May 17, 2017

Why a Slower Rate of Growth is Possible - and What It Means

By Gene Balas

If you look at the Federal Reserve’s forecasts for the long-range economic growth for the U.S., you might note it could appear rather low, with the central tendency of Fed officials’ individual forecasts for gross domestic product (GDP) growth to be 1.8% to 2.0%. Many would compare that to the 30 years up to the start of the Great Recession, when the average GDP growth rate was 3.1%, according to the Bureau of Economic Analysis. However, there are reasons why now is different than then.

Potential economic growth is basically the sum of growth in the labor force (and how many hours each employee works) and how much each worker produces in an hour. The more a worker produces, the more a company can pay that worker without driving up its prices or draining its profits. This much you may already know, and you probably also know that productivity gains – always hard to forecast, by the way – have been modest at best recently.

The economy is running at full employment

Now let’s get to the crux of the issue. We have a labor market that is near full employment for those with skills that companies demand. The unemployment rate, at 4.4% according to the Bureau of Labor Statistics, is below the levels where many economists generally believe inflation might accelerate. I do recognize there are discouraged workers without a job and who have stopped looking for work, but not everyone is, say, a software engineer. If a company needs a software engineer and can’t find one, wages on offer must go up for that position, even if some people are still unemployed. The economy has a shortage of talent in many occupations, ranging from welders to electricians and other skilled trades, according to survey data of companies, such as the Business Roundtable for larger companies and the National Federation of Independent Businesses, for smaller companies..

We’re arguably growing at full capacity right now, in large part because of an aging population (more on this later). One way of looking at economic growth is by comparing gross domestic product (GDP) to the size of the labor force, as seen in the nearby graph.


Economic growth per member of the labor force in line with history

Because the labor force is growing more slowly than in the past, the annual changes in inflation-adjusted GDP per member of the labor force since the end of the Great Recession doesn’t really fit a definite pattern of any deceleration. Yes, the 1990s were a period of robust growth, but this coincided with the introduction of new technologies – and even new industries. But aside from that, the current environment, measured per member of the labor force, hasn’t been all that bad. You’ll find a very similar pattern if you look at GDP relative to the total population.

What can we expect for the future?

What is important is not where we are now, but rather where we are going. We honestly can’t expect growth to be much more than where it is, given the Bureau of Labor Statistics projects the labor force will grow by just 0.5% per year. In decades past, the labor force had grown by an average of 1.5% in the 30 year period up to 2007, at the start of the Great Recession, according to the BLS. That allowed higher growth – but at the same time, it also required higher growth to pad all those extra workers’ pockets.

Now, the pockets that need padding are those of growing numbers of retirees, and part of those funds will come from Social Security. We’ll depart from the demographics here and jump to the federal government’s finances and its contribution to GDP. We can think quantitatively, or conceptually, but I’ll opt for the latter for this discussion.

Federal fiscal strains require funding at some point

Think of Social Security and government spending as a transfer system, from tax payers to recipients of benefits. In fact, Social Security, unemployment benefits and so on are formally referred to as transfer payments. The time period is not necessarily the same: government deficit spending now means funds are transferred to the present from future generations.

As we discussed earlier, slower growth of the labor force means slower potential economic growth. From that lessened growth, we must eventually subtract tax increases, either now or later, or find a way to offset that with spending cuts. Now, there is one little problem with spending cuts – non-defense, non-entitlement spending is just 2.8% of the economy, according to the GDP report from the BEA. It seems a bit impossible to close budget gaps by spending cuts alone, if one doesn’t touch defense or entitlements.

Will the economy grow even slower in the future?

So, at some point, that means the federal government will need to tap additional revenue sources. This is where the drain on the economy becomes more acute. If the government receives a dollar in taxes from Jane now and then spends it, it is neutral for the economy, because the dollar that Jane didn’t spend is instead spent by the government.

If, however, the government spends a dollar now, but borrows it, then what is economic growth now will become an economic subtraction later, through taxes to pay the bill when it eventually comes due. Simultaneously, at some point, needs for funding entitlement spending will only increase, compounding the difficulty in balancing the budget without tax rates spiraling higher.

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Now here’s a bit of a wrinkle. I mentioned that the economy is already arguably at full employment. Stimulating the economy even more from here may increase inflation. If that happens, then the Fed would tighten policy more than it would otherwise, and the bond market would similarly drive up rates across the yield curve. Higher interest rates would crimp economic growth – and cause government interest costs to be greater, harming its fiscal balance.

Never mind slow growth now. Unless we somehow achieve those elusive productivity gains (which are arguably the only path to a better standard of living), the culmination of all of these factors may conspire to be a drag on economic growth later.

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Gene Balas

Gene Balas

United Capital Financial Advisers, LLC (“United Capital”), is an affiliate of Goldman Sachs & Co. LLC and subsidiaries of the Goldman Sachs Group, Inc., a worldwide, full-service investment banking, broker-dealer, asset management and financial services organization. Investing involves risk and clients should carefully consider their own investment objectives and never rely on any single chart, graph or marketing piece to make decisions.

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