The Causes of Slowing U.S. Growth Potential
In the U.S., potential GDP—the amount output can rise without increasing inflation—has slowed markedly since the 1980s and 1990s, when inflation-adjusted potential GDP was 3.3% a year. The potential growth rate embedded in today’s economic forecasts is much lower; for example, the Congressional Budget Office’s August 2015 federal budget update projected a 2.1% annual rate for the next 10 years. A recent Federal Reserve staff forecast says annual potential GDP growth is only 1.75% in the next five years.
Some pessimists, such as Robert Gordon of Northwestern University, believe that less innovation, reductions in labor quality improvement, and weak capital accumulation mean that potential growth could be as low as 1.4% annually through 2020.
A slow potential GDP growth rate has important ramifications for individuals and firms, particularly if the deceleration is due more to sluggish productivity growth than labor force demographics. If productivity is the cause, the reduced pace of growth in labor compensation and consumer spending over time impedes improvements to standards of living.
Low potential growth also reduces tax collection, increases our government debt burden, concentrates the burden of funding social welfare entitlements on workers, and causes firms to ratchet down capacity plans and thus invest less over time.
What Potential Means
Potential output dictates how rapidly the economy can expand the production of goods and services without increasing inflation. Potential GDP is not, however, the nation’s maximum production. Instead, it is the output that is within our resource availability over a prolonged period and that will not strain productive capacity and bid up prices. When actual GDP is higher than potential, the rate of inflation rises above the Federal Reserve’s goal.
The Congressional Budget Office’s actual/forecast and potential GDP annual growth rates are on the left scale of Figure 1. The right scale measures the output gap. These are two different concepts; actual and potential GDP are annual percentage changes or growth in the level while the output gap is the percent difference between the actual or predicted GDP level and the potential GDP level. The interaction between the growth rate and the gap is important—GDP growth can be above potential without creating inflationary pressure as long as output is below potential (a negative gap).
The inflation rate in the U.S. economy has had a declining trend since the early 1980s, so most of the time the output gap has been negative. Inflationary pressures built prior to the 1990 recession and during the dot-com boom in the late 1990s (until the 2001 recession). The economy was at potential in 2006 and 2007 but the 2008-2009 recession created a 6.9% gap by 2009; that huge gap has narrowed to 1.7% this year. With above-potential growth projected in 2016 and 2017, the gap should nearly close. CBO’s forecast for 2018 and beyond is that GDP growth will be noninflationary because it is equal to potential and maintains a slight negative output gap.
Causes of Slow Potential Labor Force Growth
Potential GDP growth is composed of two basic building blocks—labor force growth and labor productivity growth. Table 1 shows that potential labor force growth decelerated following the entry of baby boomers into the labor force in the 1970s and 1980s. Potential labor force growth decelerated from 1.6% a year in the 1980s to 1.3% a year in the 1990s to 1% a year in the five years before the 2008-2009 recession. A combination of the cyclical impact of the recession, demographics changes, and federal policy further reduced annual potential labor force growth to only 0.5% since 2008.
CBO decomposed the causes of the recent deceleration in potential labor force growth into three factors. About a third of the deceleration was the cyclical impact of the last recession on people’s ability to find jobs and lower wage prospects. Approximately half of the deceleration came from baby boomers entering their retirement years. The rest is attributed to recent trends, including delayed participation of young people in the workforce, workers who became discouraged by the lack of jobs and permanently dropped out of the labor force, and reduced job participation by some workers as a result of the Affordable Care Act.
CBO projects annual potential labor force growth over the next 10 years to be the same as during the previous six years. The percent of the civilian noninstitutionalized population aged 16 and over should grow only slightly slower than the past.
The most important factor depressing potential labor force growth is the continuing decline in labor force participation, which fell 3.1 percentage points (from 65.9% to 62.8% of the population) in the last six years. CBO expects a further 2.1 percentage point reduction by 2025. The downward pressure on the participation rate from an aging population will steadily erode the overall participation rate even though baby boomers will work longer before retiring. A rising share of people over age 65 in the population will overwhelm the rising participation rate among older workers.
A Cyclical Rebound in Productivity
Labor force productivity averaged 1.6% annually from 2002 to 2007 but decelerated to only 1% growth in the period that included the Great Recession (2008 to 2014). A Federal Reserve paper found that there are numerous reasons recessions, especially severe ones, might affect productivity growth. The decline in production in a recession leads to decreased business investment in plant and equipment and that can depress the adoption of new technologies embodied in the capital stock. A period of less improvement in capital efficiency means that the pace of growth in worker productivity slows.
Another aspect is the rate of improvement in the quality of the labor force. Unemployment surges during recessions and unemployed people may lose job skills because they are not learning by doing or benefiting from other types of informal skill improvement through work. Structural change forces many workers to acquire new skills.
CBO believes that the sharply lower business investment in a recession that reduces the growth of capital services available to workers is cyclical and thus temporary. A rebound in business investment starting in 2010 suggests that the recession-induced impact of less capital will reverse. After all, recessions tend to produce a survival of the fittest effect as low-productivity firms close and volume shifts to surviving firms and workers, increasing productivity. CBO projects a return to 1.6% annual growth in productivity per worker in the decade ending in 2025.
Conflicting Views on Innovation
CBO’s projection of 2.1% potential annual GDP growth over the next decade reflects a consensus view. The IHS Global Insight model that the MAPI Foundation uses, for example, forecasts 2.2% annual growth in potential GDP. Nevertheless, there is a raging debate and a great deal of academic work on the critical projection that innovation and capital investment will return to prerecession growth rates.
Some believe that the U.S. is running out of breakthrough innovations. Others think innovation is growing rapidly but that it takes a long time to show up in labor productivity—or the lack of worker skills limits the productivity benefits of innovation.
Most economists agree that the government statistics on output and productivity are not accurately measuring innovation such as internet products, software, and the sharing economy. But even on the mismeasurement point there are differences in opinion as to the degree of underestimation.