Is the US Economy Living Up To Its Potential?

Just how good could this economy actually get? Could it get even better than today or are we destined for trouble ahead?

This is something I ponder often and one of the tools I like to use when thinking about this is something called Potential GDP, which estimates the level of output that the economy?could have?produced if labor and capital had been optimally deployed at sustainable levels. Despite being just an estimate and somewhat theoretical, I find this calculation important as it highlights the key components to economic growth. And frankly, there are areas that increasingly point to future headwinds to Actual GDP that we just need to think about. Let's face it, Potential GDP has been in a pretty significant funk ever since the Great Recession and some factors that has limited it may persist for a while.

Understanding the variance between Potential and Actual GDP also helps to uncover potential second-derivative issues that might sneak up to contain or propel the US economy's growth.??For example, if the "actual" economy grows faster than its sustainable potential (a positive output gap), then factors like inflation can become problematic. The reverse is true for negative output gaps, where the economy doesn’t live up to its potential.

To best decipher what areas we may need to study more deeply, we first need to know the two factors that comprise Potential GDP: (1) growth of the labor force and (2) the pace of productivity growth (output per hour of work or said another way, how productive labor and capital is at driving output).??So, Potential GDP growth can accelerate if more people enter the labor force, or if capital investment expands in the economy, or if the existing labor force becomes more productive. Makes sense to me: the more people you have, the more output you have the potential to make (and consume). Plus, if people can produce more, through being more productive with education, or skill, or technology, more output is made.

So, at a headline level, you can see the possible longer-term issues we might face.??Labor growth is a mess right now with some of the lowest participation rates in a generation, as well as labor shortages that will likely persist (albeit at a lessening level), an aging population in the US, declining population growth due to decades of smaller families, and immigration policy that has been more restrictive than the past. These are just a few factors and I wrote a lot about this here. Bottomline is that labor growth doesn't seem like a sustainable lever to pull to increase our long-term economic potential.

So that leaves the other factor: productivity.??Here we have a mix bag of data.??Businesses are investing more and more to drive up productivity through technology and automation (self-checkout is now everywhere and increased work-from-home eliminates unproductive commutes, are just two of many examples). This is certainly great news and helps drive economic potential higher.??But supply chain constraints are hindering productivity as businesses often have to wait and wait to fulfill orders, which makes their capital and labor less productive.?

While its likely the US economy stays strong and surpasses its “potential”, keeping an eye on Potential GDP and any Output Gaps will be important to watch in the quarters and years ahead.??Specifically, I will be on the watch-out for:

1)????What is the catalyst for labor growth to reverse course???The US isn’t getting any younger and the pandemic really created a change in how working Americans look at the balance of life and work.??Immigration continues to look like a political landmine that isn’t likely to contribute as much growth as decades past and a burnt-out, tired work force needs to find its engagement and productivity.??Maybe the more work-from-home, virtual environment will bring in more workers to the labor force but we haven’t seen that happen yet.??So what will make the labor force grow?

2)????Will Corporate America keep up its capital investment cycle and invest in productivity measures? If you can’t count on a larger volume of workers, you need to make the workers you do have really productive or replace them with more efficient automation.??Will this pandemic-fueled investment cycle continue for companies? Will the take-out, delivery-based, self-service, and automation-led trends lead to more spending by existing corporations to retool and better yet, spawn a whole new slew of new businesses to open?

3)????How quickly will the global supply chain be re-established from its dead stop in 2020? My good friend and big-thinker Doug Sandler of Riverfront so appropriately compares this to a complex machine being restarted and it needs time to get the pipes flowing again.??Machines need to run and when they stall, it’s hard to restart.??He is dead on.??One other thing to watch is how these supply chain pipes get reconnected.??Parts that used to come from China might now come from Brazil or Poland, which changes the landscape of global trade on many fronts – from price to currency to quality.

4) Nationalism has taken on much more relevance lately- spurred politically but also a by-product of the supply-chain issues that arose during COVID-19 that is pushing more and more to push for US-based products. That sounds all well and good, but to make these products domestically, you need the labor force and capacity to do it. Back to problem number 1. The US is struggling to find labor that is either qualified or desires the open jobs we currently have - much less new jobs in the future. This puts even more importance on productivity through automation and technology investment.

5)????While inflation is dubbed as transitory, something I largely agree with, it will be stoked higher if our economy continues to run faster than the sustainable potential GDP levels show it can support.??This puts higher pressure on rates and moves the Fed into a possible behind-the-curve position.??Lots of cross-currents here and likely inflation moderates, but if there is risk, it is to the upside.??Running a machine faster than it sustainably can support (Actual GDP > Potential GDP), is one of the quickest ways to overheat an engine (or an economy).

For now, things look pretty good for the economy but lots of challenges lie ahead for the US over the longer-term.??Mounting debt pulls forward future growth, twin deficits act as economic brakes, and a lower potential for our economy could keep growth more moderate.??That said, America has an elixir that has worked pretty well when tested with obstacles, which is the adaptability and resiliency of US-birthed capitalism and the strength of the American spirit. Or said another way by the legendary Johnny Cash, America is blessed with a folk that are tested with “the gravel in your gut and the spit in the eye”.??Simply put, despite looming trials, our potential is promising.