Beware the New Normal

Jared Bernstein is a senior fellow at the Center on Budget and Policy Priorities in Washington and a former chief economist to Vice President Joseph R. Biden Jr.

As the year winds down, there’s some optimism about where the economy is heading.

-The Federal Reserve, while stressing labor market weakness, judged that the macroeconomy was on the mend to the point where it could begin to pull back slightly on its asset-buying program.

-The revised growth rate for gross domestic product for the third quarter came in with a “4” handle â€" 4.1 percent â€" something we haven’t seen for almost two years.

-The pace of job growth has picked up slightly in recent months.  The average monthly payroll gain over the past four months was 200,000 a month; over the prior four months, the comparable gain was 160,000.

President Obama tapped the optimism in his news conference at the end of last week: “We head into next year with an economy that’s stronger than it was when we started the year. … More Americans are finding work and experiencing the pride of a paycheck.  Our businesses are positioned for new growth and new jobs. And I firmly believe that 2014 can be a breakthrough year for America.”

As he often does, with good reason, the president stressed that we weren’t out of the woods â€" more moving down the path out of the woods with perhaps a bit more pep in our economic step.  And, importantly, all of those indicators cited above are aggregate ones.  In an economy with as much inequality as ours, growth is necessary for the broad middle and poor to get ahead.  But it is not sufficient.

That said, let’s stick with the macro but add what I and a growing body of econo-watchers worry may be a serious structural problem: We’re settling into a growth rate that’s too slow.

That may sound confusing.  Once we’re out of the downturn and into the bona fide expansion, isn’t the growth rate … um … the growth rate?  You might want it to be faster, but isn’t that like telling short people that if they just grew more they’d be taller?

In fact, an economy’s potential growth rate is both limited by real constraints and influenced by a bunch of factors, the same way height is influenced by both immutable genes and variable nutrition.  If the labor force contracts because of weak demand or investment is unusually weak because such resources are misallocated (say, oh, I don’t know … into derivative bets on bundles of funky mortgages) or each expansion is driven by a bubble that bursts and leaves lasting damage, these events diminish potential growth in ways that are not the natural workings of organic economic constraints.

The first chart below begins to get at the problem.   The blue line shows the actual path of real G.D.P. per person in today’s dollars.  The other two lines approximate the potential growth by extracting a smooth trend from the underlying G.D.P. series, controlling for cyclical movements.  The yellow line shows the trend if you stop that trend extraction process in 2007.  The red one shows what happens if you use the full series right through last week’s revision.

Clearly, the protracted recession has cost us dearly, both in terms of level (per capita G.D.P. is more than $5,000 below the pre-recession trend) and slope (more on that in a moment).  And these per capita results don’t account for increased inequality, wherein the average is increasingly less representative of what most people end up with.

Source: Bureau of Economic Analysis data and author’s analysis.

To confirm that these results are not just a function of my little exercise, note the chart below, from the Congressional Budget Office’s more rigorous work on potential G.D.P. growth.  The blue line shows the growth rates the office calculated in 2007, including those it thought would prevail now, based on consensus estimates of labor supply, productivity, investment and other relevant inputs.  The lower red line represents its 2013 update of where it thinks potential growth is headed.  This lower growth path provides evidence of the damaging effect of the protracted recession on the economy’s inputs; it also conforms to the movements in the per capita series plotted above.

Source: Congressional Budget Office.

Is it really such a bad thing to grow a more slowly?  And even if it is, can anything realistically be done about it?

On the first point, slower average growth obviously means less income on average.  A decade of per-person income growth at the endpoint of the blue line from the chart above leads to a $5,000 higher annual income (2013 dollars) than the red line endpoint.  But it also means more labor market slack, the absence of full employment and the income stagnation and unequal outcomes associated with those conditions.  Essentially, slower growth means more slack, which in turn implies less bargaining power for most workers and thus a lesser shot of claiming their fair share of what growth there is.

On the second point, there’s a lot we could do.  The ideas I offered in an earlier post would help, especially fiscal policy applied toward infrastructure investment, more balanced trade, and direct job creation, as that has the potential to bring labor force dropouts back in. (Work sharing could also help in that regard.)

Once again, of course, we smack head on into the biggest constraint against increasing potential G.D.P. growth: political will.  Though it’s naïve to imagine that some threatening graphics could move our more benighted political actors, it’s possible that a lot more of this type of analysis, by pointing out the highly significant costs at stake, could begin to underscore the danger of blithely accepting the new normal.