In my last post, I argued that it would be socially beneficial to adopt policies that would lead the US economy to grow at 4-5 percent per year over the next four years (about 2.5 percent per year faster than current projections). My argument focused on the benefits of increasing output in 2020 by increasing the rate of growth of capital and labor. My analysis took the path of total factor productivity (the amount of output generated by a given level of capital and labor) as given.
In this post, I consider the possibility that super-normal aggregate demand growth over the next four years could generate super-normal growth in total factor productivity (TFP) The evidence and theory are suggestive as opposed to definitive. But my conclusion isthat there are good reasons to believe that, with appropriate stimulus, it would be possible to achieve growth outcomes of around 5-6% per year for the next four years.
In terms of evidence: As I describe here, the most striking evidence comes from the Great Depression in the US. Total factor productivity fell dramatically at the beginning of the Depression and was in fact 15% below its normal trend by 1933. Over the following three years, in conjunction with the various forms of demand stimulus undertaken by the Roosevelt administration, TFP grew more than 5% per year faster than normal. This super-normal growth rate of TFP was a key contributing factor to the near double-digit annual growth in real GDP from 1933-37.
Baupost's investment process involves "never-ending" gleaning of facts to help support investment ideas Seth Klarman writes in his end-of-year letter to investors. In the letter, a copy of which ValueWalk has been able to review, the value investor describes the Baupost Group's process to identify ideas and answer the most critical questions about its potential Read More
Of course, this is but one short period in US history. But it seems to be illustrative of a more general and systematic pattern. In his 2012 book, Alexander Field (chapter 7) concludes that there is a stable relationship in US macroeconomic data whereby a fall in the unemployment rate of 1 percentage point is associated with a 0.9 percentage point increase in TFP growth. (This kind of relationship is also critical in Professor Friedman’s recent analysis of Senator Sanders’ economic proposals.)
(Despite its stability, there is an important reason to be cautious about using this estimated relationship to assess the TFP impact of government stimulus in the next few years. At least some of the effect in the past data is attributable to businesses’ reducing their utilization of their workers and capital during recessions and ramping it back up during recoveries. This observation raises a key question: To what extent would businesses further increase their utilization of capital and labor over the next four years in response to super-normal growth? My own (tentative) answer is that they would ramp up utilization to some extent, but the scale of the increase may not be as large as the past data suggests.)
Thus, there is an empirical basis for the proposition that super-normal demand growth in the next few years would generate super-normal TFP growth. There is less support in existing macroeconomic theory, which typically treats the cyclical evolution of TFP as exogenous. My own intuition is that TFP growth is the product of the creation and implementation of ideas. These are investment activities, and businesses should be willing to undertake more of these activities if they anticipate higher demand. This basic intuition lies at the heart of a classic paper by Comin and Gertler (2006) and a more recent (and very interesting) paper by Benigno and Fornaro (2015).
To summarize: there are good reasons to believe that policies that would generate super-normal demand growth in the next four years would also lead to super-normal TFP growth. Taking into account my caveat above, I would (very cautiously) offer the estimate of an additional 1 percent per year for this latter effect. Overall: I see it as possible and beneficial to adopt policies that would lead to 5-6% growth per year over the next four years – which translates into a level of output in 2020 that is about 15% higher than is currently anticipated.
Some might use graphs on post-World War II data on real GDP growth to dismiss this claim as outside the realm of what is plausible. But growth is a product of policy choices and circumstances, not historical determinism. To me, our current circumstances – notably low real wages and low real interest rates – are such that the government can and should make choices that generate much higher growth than is considered normal by historical standards.
Rochester, NY, February 21, 2016
Please address media enquiries and non-academic speaking requests to Monique Patenaude ([email protected] and 585-276-3693).
Thoughts on Policy
Economic Policy Page