Jumat, 27 April 2012

Thoughts on why real growth has been disappointingly slow

According to the government's first estimate of Q1/12 GDP growth, the U.S. economy grew at a 2.2% annualized rate, a bit less than the 2.5% expected. In numbers, that shortfall from expectations works out to about $10-12 billion, and that is essentially a rounding error. The government is going to revise its growth estimate several times in the future, and the final number could be a lot more—or a lot less—than what these charts show. One thing that won't change, however, is the fact that the U.S. economy is growing by much less than it should be, given the degree to which it suffered in the last recession. The top chart above is my attempt to quantify that underperformance, which I'm guessing is 12%, or about $1.8 trillion. That's a lot of income that should have been recovered by now.

This next chart shows that the the economy has been growing at a nominal rate of about 4% for the past seven quarters. Nominal growth has been fairly constant, but real growth has varied significantly over that same period. On balance, the economy has been muddling along, not doing anything very impressively.

Before the current recovery started, I thought the economy would post 3-4% growth, which at the time qualified as a "sub-par" or disappointing growth forecast given the depths of the recession. Instead, the economy has posted 2-3% growth on average (to be exact, real GDP has grown at a 2.4% annualized rate since the middle of 2009). My projection was relatively pessimistic at the time from an historical and theoretical perspective, but it turns out I was a bit too optimistic relative to the ensuing reality. Nevertheless, I have resisted the double-dip recession fears which have arisen a few times in recent years (most recently last Fall), and so far I've been right on that score. I still don't see signs of an impending recession, and I continue to expect sub-par growth. But in the end, whether growth is 2.5% or 3.5% makes little difference, I suspect, since my reading of the market tea leaves (notably the 2% yield on 10-yr Treasuries and the below-average PE ratio of the S&P 500) suggests that the market is not even priced to 2% growth.

The next two charts show inflation as measured by the GDP deflator, the broadest measure of inflation. The first chart shows the year over year growth of the deflator, whereas the second shows the quarterly annualized growth of the deflator. Inflation by this measure has averaged about 1.4% per year over the past three years. That's pretty tame, and about as low as we've seen for quite some time. But it is only slightly below the 2% upper range the Fed is targeting, and there are no signs that deflation is threatening.

Which brings me to the elephant in the room. The fact that we have not experienced any deflation (expect for the Q2/09 quarter, during which the deflator fell at a modest, 0.5% annualized rate), despite the magnitude of the recession and the huge 12% output gap which has prevailed for some time, is really big news. The prevailing theory of inflation (embodied in the Phillips Curve), which the Fed shares, is that it should vanish or turn negative if the economy were to experience a huge output gap for several years, such as we have experienced. Instead, inflation has been about the same in recent years as it has been for the past two decades. This probably should be a testament to the brilliance of Fed Chairman Bernanke, but the Fed's record of keeping inflation low on average has been marred by the relatively high degree of inflation volatility that we have seen in the past decade, as highlighted in the second chart: inflation has varied from a low of -0.5% to a high 4.7%. Given the nasty recession and painfully slow recovery we've been through, it's tempting to forgive the Fed this error, except for the fact that it's unsteady hand on the inflation tiller likely contributed to the 2008 recession.

In any event, the record of recent years is good evidence that the Phillips Curve theory of inflation has not done a good job at all of explaining or predicting the behavior of inflation. It's never made sense to me that inflation should be a function of the strength of the economy, or of the level of unemployment, or the degree to which resource slack exists. Inflation is a monetary phenomenon, pure and simple, and central banks therefore are the primary source of inflation.

As a corollary, while central banks have the ultimate control over our inflation destinies, they have very little ability to create real growth. Good monetary policy can contribute to growth by promoting the stability of a currency and thus bolstering the confidence of investors, but it can't just create growth out of thin air by artificially lowering interest rates or running the printing presses. In the end, real growth only occurs when the resources available to the economy (e.g., capital, labor, raw materials) are put to work in a manner which increases total output.

The federal government is also very limited in its ability to generate real growth, since spending money on more bureaucrats or more transfer payments doesn't do anything to create more output, and more likely results in greater inefficiency and thus less output. Generating more output from scarce resources is where the private sector excels. It's hard for an entrepreneur to figure out get more out of a given amount of resources, and working more hours is hard too. Working hard or harder generally requires giving people an incentive to do so, and the profit motive operating in free markets is what has proven to work best.

So if we're looking for a reason why the economy is 12% smaller than it otherwise should be, we shouldn't be looking at the Fed. I think one obvious source of the shortfall is the huge increase in government spending in recent years, most of which has been in the form of transfer payments. Instead of allowing the private sector to utilize the trillions of dollars the federal government has borrowed to fund this increased spending, the government has effectively just taken the money from the pockets of those who have been productive and put it into the pockets of those who have been unproductive or less productive. That doesn't create growth, it just wastes our scarce resources, because—as Milton Friedman taught us—nobody spends other people's money as wisely as they spend their own money. It's as if the government simply directed all of us to pour some of our hard-earned money down the toilet by buying things we don't need.

Here's another way of appreciating what has happened in recent years. The private sector has been working very hard to increase its efficiency and its output, and that shows up in the record level of corporate profits, both in nominal terms and relative to GDP (see charts above). But instead of allowing or encouraging the private sector to plow those profits back into the economy in the form of new plant and equipment, new jobs, and new technologies, the federal government has effectively borrowed all the corporate profits generated since 2009 and distributed the money to the unemployed, to the poor, to favored "green" industries, to unions, to state and local governments, and to "make-work projects," among other things. There's been a lot of money thrown around, but lots of it has been wasted in the process that could have been put to better use; we simply don't have much to show for the $1.25 trillion of after-tax profits generated per year on average by U.S. businesses since 2009. (I'm referring here to the fact that federal deficits in recent years have been roughly equivalent to after-tax corporate profits—actually a bit higher. So on a "sources and uses of funds" basis, the government has effectively used all corporate profits to fund its spending.)

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