Many on Wall Street believe the American economy will finally pick up in 2014.
BofA Merrill Lynch chief investment strategist Michael Hartnett argues “escape velocity” is “tantalizingly close.”
Nonetheless, it hasn’t happened yet, and the ultimate debate about the future of the U.S. economy is still this: can it?
If recent trends in sub-par GDP and labour market growth reflect a structural decline in the economy’s potential, the answer might be no. If we are still just working through the cyclical damage from the recession that gripped the U.S. six years ago, on the other hand — and the persistent fiscal drag that has weighed on the economy in more recent years — then perhaps the answer is yes.
The government shutdown seemed to bring out a fair amount of pessimism toward the matter.
Jonathan Laing wrote of a “stark reality that many politicians and their constituents are unaware of” in an October 28 Barron’s article.
“U.S. economic growth figures to slow dramatically over the next 20 years or so,” said Laing, “generating far less money to achieve the Republican goal of a balanced budget or the Democratic aim of continued social spending.”
The discussion was taking a tilt toward the bearish side among investors as well.
“We’ve noticed investor sentiment shift decisively through the course of the year,” wrote Dario Perkins, director of global economics at Lombard Street Research, in an October 17 note. “The economy’s recent sluggishness has made our clients more sceptical of our strong 2014 forecast.”
In an August report, JPMorgan economist Michael Feroli broke down the argument that the country’s future isn’t what it used to be by demonstrating that potential GDP growth — a proxy for the long-run trend growth rate — in the United States has fallen below 2%.
“As recently as the late 1990s, potential growth in the U.S. was estimated to be around 3.5%; by our estimates that figure has recently fallen by half, to 1.75%,” wrote Feroli.
The JPMorgan economist explained how an ageing society, a crackdown on immigration, decreased levels of innovation in information technology, and declining R&D spending in both the private and public sectors were all dragging this figure lower.
Of course, there likely are cyclical factors at work as well — remnants of the damage caused by the recession.
Joe LaVorgna, chief U.S. economist at Deutsche Bank, points out that Federal Reserve officials believe the impairment in potential growth is only temporary.
“The Chairman cited three factors behind the possible decline in potential GDP growth: One, a labour mismatch; two, a lack of business investment; and three, an inability of firms to find commercial applications for new technologies,” wrote LaVorgna in a recent note to clients, citing a November 20, 2012 speech by Fed chairman Ben Bernanke.
LaVorgna warns that these impediments may be structural, however.
“While intuitive, we are worried by the fact that much of the weakness in job growth has been in three areas of the economy — construction, finance and government — and this could be more structural than cyclical in nature,” he writes. “This is evident in the nearby chart, which shows reasonably solid job gains outside of the sectors which boomed in the previous expansion. Regulatory and budgetary impediments will likely continue to weigh on job growth in the financial and government sectors; construction employment should improve, but only modestly.”
LSR’s Perkins believes American growth potential will make a comeback nonetheless.
For a variety of reasons related to the severity and duration of the recession, it is likely U.S. potential output has slowed since 2008,” he says. “But this doesn’t mean the economy is now doomed to persistently sluggish activity.”
Perkins argues that “powerful cyclical forces have been depressing demand” as the private sector retrenched in the wake of the crisis:
By 2012, these drags on private sector demand had started to fade. The recession in the housing market had ended, with construction activity and house prices beginning to recover. This started as a rental/apartment boom, but it was gradually becoming broader based. Meanwhile, the private-sector deleveraging process seemed to be nearing an end.
Household debt had fallen sharply relative to income and, according to our analysis, was returning to sustainable levels. Debt servicing costs were also at historic lows, easing the desire to rebuild balance sheets. Finally, the banking sector was in better shape, with lower levels of leverage and improving profitability. This was feeding an economy-wide improvement in credit availability.
“Given these positive dynamics, clients often ask why the economy has not recovered more meaningfully over the past 12 months,” says Perkins. “The simple answer is that public-sector retrenchment has taken over from private-sector retrenchment. In 2013, the government has implemented a structural budget tightening worth more than 3% of GDP — the largest since at least the 1980s.”
Perkins believes the outlook for public-sector retrenchment is key.
“By cutting government spending and raising taxes, this has depressed overall activity and masked a significant improvement in underlying demand. This is important because it means, if the fiscal drag fades in 2014, growth could pick up materially,” argues Perkins.
“Potential GDP isn’t a fixed concept. Just as the recession dragged potential growth lower, sustained strong growth would eventually help to reverse this trend.”