VIEWPOINT. Real Economic Growth in America. A Stephens Inc. Economic and Financial Commentary. October 1, 2014

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1 by Thomas Goho, Ph.D., Chief Economic Consultant October 1, 2014 The economy experienced solid growth in the second quarter. Second quarter Gross Domestic Product (real GDP) rebounded robustly with real growth of 4.2% after a drop of 2.1% in the first quarter. Yet among Americans a lingering sense remains that something is amiss in the U.S. economy a malaise. They are right. Based on a study by the Heldrich Center at Rutgers University, the economic malaise is real. One-quarter of the Americans surveyed reported a major decline in their quality of life since the recent recession, and 42% of the respondents said they are financially less well off. Those results are consistent with recent government reports that found that the median family income (after inflation) has fallen 5% in the past three years and 8% since Many economists think that excessive economic regulation and/or a dysfunctional tax code are the primary contributors to post-recession economic sluggishness. The economic data provides a quantitative account of the salient issues affecting the current recovery which include: Sub-par real gross domestic product growth Sluggish capital formation Weak employment and minimal increases in real wages and salary Stagnating household incomes Modest increases in labor productivity Real Economic Growth in America The economic recovery since the recession has been a disappointment by almost any objective measure. (See Figure 1.) This graph shows the powerful recoveries in output that have occurred after most recessions, especially the one during the Reagan presidency. The post-recession recovery in the early years of the last decade was muted, and the current recovery is clearly subpar. People across the country are feeling the effects of this weak recovery. 1

2 Figure 1: Growth in Real Gross Domestic Product (1970 to the Present) Source: Federal Reserve of St. Louis. Extracted from the Federal Reserve Economic Database (FRED) on September 2, Economists across the political spectrum are beginning to believe the economy is suffering from serious long-term conditions that create permanent impediments to growth. The Congressional Budget Office (CBO) of the federal government in early 2014 revised downward the potential growth in the U.S. economy. (See Figure 2.) The dark dotted line in the right section of the graph shows potential economic growth as forecasted in January The light dotted line indicates the CBO s recent downward revision to that forecast. The dark solid line indicates the actual performance of the American economy. The CBO s forecast suggests that the U.S. economy is close to its maximum growth rate, which only translates to a modest improvement in the standard of living for Americans. If the economy is relatively close to its maximum noninflationary output, the Federal Reserve is likely to be very vigilant of potential rising inflation often a precursor to tighter monetary policy and higher interest rates. 2

3 Figure 2: Congressional Budget Office Estimates of Potential Versus Actual Real Gross Domestic Product Source: Congressional Budget Office. Revisions to CBO s Projection of Potential Output Since February 28, Page 2. If the U.S. economy is currently nearing its maximum output potential, the country will continue to experience relatively high levels of idle labor that could mean high unemployment, underemployment and low labor-participation rates. Capital Formation Another component contributing to America s sluggish economy is the recent slow growth in capital formation. Part of the slowdown in capital formation is tied to a glacial shift from heavy industry toward a service-oriented economy. (See Figure 3.) However, a greater contributor is a slowdown in business investment (excluding housing investment). 3

4 Figure 3: Gross Fixed Capital Formation (2001 to Present) Source: Federal Reserve of St. Louis. Extracted from the Federal Reserve Economic Database (FRED) on September 2, Business investment in 2014 has only now returned to the level seen in the prerecession year of 2007, but remains below levels achieved at the beginning of the last decade when the economy was smaller than it is today. (See Figure 4.) Figure 4: Net Domestic Private Investment (2000 to Present) Source: Federal Reserve of St. Louis. Extracted from the Federal Reserve Economic Database (FRED) on September 6,

