Growth Expectations: A New Era?

by Bill Apfel

In a widely discussed book, Dow 36,000, published near the time of the market peak in 1999, James K. Glassman and Kevin A. Hassett proposed the appealing theory that stocks were less risky than traditional alternatives like long-term bonds. As such, they deserved to sell at high price/earnings (P/E) ratios. The claim was neatly based on history and math. Market volatility, and thus risk, had been declining for years; equity investing had produced good results; and the most widely accepted formula for valuing stocks included a “risk premium.” Plug the numbers into the formula and much higher valuations were forecast.

Ten years later the theory seems a naive artifact of a delusional time. Market volatility has risen dramatically. (Since early 2000 the stock market, as measured by the S&P 500, has twice dropped by roughly half and doubled once.) In 2008, the entire financial system teetered on the verge of collapse. There is no longer any argument: Stocks are indeed very risky. But what about the underlying economic trends? Are they too a chimera? Strong economic growth provided the best rationale for good market returns. Does the market collapse signal a permanently lower rate of growth for the U.S. economy?

Here are some numbers about the past trends. Over the last 60 years the gross domestic product (GDP) has grown 6.7 percent per year. When you subtract inflation, “real” growth has been 3.2 percent. That can be divided further into annual productivity gains averaging over two percent, labor force growth of more than one percent, and a small but persistent decline in average hours worked. All of these figures should be treated with skepticism since they entail myriad statistical complexities, but they provide some context for thinking about what is in prospect.

First and foremost, unlike the stock market, and with the notable exception of inflation, economic trends have been remarkably stable. Productivity, the key generator of economic progress, was a bit lower than its long-term average during most of the 1970s and 1980s, but has more often exceeded the average in recent years. Annual rates only rarely have dipped below one percent. True, demographic trends ensure that the labor force will grow more slowly during the next decade than in the past, but this would have no impact on per capita wealth if population growth slows at the same rate.

Still, the widely held suspicion that the sustainable pace of U.S. growth has slowed is more than an overreaction to the sharp decline in the stock market. There is, in fact, good reason to think that simply extrapolating from the recent past to predict the economy’s future won’t work much better for economic forecasters today than it did for market forecasters in the late 1990s. Most obvious is the massive and unsustainable household debt that we have accumulated over the past decade. For the 10 years prior to the current recession, household debt, mostly mortgages, grew 10 percent, outpacing economic growth of less than 6 percent. By the end of 2007, household debt had risen to over 90 percent of GDP from about 60 percent just 10 years earlier. It is a standard assumption of blue chip forecasters that the rebuilding of household balance sheets will slow the recovery from the current deep recession. But as severe as the pattern is this time around, excessive debt expansion and subsequent debt liquidations are standard features of economic cycles. They don’t have much to do with the long-term growth rate of the economy as a whole.

Of greater concern is that the growth in debt in recent years did not fund investments in the productive capacity of our economy. More typically, funds were borrowed to buy a bigger house, upgrade a current one, or simply acquire more consumer goods, often manufactured abroad. Here’s an extraordinary statistic: While the size of the average American household fell from three to 2.5 persons over the past 35 years, the average size of an American home rose from 1,600 square feet to more than 2,500. By the end of 2007, consumer spending had reached an all-time high share of the total economic activity. Business  investment spending, in contrast, stayed near historical averages. When you put the numbers together, it is apparent that economic growth, as measured by the GDP, has been kept strong by consumer spending funded by borrowing. And just as more of the products we purchased were manufactured abroad, lending increasingly came from foreign sources too—often funneled through our overly leveraged financial institutions. Given all that, it now appears that the  sustainable growth rate of our economy had declined well before the current recession—it simply wasn’t apparent as long as we persisted in living beyond our means.

If this is true, it still leaves unanswered the question of why underlying growth seems to have slowed. Some of the reasons are clear. In a global economy, labor is also global. In a slow but inexorable process, a massive global labor arbitrage is occurring. Most commonly, this means that less developed economies willingly supply manufacturing or service workers at much cheaper rates than the American norm. Increasingly, highly skilled and creative professionals, like those in technology or medical research, also compete effectively with Americans. We should, of course, applaud the strides made by others as they earn their place in the global economy. But we can only regret the failure of our educational systems to keep pace with a rising global standard.

Exploding healthcare costs and the end of cheap energy are the other main culprits usually cited in explaining our economic challenges. To a large extent, both are consequences of our success, not our deficiencies. Healthier citizens add to economic vitality, but good health also means that life can be extended long beyond traditional retirement ages, reducing the size of the labor force relative to the population. Better health outcomes are a worthy goal in and of themselves. But inefficiently delivered healthcare is simply a waste of resources. There seems little question that among developed countries we spend more resources and have less to show for it.

Higher energy costs will also restrain growth. This is true whether we succeed in developing more sustainable energy alternatives or if we continue to extract fossil fuels from more challenging environments. If we accomplish the former, and in a manner that is more environmentally benign, we will smooth the path to sustainable growth. This, however, will be expensive. Unlike better healthcare, the best we can hope for from our energy future is a substitute for fossil fuels, an energy source that has long been beguilingly cheap.

So what pace can we expect for growth in the years ahead? In the near term, perhaps for the next three years, a convincing case can be made that growth will stay closer to two percent rather than the three percent historical average. The factors are straightforward. Consumers will spend less. Large resources will be devoted to higher energy costs. The total healthcare budget is unlikely to trend downward soon.

But over the long term there is every reason to believe that the sustainable growth rate will be closer to the long-term average. Long-term economic trends are not easily disturbed by the emotional swings that can make equity investing so risky in the short run. At its core, the U.S. economy retains the extraordinary flexibility that has sustained its steady growth over many years. Each of the limiting factors cited can be addressed by innovation and good policy. Globalization can foster more efficient production and distribution just as it encourages more competitive labor markets. More efficiently delivered healthcare can make our economy more competitive. Higher energy prices induced by scarcity and good policy can prompt innovation that has a ripple effect throughout the economy. And the education system is simply in our own hands. The surest path to strong long-term growth is reinvigorating the skills of our people.