How do we explain the fact that GDP is growing very slowly, unemployment is falling faster than GDP growth would predict, and inflation isn’t falling as quickly as we might otherwise expect? Greg Ip of The Economist offers a tentative hypothesis after revisiting various alternatives:
Or you could go with a simpler but more pessimistic explanation: both the level and growth rate of American potential output is much lower than we think. This would resolve all these puzzles: GDP growth of 2.5% is above, not at, trend, the output gap is closing, and it was probably smaller than we thought to begin with. That would explain why unemployment is falling so quickly, and why core inflation hasn’t fallen further. The excess supply of workers and products that ought to be holding back prices and wages is not as ample as we thought.
So this explanation has the merit of simplicity; is it plausible? Adam Posen likes to dismiss supply-side explanations for Japan’s economic underperformance by saying the Japanese did not one day wake up and find their left arms had fallen off. I have long agreed with the American analogue: while the crisis and recession have set back America’s output, its productive capacity remains largely intact. The rise in unemployment does not seem to be sectorally concentrated. The ratio of unemployed to job vacancies is falling, but not by much more than is typical at this stage of the cycle.
That’s still my view. But lately, it is starting to look more like some left arms have gone missing.
Labour force participation seems to have settled at 64%, two percentage points lower than its pre-recession level. If that drop is permanent, it would alone entail a significant decline in the level of potential output. What about productivity? My colleague notes there’s a healthy debate going on about whether trend productivity has slowed. I don’t know the answer, but it’s clear that actual productivity has been pretty unimpressive for this stage of recovery (see the nearby chart from Barclays), and certainly compared to a decade ago. For all the talk of social media IPOs, Apple’s market capitalisation and the money pouring into alternative energy, none of these represent transformative technologies with much impact on productivity.
We’ve discussed how the stagnation of labor quality will shape the future productivity landscape. Improving the productivity of the education sector is extremely important, yet it is far more likely that we will pursue costly, ineffective strategies that reward incumbents than that we will facilitate new entry and the rise of productivity-enhancing business models. Entitlement reform might increase labor force participation, and addressing growth-undermining land use regulation might mitigate the “moving to stagnation” dynamic. Patent and copyright reform might also make a contribution. But none of this will be easy, in part because some of these reform agendas have proven awkwardly polarizing. The right doesn’t support all of the above, and neither does the left. And it’s not obvious that combining all of them (the best case scenario) will result in a workable bipartisan settlement.