5 This muted level of business investment is particularly startling in light of the fact that corporations are generating the highest levels of profitability (as a percent of GDP) in decades. Equally surprising is the fact that corporations have been hesitant to invest in information equipment and software. (See Figure 5.) The annual growth in such investment is weaker than at any time during the past three recoveries. Figure 5: Private Fixed Investment in Information Processing Equipment and Software (1990 to Present) Source: Federal Reserve of St. Louis. Extracted from the Federal Reserve Economic Database (FRED) on September 7, The previous three graphs are indicative of an economy that is failing to invest for the future. This subpar investment by businesses shows up in recent research data. The average age of American industrial equipment is now over 10 years such old equipment has not been seen in our factories for over 75 years. In 2013 American firms increased their capital spending by 3% far below the long-term average of 8%. Capital spending is forecasted to increase 4% in 2014 and 5% in 2015, both below the long-term average. Lack of investment in state of the art equipment by businesses creates a more difficult environment for an improvement in worker productivity over the long run. Both factors are inextricably tied to growth of the American economy. 5

6 Employment in the Business Sector Tepid employment growth is another factor contributing to the sluggish economy. We have seen the unemployment rate fall since the last recession, but in fact, the number of people working in 2014 remains about the same as in 2000 despite a nearly 10% growth in the U.S. population over the past 15 years. (See Figure 6.) The robust employment growth after the recessions in 1983 and 1991 is not visible in the current recovery and hardly evident in the recovery after the recession of Figure 6: An Index of Nonfarm Business Sector Employment (1983 to Present) Source: Federal Reserve of St. Louis. Extracted from the Federal Reserve Economic Database (FRED) on September 5, Labor Productivity Historically, robust labor productivity has been a driving force in a strong U.S. economy. However, productivity of American workers is currently tepid by historical standards. If one examines just the first five years of each recovery in the last several decades, it is clear that labor productivity in the current recovery is especially weak. (See Figure 7.) In the recoveries starting in 1982 and 1991, the economy benefited not only from increases in the size of the workforce but also from productivity gains. In the 2001 recovery the labor force growth languished, but was offset in part by strong growth in unit output per hour. In the current recovery, the economy is suffering from not only weak workforce growth but also from anemic unit output per hour. 6

7 Figure 7: Five-Year Growth in Labor Productivity in the Business Sector in the Last Four Recoveries Recovery Five-Year Growth in Labor Productivity % % % % Source: Calculations derived from Bureau of Labor Statistics data. According to the Bureau of the Census, overall labor productivity from 1947 to 2007 increased at an average annual rate of about 2.3% per year. Since 2007 productivity gains for the whole economy have averaged about 1%. This data suggest that Americans standard of living will grow at a muted rate because productivity gains over the long run determine the increases in the quantity of goods and services that are available to our consumers. The confluence of weak labor force growth and modest productivity gains is a bane for U.S. economic growth. (See Figure 8.) In the last decade the labor force growth was weak, but there were substantial improvements in labor productivity as a result of fairly strong capital investment. Figure 8: Labor Force Growth and Productivity Growth (1950 to Present) Period Labor Force Growth Non-Farm Business Productivity 1950s 1.2% 2.2% 1960s s s s s s.3.2 Source: U.S. Department of Labor. Bureau of Labor Statistics. Extracted from the BLS database on September 11, Small gains in labor productivity lead to small gains in wages and salaries. Minimal increases in the number of people in the labor force retard the growth of household incomes, and it is not surprising that household incomes are languishing. 7

8 Best Guess on Conditions in the Economy A malaise continues in the U.S. economy, but conditions are improving. The unemployment rate, first time jobless claims, and similar measures of labor market conditions are significantly better than they were two or three years ago. Household incomes seem to be stabilizing in In addition, the manufacturing and housing sectors are stronger than they were at the depths of the recession. Consumer confidence and spending are supporting some growth in the economy. Monetary policy by the Federal Reserve is still slightly accommodative. Governmental spending is no longer a drag on the economy compared to several years ago when governments at all levels were slashing spending in line with drops in tax revenues. It is reasonable to expect that real GDP growth for the second half of 2014 will be slightly less than 3%, a spectacular rate compared to Japan and the Euro zone. However, 3% growth in GDP hardly offsets the weak growth of the last five years caused by meager investment and modest productivity gains. Final Thoughts For years the United States was known as an innovative country that fostered strong capital formation across a range of industries. Some sectors such as pharmaceutical, energy, information technology and aircraft industries continue to invest and innovate. However, in a broad sense American firms seem to be underinvesting in productivity-enhancing technologies that in turn slow America s economic growth. Why during a period of high corporate profitability are U.S. companies hesitant to make needed capital investments? In my opinion, a substantial reason is the high level of economic uncertainty that started with the financial crisis in the middle part of the last decade and continues to the present. One research organization has attempted to quantify U.S. economic uncertainty in a single index number. (See Figure 9.) Uncertainties about economic policy spiked during the financial crisis and have continued at an elevated level. This finding is hardly startling. 8

