Economy Back to Low-Growth Normal

This morning the Bureau of Economic Analysis released its advance Gross Domestic Product estimate for the third quarter. According to the BEA, U.S. GDP

increased at an annual rate of 2.0 percent in the third quarter of 2021 (table 1), according to the “advance” estimate released by the Bureau of Economic Analysis. In the second quarter, real GDP increased 6.7 percent.

These are seasonally adjusted annual-rate numbers. Below I will report the “actual” numbers, which are even more compelling.

The adjusted numbers that the BEA press release discusses, are commonly used in the public debate and often referred to in discussions of longer trends in the economy. However, the modifications of the data drive a wedge in between the consumer of statistics and the reality he is trying to understand. Seasonal adjustment means that the statistical producer adjusts his numbers for calendar differences: if there were more workdays in the third quarter this year than last year – according to the calendar – then the statistician will recalibrate his GDP data “as if” the calendars were identical.

Furthermore, the annual form in which the GDP numbers are reported, means that the statistician multiplies his seasonally adjusted numbers by four, getting a number for GDP. An even more dubious method is to sum up the last four quarters and thereby “annualize” GDP.

I avoid doing any of this as best I can. The only adjustment that has analytical merit is that which separates current-price economic activity from its inflation-adjusted companion.

Some statistics producers will not allow you the discretion to analyze raw data, but the BEA publishes its raw data alongside its adjusted numbers. Under Section 8 of its National Accounts database, Tables 8.1.3 – 8.1.6 give you ample insight into the actual GDP numbers.

Relying on those tables, we find the following real annual growth numbers for the third quarter:

  • Real GDP was up 4.7 percent;
  • Private consumption increased 7.2 percent;
  • Gross Fixed Capital Formation, a.k.a., business investments, expanded 4.9 percent;
  • Government spending (which does not include cash entitlements) grew by only 1.1 percent.

These numbers are noticeably different from the numbers included in the BEA press release, but we have to keep in mind that the press-release numbers are converted into “annual” numbers. This can cause enormous anomalies, such as last year:

  • In the second quarter the “massaged” numbers, i.e., those that were seasonally adjusted and annualized, reported a GDP decline of 31.2 percent, while the raw data only saw a decline of 9.4 percent;
  • In the third quarter, the massaged numbers told of a 33.8-percent rise in GDP, when the raw numbers still showed a decline, albeit of only 2.8 percent.

Even in a “normal” year like 2019 the differences can be as big as one percentage point per quarter. That said, the trends in economic activity are still visible in both data forms, giving us a good picture of where the economy is heading over the longer term. In that context, Figure 1 has something important to tell us:

Figure 1

Source of raw data: Bureau of Economic Analysis (GDP). See Larson: Industrial Poverty (Gower 2014) for IP analysis
  1. This is the last time the U.S. economy managed to crank out three percent real annual growth over four consecutive quarters.
  2. The Great Recession.
  3. The Trump economy. We saw a growth spurt in 2018 as a result of the tax reform, and a second wave on its way in 2019. Had we not had the artificial economic shutdown in 2020, it is at least possible that we would have reached three percent for more than one or two quarters.

The really compelling part of Figure 1 is the Z-shape (4). Due to the artificial shutdown, the economy contracts for three consecutive quarters; when the government-imposed restrictions on economic activity are lifted, the economy makes its best to return to its pre-shutdown levels of operation. The very high growth number in Q2 of this year, 12.6 percent adjusted for inflation, reflects this return to normal.

At the same time, it is also perfectly reasonable to expect that once the return-to-normal phase is over, the economy will fall back into a long-term growth trajectory somewhere in the vicinity of where it was in the 2010s. This is not because there is some long-term equilibrium around which the economy fluctuates – that concept is merely a figment of the econometrician’s imagination – but because that is what businesses, households and the workforce in the U.S. economy have been able to produce of late. The institutional and conventional conditions of economic activity in recent years have conditioned the economy to operate roughly in the 2.2-2.7-percent real annual growth span.

In other words, when the anomalies of 2020 have finally disappeared, we can expect to return to an economic “normal” where the economy has a hard time keeping its nose above the two-percent industrial poverty threshold. This is the growth rate at or below which the economy merely reproduces its standard of living: there is no overall improvement in either economic living conditions or the quality of life in other respects. For all intents and purposes, an economy operating at this level is a stagnant economy.

This, however, is an outlook based on the classic economic “ceteris paribus” condition: all other things equal. Last year’s shutdown has added what seems to be some permanent new restrictions to the economy – including but not limited to recurring or even lasting regulations on some service sectors – as well as a changed incentives structure for the workforce. To take the latter as one example: if we cannot return to the same workforce participation and employment levels we had in 2019, we cannot recover the economic value that 5.6 million workers would have added. That is how much bigger our employed workforce would be if we were back at 2019 levels.

If the economy continues to suffer from the drag imposed by a tightened regulatory noose, and if it remains at its current, lower level of capacity, the 2.2-2.7 percent GDP growth outlook will be optimistic. A more likely scenario is that we will not be able to maintain growth rates of even two percent per year, adjusted for inflation.

Such a low level of economic expansion will have serious consequences for all parts of American society, but the most immediate repercussions will be for government finances. To get an idea of what this means, consider the July 2021 ten-year forecast by the Congressional Budget Office, where real GDP growth for 2021 is set at 4.2 percent and – hold on to your had – the 2022 number is 6.1 percent. With these numbers in mind, the CBO predicts a decline of the federal budget deficit to 753 billion by 2024. With only two percent real GDP growth in 2022, personal income will also grow more slowly (the two variables fluctuate closely in tandem with each other) and as a result, so will revenue from personal income taxes. Adjusting the growth scenario in the CBO outlook, the budget deficit by 2024 lands in the vicinity of $1.1-1.2 trillion, in other words about $400 billion higher than what the CBO predicted in July.

These numbers are solely based on a recalculation of tax revenue; they do not take into account the increased eligibility for entitlements that come with stagnant household incomes. Furthermore, they are valid under the assumption that Congress does not add any new entitlements on the spending side.

In short: the new GDP numbers released by the Bureau of Economic Analysis tell us that we are well underway to return to a not-so-spectacular macroeconomic normal. If the expansion of government in 2020, this year and next leave the economy with a heavier government burden, that “normal” will turn out to be markedly less prosperous than if the economy had simply returned to its 2019 structure of taxes, regulations and government spending.

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