Why are the Economy and Incomes Growing So Slowly?

Why are so many people unhappy and angry?  Why is the electorate turning to populist candidates like Bernie Sanders and Donald Trump?  Why are they so mad at the Washington D.C. establishment?  What’s the problem?

This is the second in a series of articles.  The first dealt with the fact that the cost of health care and education have been growing much faster than family incomes making these essential services unaffordable to more people.

This second article will discuss the other half of the problem, slow growth of the economy leading to low growth of household incomes and the shortage of good quality jobs.

The most important economic question facing the U.S. is how do we grow the economy faster?  Faster growth solves a lot of problems.  Growth increases government tax revenues without any tax rate increases, adds jobs and increases wages, and makes our debts and entitlement obligations easier to support.

Since the end of the Second World War until about 2000, the economy as measured by gross domestic product (GDP) grew an average of 3.5 %/year for over 50 years.  At that growth rate, the economy doubles about every 20 years raising incomes and living standards.  This is real GDP growth, nominal or current dollar GDP less inflation, as reported by the U.S. Federal Reserve.

Since 2000, the economy has grown less than 2.0 %/year.  This year, 2016, the economy has only grown about 1.5 %/year so far.  The latest official forecasts by the Congressional Budget Office and the Federal Reserve forecast real growth of only about 2.0 %/year.

The difference between 3.5%/year growth and 2.0%/year growth is not 1.5%, it’s almost 60% less, a very big deal.  What’s happening?  Why the slowdown and why can’t we grow the economy faster?  According to Stanford economist John Cochrane, “restoring sustained, long-term economic growth is the key to just about every economic and budgetary problem we face.”

If the economy had grown at 3.5%/year since 2000, the economy today would be $3.0 trillion larger and household incomes would be an estimated 18% larger, about $10,000 per household.

On a per capita basis, adjusting for a growing population, GDP has grown about 2.2 %year from the end of the Second World War until 2000.   But since 2000, GDP per capita has only been growing about 0.9%/year, a major slowdown.

A consequence of slower GDP growth is slower growth of wages and household incomes.  The Median household income peaked at $57,900 (2015 constant dollars) in 1999 when Bill Clinton was president. It is now $56,500 as of the end of 2015.  There is no improvement when adjusted for inflation.

In addition, real average hourly wages have been flat at about $21/hour for decades, according to the Pew Research Center.

Where does growth come from anyway?

It’s really simple.  The economy only grows due to two factors, an increase in total hours worked (people with jobs) and productivity improvements (output per hour worked).

Total labor hours are based upon the percent of the population of working age times the labor force participation rate (the % of the workforce employed or looking for work), and the average hours worked per employed person.

Demographics are leading to slower growth in the work force, from an average of about 1.2 %/year since World War II to about 2000 to about 0.5%/year today.

The more serious problem is below trend productivity growth.  This is especially serious since productivity improvements are the only source of rising living standards (higher incomes).  Without productivity improvements, we’d have on average the same incomes as our parents and grandparents. Non-farm business sector labor productivity growth has averaged about 2.2%/year from the end of the Second World War to 2000 but has dropped to less than 1.0%/year since then.  Over the past year, productivity grew at only 0.6%/year.

At 2.2%/year, incomes double about every 33 years.  At 1.0%/year, it takes about 70 years to double incomes.

Let’s take a closer look at productivity first, then the labor force.

Why is productivity so low and what can we do about it?

To quote John Cochrane again, “Nothing other than productivity matters in the long run.”  It’s the only source of rising living standards.  However, the U.S. Federal Reserve believes that productivity growth will remain low for an “extended period of time.”  Why?

What could be the causes of the productivity slowdown?  Is it a permanent condition or will productivity improve on its own over time?  Surprisingly, there is very little agreement on why we are seeing a slowdown in productivity growth or what to do about it.  We can’t come up with effective solutions if we don’t know what’s causing the problem.  Several reasons have been proposed for the slowdown:

1. A pessimistic assessment: An explanation is advanced by Professor Robert Gordon in his latest book entitled The Rise and Fall of American Growth.  He makes a strong argument that the growth we’ve seen over the past 250 years could be a unique episode in history.  There is no guarantee that we will progress at the same rate in the future.  Yes, we have the Internet and other recent advances.  However, they will not have the same impact on productivity and growth as, for example, the steam engine, indoor plumbing, electricity, and the internal combustion engine.  The major inventions that replaced repetitive manual and clerical labor happened in the past.  Recent inventions have centered on entertainment and communications and have made things smaller, cheaper, and more capable but don’t do much to enhance labor productivity.  The Internet may add to our convenience and entertainment but may not do much to boost productivity.  Are the Internet and wireless communications a problem?  On average, we spend a lot of unproductive time on social media and talking on our ever-present cell phones.

Others disagree with Gordon’s conclusions and say we just need more time for exciting new technologies to impact productivity.

2. The switch from manufacturing to services: To date, productivity improvements have been lower in the labor intensive service sector of the economy which now makes up about 80% of nonfarm employment in the U.S.  There are more than 6 jobs in the service sector for every manufacturing (goods producing) job.

Health care, education, and government employment are an increasing share of the GDP and show low to no productivity growth.  They make up about 57% of the economy.  If the right kind of investment, new technologies, and other changes eventually lead to major productivity improvements in services such as retail, education, health care, and banking and finance, then output per service worker could rise.