9 Figure 9: ndex of U.S. Economic Policy Uncertainty (2005 to 2013) Semi-Annual Data Source: Federal Reserve of St. Louis. Extracted from the Federal Reserve Economic Database (FRED) on September 7, Think about the questions that linger for American businesses since the financial crisis. What impact will the Dodd-Frank financial reform legislation have on the long-term availability of financing for businesses and households in the United States? How will the Federal Reserve s unorthodox monetary policies affect inflation? Has the Federal Reserve created the conditions for rapidly escalating inflation? What are the ramifications of Obamacare for businesses, especially small businesses? What is the exact timetable for the full implementation of this legislation? What new executive orders will alter the timing and conditions of the law s implementation? Will corporate and individual tax codes be revised to create a more rational system of taxation? If so, when? Will Congress restore the bonus depreciation provision of the corporate tax code that encourages companies to invest in plant and equipment? Will the government develop and implement a workable plan for the efficient utilization of America s new abundance of oil and natural gas? What will be the environmental regulations surrounding this development? What new minimum wage rate, if any, will be legislated for low-skilled workers? $10 per hour? $12 per hour? 9

10 What immigration policies, if any, will be legislated to control the flow of legal and illegal immigrants into the country? Will more or fewer technically trained immigrants be granted legal entry into the country? Will Congress and the President create crises in government funding as the country moves toward future spending limits tied to raising the debt ceiling? Will Congress and the President do anything to cut regulatory complexity for businesses, especially small businesses where most new jobs are created? These questions are not theoretical questions but the daily nitty-gritty issues that face American businesses: tax rates for corporations and individuals, the cost of employee health care, availability of credit, future inflation, mandated wage rates, and environmental rules for operating a business. A recent study by the Federal Reserve found that only 11.7% of American households now own their own businesses, the lowest level in 25 years certainly understandable in the current uncertain environment. Many unknowns always plague businesses, but the current environment seems exceptionally undefined thereby discouraging capital investment and new business formation. In my opinion, much of the problem of our current slow growth rests on policies (or lack of policies) by legislative and executive decision makers in Washington. The economy is progressing and will continue to improve in the near term. But solid sustainable growth requires a clearer regulatory and legislative policy than is currently available to U.S. businesses and households. Thomas Goho, Ph.D. is Chief Economic Consultant for Stephens Inc. He also serves as the Co-Director of Stephens University at Wake Forest University. Tom enjoys a successful career in both education and business. He served as a professor of finance, Wayne Calloway School of Business and Accountancy, Wake Forest University for 30 years. Before retiring in 2007, Tom was the first to hold the Thomas S. Goho Chair of Finance. Tom also served on the Board of Directors of the Wells Fargo Family of Mutual Funds for 20 years, and also was on the Board of Directors of Lifepath Funds of Barclay s Bank. A former Certified Financial Planner, Tom earned his BS and MBA from Pennsylvania State University and his Ph.D. from the University of North Carolina-Chapel Hill. 10

11 This Viewpoint is an economic analysis and financial commentary, and it is not intended to constitute investment advice or tax advice to any particular person. This Viewpoint represents the author s views and opinions which are subject to change. Because of the imprecise nature of economic forces, this Viewpoint is not intended to predict with any degree of certainty a particular outcome or event. The information contained herein has been obtained from sources which we consider reliable, but it has not been independently verified. Consequently, we do not guarantee that information herein is accurate or complete. Stephens Inc. is a member of the NYSE and SIPC

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