Gad Levanon, Ph.D., Managing Director for Economic Outlook & Labor Markets at The Conference Board, was a guest of our June 2015 assemblage at Leen’s Lodge in Maine. Gad subsequently posted a provocative blog entitled “The New Normal in the US Is Slower Than You Think.”
If the work cited in Gad’s blog is taken to its conclusion, the result is a growth rate that is far below the expectations found in the Fed’s dot plots and the markets. It has huge implications if it turns out to be close to accurate.
Think of what it would mean to have this characterization of low productivity, low economic growth, and the alteration in the labor force coalesce to a growth rate in the US of somewhere between 1% and 2%, with very low inflation persisting for a very long time. Implied in such an outlook is an interest-rate scenario in which the short-term interest rate may be approximately 1% or so for several years and the long-term interest rate not much more than 2% or so. This would not be as bad as Japan’s 20-year experience of near zero in everything, but it would certainly be much lower than people are thinking and market agents are planning for as an outcome to their investment strategies.
We do not know what the productivity rate will be for the next 5 to 15 years. We have demographic statistics that indicate an aging labor force. We do know that productivity is measured as a residual in calculations and is therefore subject to massive revision years after the residuals are computed and estimates are made.
Gad’s work is provocative because it outlines one alternative and argues it with his available data. An alternative can be seen from the models that are now generally accepted in the mature economies of the world. Let’s take those apart and examine them thematically.
In the old days, fiscal policy would say that balanced budgets were sought after. Surpluses were prepared when economic conditions permitted them, and deficits were run when necessary. The surpluses enabled paydowns on debt accrued in deficit situations such as war, emergencies, or recessions. But the old notion of balancing pluses and minuses to a zero target is long gone.
The generally accepted model today is to run deficits of about 3% of GDP as a baseline. The theory behind that goes something like this: The growth rates of economies are assumed to be approximately 3% in real terms; thus a constant baseline deficit of 3% of GDP is assumed to equate to some stability in the debt-to-GDP ratio. That is a widely accepted standard now ensconced in literature and policy statements in many parts of the world.
The 3%-of-GDP deficit standard has proven to be an outright disaster in Europe. Lower deficits become the floor, and higher deficits become the ceiling. Politicians then use the forecasted 3% growth rate but do not achieve 3% growth in the real economy; the debt accumulates; and the debt-to-GDP ratio rises. Lowering interest rates offsets the carry cost of the rising debt-to-GDP ratio.
Let’s get to the inflation issue. In the past, a target of zero inflation was the acceptable and preferred goal. It was said that deflation was not desired because it deferred economic activity as agents awaited falling prices. Meanwhile, inflation was not desired because it introduced distortions of various types and altered behaviors in favor of accelerating purchases and accumulating debt before prices rose. So the standard used to be zero inflation. The caveat was to measure zero inflation properly, meaning that no one really knew how to measure it, but everyone tried anyway.
Now let’s take the two new standards together: 3% deficits presuming 3% growth and 2% inflation as a stated target, which happens to be the target in Europe, the US, and Japan. The policies in effect and the outcomes in those places do not achieve the targets.
Compare the two standards. Gad’s standard in his work would have a very low growth rate, very low inflation, and very low productivity. The targets would have a 3% deficit composition and 2% inflation. Those two positions cannot be reconciled. In a 1-2% growth scenario, it is impossible to sustain the 3% deficit composition since real growth is too low and the debt-to-GDP ratio rises. France is a good example, as my colleague Bill Witherell just described. It gets more complicated with a policy target of 2% inflation. If inflation is lower, the debt burden is not relieved by inflation. If inflation reaches the target or exceeds it, the distortions combine with rising interest rates to lower real growth.
So here we are on the July 4th, or July 5th in Greece, facing profound questions without ready answers. We are observing models as diverse as Gad’s blog versus the baseline assumptions of 3% deficits and 2% inflation that currently prevail throughout the mature economies of the world.
We don’t have a clue as to what the future holds for us, how these various alternatives will play out, or what the results will be.
It is a fascinating time in America as we celebrate our country’s birthday. We contemplate how productivity used to be so high, our growth rate so vibrant, and our policy’s promotion of both so robust. Now we face huge policy dilemmas and uncertainties. The resilience of our great country’s fabric is all that sustains us and keeps us together.