3. A potentially more optimistic assessment: Stanford Professor John Taylor and others believe that the decline in productivity is largely due to poor economic policies. There is a lot of unrealized potential that can be made available by making changes to improve productivity and get more people back into the workforce. In the past, there have been large swings in productivity growth depending upon government policies in effect at the time.  Professor Taylor concludes that today’s low productivity growth is largely due to a lower rate of investment in capital stock per worker.  This can be corrected by tax and regulatory reforms.

Note that investment in new equipment, software, and new product development is the primary means by which better tools and technology get into the hands of workers and contribute to productivity improvements.

Part of the problem is that U.S. businesses are going into debt, $793 billion in 2015, largely to pay for stock buybacks and mergers and acquisitions rather than for productive investments in new equipment and new technology.  This “financial engineering” bids up stock prices and makes stock options more valuable for company executives.  These investments do nothing to improve productivity or add jobs.

Our tax code is probably discouraging capital investments.  There are also disincentives associated with the increasing number of government regulations at the state and federal level. Do we have too much bureaucracy?  The Dodd-Frank bill on banking reform was 2,300 pages long.  The Affordable Care Act was 961 pages long.  Each spawned thousands of pages of detailed regulations applied to the banking system and the health care industry.

Labor force growth:

The other reason for low GDP growth is the slower growth of the workforce in the U.S. from about 1.2%/year until about 2000, and 0.5%/year since then.  This is due to the ending of the baby boom, the increasing percentage of older retired citizens, and the fact that the percentage of working age women in the workforce is no longer increasing.  There has also been an increase in the number of people who are discouraged and no longer looking for work, mainly working age men.  This leads to a slower growing labor force.

This is reflected in the labor force participation rate, the percentage of the working age population who are employed or actively looking for work.  The participation rate peaked at 67% in 2000 and has since declined to slightly less than 63% today.  Due to this decline in the participation rate, there are over 7.0 million fewer people in the workforce.  Professor Taylor points out that only a small portion of this decline can be attributed to retiring baby boomers.  The rest is due to people deciding to exit the workforce for various reasons such as finding it difficult to find a job or deciding to apply for disability benefits instead.

If the participation rate could be raised to say 65 percent over 5 to 7 years, this would add more than 1.0 million people to the civilian labor force each year and double the growth of the labor force from 0.5 percent/year to 1.1 percent/year and increase GDP growth by the same amount.

The Federal Reserve says that we have achieved full employment, meeting their target of 5.0%.  Is this true? If we account for those who have dropped out of the workforce and those who are working part-time but want full-time work, the unemployment rate would be 9.7%.  There are a lot of people who are working in low paying jobs or working part-time even though they want to work full-time.

The percent of the male working age population who are in the workforce has been declining for a long time from 86% in the 1950s to 75% in 2000, and down to 69% today.  There are a lot of discouraged men who are no longer looking for work.

Where do jobs come from anyway?

Government tax policies and regulations can encourage or discourage investment, business expansion, and job creation.  But the government can’t create jobs no matter what politicians say.  Jobs are created when someone in the private sector expands an existing business or starts a new business.  Each job created requires a substantial investment plus other startup expenses and a lot of hard work by someone. This investment varies from $25,000/job or more for a fast food restaurant employing minimum wage “burger flippers” to $ millions/job for a high-tech factory to manufacture jet engines or microprocessors.  Policies that discourage investment and business growth are job killers.

Ominously, there has been a marked slowdown in the number of job producing startups.  In addition, since about 2008, the number of firms that have gone out of business has exceeded the number of startups.

If we improve productivity it will mean fewer jobs in today’s businesses that can produce more with less labor.  That is an issue and always has been.  However, we have been able to count on the private sector to create new jobs and new businesses to replace jobs that have been lost due to changes in technology and other causes.  For this to happen in the future, we need to be sure that investors and entrepreneurs have strong incentives to invest in new businesses and the expansion of existing businesses to provide enough jobs in the future.

We also need to figure out what needs to be done to offset some of the wage differential between the U.S. and lower wage countries if we want U.S. and foreign companies to choose to locate or expand facilities here.

So what?

If Professor Taylor and others are right, there is a lot of untapped potential in today’s economy.  If it is possible to increase productivity and get more people into the labor force, then it is possible to boost GDP growth from the recent 2.0%/year to 3.0%/year or higher with the right government policy changes.  However, do we have the political will needed to make these changes?

The next article in this series will look at the government’s 10 year forecast and its implications.

A later article will look in more detail at possible ways we might be able to increase GDP growth by improving the labor participation rate and raising productivity growth.

About the Author:

William Fletcher is a business executive with interests in public finance and national security. He retired as Senior Vice President at Rockwell International where most of his career was spent on international operations and business development for Rockwell Automation. Before joining Rockwell, he worked for Bechtel Corporation, McKinsey and Company, Inc., and Combustion Engineering’s Nuclear Power Division, and was an officer and engineer in the U.S. Navy’s nuclear program. His international experience includes expatriate assignments in Hong Kong, Europe, the Middle East, Africa and Canada. In addition to his interest in California’s finances, he is involved in organizations dealing with national security and international relations. Fletcher is a graduate of Tufts University with a BS degree in Engineering and a BA degree in Government. He also graduated from the U.S. Navy’s Bettis Reactor Engineering School.