As Fed normalizes policy, economy’s ‘new normal’ is anything but.

The Federal Reserve is launching a major transition away from the extraordinary measures it used to boost recovery from recession. But the problem of sub-par economic growth remains.

Reuters
The seal for the Federal Reserve Board of Governors. The Fed’s policymaking committee, led by Chair Janet Yellen, on Wednesday moved to begin downsizing the central bank's massive bond portfolio. (The Fed bought bonds in an effort to keep long-term interest rates low and stimulate economic recovery.)

The Great Recession is over. More people are working than ever before. Unemployment is back to pre-recession lows. Average housing prices are at record highs. So is the stock market.

On Wednesday, the Federal Reserve announced it, too, was moving on, preparing finally to whittle away its huge $4.5 trillion portfolio of bonds that it bought to stimulate the economy. Although other anti-recession policies remain, Wednesday’s move puts the Fed on its final staircase in a return to normal.

But normal isn’t what it used to be. Economists foresee dramatically slower growth in the decades ahead because the previous natural drivers of economic growth – an expanding workforce, increasing education, and rising productivity – seem to have largely plateaued. Without economic growth, Americans’ incomes can’t rise.  

If the United States is to counter this bleak “new normal,” the Fed can only do so much with its hand on the lever of money supply. Either new technology will have to make workers much more productive, or the federal government will need to embrace a suite of big policies to encourage growth, or both.

“Forty years ago, things also looked bleak,” writes Bret Swanson, president of Entropy Economics LLC, a strategic research firm specializing in technology, innovation, and the global economy. “We had entered what the Club of Rome asserted in its famous 1972 ‘Limits to Growth’ report was a long state of decline.... [But] the United States stood up and chose a bold, new, distinct path across a range of policies, unleashing waves of growth and technology not only in America but across the globe.”

Can the US do it again?

The slowdown is unmistakable. Of the 11 post-recession recoveries since 1950, the current one has been the slowest, with the economy growing at 2.1 percent a year, half the rate or less of the rebounds before the 1990s.

And growth has been uneven. While average home prices are now above the highs before the recession, most of the gains have been in booming metros, while two-thirds of US homes have not fully recovered, real estate website Trulia reported in May. Income inequality remains worse than before the recession.

Going forward, growth will be even slower, many economists warn. “GDP growth is likely to be well below historical norms, plausibly in the range of 1-1/2 to 1-3/4 percent per year,” John Fernald, a senior research adviser at the Federal Reserve Bank of San Francisco, concluded in an article last October.

There are two main factors behind the slowdown: 1) the workforce is no longer growing rapidly, due to baby boomer retirements, and 2) The educational gains of the workforce have for now plateaued. In the past, college graduates took over from retirees who had high school degrees; now, college graduates are more frequently replacing college graduates.

The productivity puzzle

A third driver of economic growth is technology. In the past, breakthrough innovations routinely made workers more productive – think steam engines, electric lighting, interstate highways, and so on. Between 1947 and 1973, productivity growth averaged 2.1 percent a year, points out Northwestern University economist Robert Gordon.

Then, from 1973 to 1995 it slowed to an anemic 0.5 percent per year. (Overall, the economy grew faster because the workforce was expanding with the influx of women into the working world.) Productivity growth surged again to 2.0 percent from 1995 and 2004 as the PC replaced adding machines, file cabinets, and mainframe computers.

But since then, productivity growth has fallen back inexplicably to 0.5 percent per year. The result is an economy that’s $3 trillion smaller than it would have been if the 1995-2004 growth rate had continued.

Economists are puzzled. The internet, smartphone, cloud, artificial intelligence, and other technologies have transformed jobs and disrupted industries, but apparently they have done next to nothing to boost productivity.

The slowdown is evident in nations around the world. That they’re taking shape in the world’s largest economy, which is at the cutting edge of many of those technologies, is sobering.

One possibility is that the benefits of the digital revolution are merely delayed.

In the meantime, many experts are pushing for policy changes to deliver more growth. Those policies may become especially important as the Federal Reserve slowly removes economic stimulus by trimming its portfolio, mostly made up of US Treasury and mortgage-related securities.

On Wednesday, Fed Chair Janet Yellen announced that instead of renewing those securities, the central bank next month would begin to allow them to expire at a rate of about $10 billion a month. That means private sellers would have to step in, and might require higher interest rates as a lure.

Higher rates, in turn, could slow the economy, discourage hiring, and spook stock and especially bond markets. The Fed figures that its portfolio unwinding will be gradual enough so the disruption is minimal.

How to revive growth?

The most obvious way to spur growth may be to cut taxes, although the benefits could be offset if the result is a higher national debt.

Economic studies consistently conclude that higher corporate taxes cause companies to spend less on capital and labor, which means workers are less productive. Republicans in Congress are hard at work on a plan to reduce corporate taxes.

“Tax reform that simplified the corporate tax code and lowered the tax rate would encourage investment,” Brookings Institution economist Martin Baily writes in an e-mail. “In the longer run, policies to provide better training for workers and sustain the funding for science and technology are helpful.”

Worker training has more bipartisan support, although Congress will struggle to find a way to pay for expanding such programs.

Some experts, such as Dutch economist Servaas Storm, point to inequality as a root cause of America’s stagnation. Companies hire low-wage workers rather than buying new equipment that would make those workers more productive, he argues.

Even if growth policies were enacted, the extent of their impact is unclear.

“It is very hard for policy to move the needle on productivity,” Mr. Baily says. President “Trump’s best hope is that he gets lucky and the economy generates faster growth through technology breakthroughs, just as happened in the 1990s.”

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