How Exceptional is the US Economy?

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For more than a decade, economists have been writing about the out-performance of the US economy versus advanced economies in general and the Euro Area in particular. That discussion has been reinvigorated by the stronger recovery in the US economy from the COVID shock. Indeed, some economists see another tech-driven productivity surge ahead for the US. For example, Edward Yardeni looks for a replay of the “roaring twenties” from a century ago.

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Vive L’America!

Like most “star” variables, measuring the trend growth in the economy is easy in hindsight, but hard to pin down in real time. The simplest approach is to look at average growth between similar periods of the business cycle. For example, we can get a rough gauge of shifts in trend growth by comparing annualized peak-to-peak GDP growth.

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The chart compares growth rates between periods of roughly “full employment” in 4Q 2007, 4Q 1999 and today. By this metric, the "re-roaring twenties" is starting off in second gear. Averaging over the downs and ups of the COVID shock and recovery, US growth has averaged about 2%. That’s only about 0.2% higher than in the prior cycle.

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The US continues to outgrow most advanced economies. The Euro Area grew at an anemic 0.8% annual rate in both periods. Within the Euro Area, Germany has been particularly anemic with almost no net growth in the recent period. France is fine. Growth has been weaker in the UK and Canada and has a small rebound in Japan. Overall, the US outperformance has increased a bit.

?Caveat Emptor

Before we break out the Brut, however, there are two major caveats. First, part of the gap in the current cycle is because the US had a much bigger fiscal response to the COVID crisis. The US fiscal expansion was two- to three-times bigger as a share of GDP than in other economies. It was also by far the biggest cyclical response on modern history. Moreover, it supported growth well into the expansion by created a massive pile of excess liquid savings. The surge in both overall savings and in bank deposits was much larger in the US and continues to fund consumer spending.

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The upshot is that the US not only had a faster recovery, but also likely overshoot the inflation neutral unemployment rate. This is why the Fed is trying to slow growth and is one reason they have been delaying rate cuts. Suppose the economy needs a year of say 1% GDP growth to fully return to equilibrium. Then the average growth in this cycle drops to 1.8%, the same as in the prior cycle.

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By contrast, the smaller stimulus outside the US has meant only a partial recovery back to full employment in most advanced economies. This is particularly the case for the UK and the Euro Area. Both have also been hurt by energy and geopolitical shocks. This goes a long way to explaining Germany’s feeble recovery. These headwinds seem to have replaced Brexit and the threat of a break-up of the Euro Area as major constraints on growth in Europe. The silver lining in the weak recoveries outside the US is that it allows an earlier easing of monetary policy.

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It also means there is room for growth to accelerate. The ECB is forecasting just 0.6% growth in 2024, but 1.5% in 2025 and 1.6% in 2026. As we saw with the US data above, we can recalculate the peak-to-peak growth rate, plugging in the implied quarterly growth path. If the ECB is right, then the average growth rate peak-to-peak would be 0.2% higher at 1.0%.

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Of course, this approach to measuring trend growth is backward looking—it suggests trend growth was not all that different in this cycle than in the previous cycle. What about the outlook going forward? The second caveat around US exceptionalism is that it is not clear whether the fundamentals justify stronger or weaker trend growth in the US (and advanced economies more generally).

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The good news is that the tech-heavy US economy is uniquely positioned to benefit from the development and application of new technology as was the case in the 1995-2005 “new paradigm” economy. A second "new paradigm" is possible. However, I would caution that many “new paradigms” have been projected in recent decades, but there has been only one ten-year period of strong growth (see the CBO estimates in the chart).

?Beyond the tech story, growth fundamentals are not good for the US and other advanced economies. Among the headwinds are:

·????? Large and persistent budget deficits tend to “crowd out” private investment or increase dependence on foreign capital that must be serviced. Here the US looks worse than other advanced economies.

·????? Climate change mitigation requires scraping dirty energy capacity and building clean energy capacity. That redundancy tends to weaken the growth in the effective capital stock.

·????? Climate events are becoming more common, diverting investment to rebuilding and prevention rather than expanding productive capacity.

·????? Deglobalization also requires building redundant supply chains. Brexit offers a cautionary example of the costs of moving away from free trade.

·????? Demographic trends argue for slower growth in the labor force as the native population in advanced economies ages into retirement. With a higher birth rate the US is in a less challenging situation than most other advanced economies.

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Increasing the Participation Rate

Finally, advanced economies that do the best job accommodating immigrants can outperform. If the Great Global Migration simply creates holding camps and a game of hot potato it is very damaging to the global economy. The quicker these people are put to work the better. Effective policy means both helping failed states recover and retain workers and finding ways to integrate workers into well-run economies.

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The US has an important advantage in this respect: with the best STEM education in the world, the US attracts a lot of talented foreigners into its universities. ?Will the US welcome them into the job market or send them home to develop new technologies outside the US? At the low end of the job market, (mainly undocumented) immigrants are critical to addressing labor shortages for unskilled jobs. Will the US kick them out and create a labor shortage in agriculture, hospitality and other sectors or will it manage an ongoing inflow?

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The bottom line is that while I think the US will continue to outgrow advanced economies like the Euro Area, I’m skeptical about a pick-up in potential GDP growth and I see more downside than upside risks. The US is better positioned to benefit from a tech-driven boom, but it has other challenges including unusually high budget deficits and a bi-partisan push for deglobalization.

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This conservative view of trend growth feeds into my views of markets. Most important, even if there is an eventual tech-driven productivity boom, I would be surprised if it was timed perfectly to rescue the Fed from its inflation fight. Instead, I'm more worried about chronic (but modest) overshooting of the inflation target(s). Low growth in GDP means low growth in earnings and stock prices over the long-run.

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