OPINION - Our Economy's 'Speed Limit'

"Raise the Economy’s Speed Limit" by JARED BERNSTEIN, New York Times 12/5/2012

WITH the budget-and-tax showdown dominating headlines, most Americans probably missed an even more ominous story: according to a report by the Congressional Budget Office, America’s underlying growth rate — that is, the best the economy could do, under optimal conditions, without driving up inflation — has slowed from just under 4 percent a year in 2000 to just under 2 percent today.

Why does this matter? For one thing, the combination of a lower underlying growth rate, which you could think of as the economy’s speed limit, and a less equitable distribution of that growth was a reason middle-income households did so badly and poverty went up in the 2000s.

During the 1990s, in contrast, stronger demand for goods and services led to much faster job growth and the last real gains experienced by middle- and lower-income households. Faster growth in those years also spun off a lot more government revenues, which interacted with slightly higher tax rates to take the budget from deficit to surplus.

Why has the underlying growth rate slowed? It’s actually pretty simple: growth is determined by the supply of labor and capital — i.e., people and machines — and how efficiently we use those inputs to make the output, or gross domestic product.

According to the report, we’re slipping on all fronts. As baby boomers head toward retirement, the growth of the labor force is decelerating; it is expected to grow about half as fast over the next decade as over the last.

This problem was exacerbated by the deep recession, as even younger un- and underemployed workers got discouraged with their job prospects and left the job market (though many will be back when things pick up). Also, for years the influx of women into the labor force raised the economy’s speed limit; that trend plateaued about a decade ago.

We’ve done better on the productivity side. But we’ve underinvested in our capital stock — factories, the machines inside them and software. In the 1990s, when the economy’s speed limit was growing, the flow of services from capital stock increased 4.7 percent a year; in the 2000s, its growth slowed sharply to 2.4 percent, even though tax rates on such investment were considerably lower.

In other words, our workers and machinery are still highly productive, but we’ve been underinvesting in them. In fact, according to the Congressional Budget Office, this investment deficit explains more than a third of the slower underlying growth rate.

Can we do anything about this? Some economists think of the potential growth rate as they do a person’s height: it may be too bad they’re short, but if you try to make them taller, you’ll just waste resources on a lost cause. Recessions may be amenable to monetary and fiscal policy, but structural shortfalls are a function of demographics, resource constraints and technological limits.

But that’s not quite right. Sometimes people don’t hit their potential height because they didn’t get enough nutrition, and it’s the same thing with economies. Bad public policy is to blame as well.

Our whole policy focus in this space tends to be on tax policy — specifically, on cutting taxes on investors and so-called job creators. But that type of “supply-side” taxation has obviously been a bust. We have to look elsewhere, and fast.

First of all, the distinction between the cyclical and the structural is artificial. Bad cyclical growth begets bad structural growth; persistent cyclical weakness in demand — a long recession, long periods of high unemployment — reduces potential growth. Workers who experience long-term unemployment thanks to a harsh cyclical downturn can find themselves less employable because of skill deterioration once the market picks up.

A weak-demand economy requires fewer workers and less capital investment. It also dampens forward-looking investment, and thus the supply of productive capital: American corporations are sitting on almost $2 trillion in reserves that they’re not investing for lack of good options.

The first thing to do is keep applying the accelerator on pro-growth policies that strengthen near-term demand and labor quality, including paycheck supports (like the payroll tax break), training for unemployed workers and investment in bridges, tunnels and other infrastructure. Over the longer term, we might want to think of immigration reform as a way to counteract our decelerating work force.

For now, though, we’re into a negative loop where persistently weak demand is chipping away at the labor and capital supply and productivity advances needed to increase our potential growth rate. Supply-side, deregulatory zeal has deprived the economy of investments in infrastructure and other public goods, innovative research and the oversight necessary to prevent the shampoo cycles — bubble, bust, repeat — that are whacking away at our potential growth rates.

This can all be corrected, but we’ve got to stop setting fiscal traps for ourselves and squabbling about a few points on the marginal tax rate. Instead, let’s start taking the steps that can get this economy back up to speed.