that half the slack that appeared during the recession has since decayed.
If this is really what has happened, the policy prescription is clear: less monetary easing. Trying to repair lost potential is something monetary policy simply can't do.
Yet the central challenge of the Fed's exit strategy is that these are risks, not certainties. How to deal with the ambiguity will be the subject of my next post.
(Evan Soltas is a contributor to Bloomberg View. Follow him on Twitter at @esoltas.)
This column does not necessarily reflect the opinion of Bloomberg View's editorial board or Bloomberg LP, its owners and investors.
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