We economists continue to earn our reputation as dismal scientists. By most measures, the US economy is strong, but economists continue to fret over how fast it will grow in the future.
Consider the numbers ….
The broadest measure of our standard of living, real gross domestic product (real GDP), grew 2.3 percent in 2017, up from only 1.5 percent in 2016. In the most current estimates for this year, the U.S. Bureau of Economic Analysis (BEA) estimates that the economy is growing at an annual rate of 2.2 percent.
Meanwhile, the rate of inflation remains below historical averages. Through April, the U.S. Bureau of Labor Statistics (BLS) reports that the Consumer Price Index (CPI) is up 2.4 percent over the same period last year, compared to a 3.5 percent annual average since the end of World War II.
The third most widely studied measure of the overall economy is employment. The national unemployment rate now stands at only 3.8 percent, well below the historical average of 5.8 percent. This figure is also well below the level economists consider normal. A “normal” rate of unemployment is not an exact number but refers to the amount of unemployment the economy experiences when everyone is producing goods and services at their full potential. According to the Congressional Budget Office (CBO), US real GDP is just at, or slightly above, its potential.
Everything looks fine. So, what is there to fret about?
A key debate amongst economists today is whether or not our economy can continue to grow at 2 percent or higher each year with lower than normal productivity rates.
First, consider why the rate of real GDP growth matters. If the economy grows at 2 percent a year it takes approximately 36 years for the standard of living to double. The standard of living for just about every generation in America was twice that of their grandparents. But if the economy falls back to the rates last seen in 2016, it will take much longer for our kids to be better off. The ultimate source of growth in our standard of living is higher productivity. Since World War II, the output per hour worked in the non-farm sector of the United States has grown at an average of more than 2 percent per year. Our standard of living is much better than our parents and grandparents because workers and businesses keep finding ways to produce more with less.
However, the rate of increase in productivity over the last decade has slowed to an average of only 1.2 percent per year. Lower productivity growth will show itself in slower economic growth over time.
So how can we improve productivity and keep growing at 2 percent or more per year?
Economic theory and historical experience show that productivity is determined by the amount of physical capital, human capital, and natural resources each worker has at his or her disposal, along with the technological knowledge to use all these resources. When businesses invest in these resources, and develop new technologies to use them, worker productivity grows faster. Looking again at the BEA data, real Gross Private Domestic Investment has increased at an average rate of only 1.5 percent over the last decade, well below an average of 4.5 percent annually since the end of World War II. We can’t expect to keep up the current 2 percent growth rate unless business investment picks up.
Over the course of last year, the stock market did well as the economy grew faster, but a continued rise is unlikely without continued business investment. Still, investors face limited choices. As I wrote in my last quarterly report, “stocks remain the better value over bonds or cash.” Investors are continuing to seek the safety of U.S. government debt, keeping its yield low. The rate of return on a current 10-year Treasury note remains well below its historical average. The yield spread, or difference between the 2 and 10-year notes, is only 0.5 percent, or half its historical average. The bond market is telling us to expect slow growth and low inflation ahead.
Over the past year or so, small company stocks have done well as growth picked up. But a slow growth economy, with low interest rates and low inflation, should favor large-capitalization stocks, particularly in the consumer staples and healthcare sectors. Without more sustained investment, the consumer discretionary and industrial sectors are not likely to do as well.
Economists will always find something to fret about, but the economy is doing well, and all types of companies should profit from it. What we must hope for is a rise in business investment that keeps the economy growing at rates that make our children better off.
The views expressed here are those solely of the author and do not represent Northwest Nazarene University or Rathbone Warwick Investment Management.
Peter R. Crabb, Ph.D.
Professor of Finance and Economics
Department of Business and Economics
School of Business, Northwest Nazarene University
Dr. Crabb holds a Ph.D. in Economics from the University of Oregon and an MBA in Finance from the University of Colorado. His research in economics and finance is published in the Journal of Business, the Journal of Microfinance, and the International Review of Economics and Finance, among others. Dr. Crabb lives with his wife, Ann, and their four children in Canyon County, Idaho.
Dr. Crabb’s regular Financial Economics column is published by the Idaho Statesman. Previous work experience includes international trade, banking, and investments.