As the peak of the business cycle nears, it’s become clear that slow GDP growth during the financial recovery wasn’t a symptom of lingering weakness in the economy. Rather, the downshift in growth that followed the recession was largely due to demographic drags that will likely last for decades. For the moment, slow growth will likely have little impact on American prosperity, but the economy will need to expand more rapidly to enable the US to meet its long-term fiscal obligations.
During the recovery’s early years, economic growth fell far short of the 3.5 percent average rate of expansion seen in the 20th century. After the 2008 downturn, GDP growth struggled to surpass 2 percent, despite the Federal Reserve’s extraordinarily accommodative monetary policy. Some analysts worried that sluggish growth would bring an era of “secular stagnation” marked by permanently elevated unemployment and a declining standard of living.
These concerns proved unfounded—from every perspective but aggregate growth, the recovery has been robust. Unemployment fell rapidly, stock valuations soared, and household net worth reached new highs, even as GDP didn’t accelerate.
Slow growth was inconsequential for the recovery because the absolute rate of expansion mattered far less than whether the economy was fulfilling its underlying potential. The current GDP slowdown is being driven by demographic factors, and slow growth has masked a healthy resurgence in demand for labor and capital.
The baby boom generation’s retirement has dramatically slowed the growth of the working-age population, which has limited the economy’s potential rate of expansion. By itself, a demographic-driven slowdown should have little impact on the nation’s prosperity. As fewer workers join the workforce, the necessary pace of job creation will naturally decline, and a modest rate of GDP expansion will be sufficient to lift living standards.
For individual well-being, worker productivity is much more important than the expansion of the country’s aggregate output. This is why the average Japanese household can still enjoy a high standard of living despite decades of slow growth. Japan’s economy has only expanded at an average rate of 0.9 percent over the past 25 years, placing it among the world’s slowest-growing economies. But over the same timespan, Japan’s population has remained stable, and households have seen their share of the nation’s wealth steadily accumulate.
The US is now facing a similar long-term demographic decline—the share of the population over the age of 55 has doubled over the past decade, and the retirement-age population is projected to grow by approximately 1 million citizens annually for the next 15 years. While the aging of the American population will continue to be a drag on GDP, there is little reason to believe it will prevent the productivity gains that promise to lift society’s living standard.
The real problem posed by a prolonged slowdown in GDP growth is a looming fiscal crisis of our own design. Since 1900, the US economy has averaged a 3.5 percent rate of growth, and our social safety net—entitlement programs like Social Security and Medicare—were designed under the assumption that the economy could continue expanding at this rate.
A prolonged downshift in growth will do nothing to contain the safety net’s costs. The rapidly growing population of retirees will rely on Social Security and Medicare in the coming decades, regardless of how quickly the economy grows. If GDP growth slows to a 2 percent pace, government spending is forecast to grow as a share of the economy, with federal outlays rising from about 20 percent of GDP today to nearly 30 percent by 2050.
This scenario would place the economy under incredible strain—to fully finance these obligations, tax revenues would need to climb considerably from current rates. Any spending that can’t be paid for with tax hikes will require borrowing, creating a permanent structural deficit.
A structural deficit of this magnitude would be challenging to maintain. Unlike cyclical deficits—when the government borrows during downturns to finance stimulus measures—a structural deficit will require borrowing during boom times as well. If private enterprise is forced to compete with a growing volume of Treasurys for limited capital, interest rates will likely rise. Higher long-term interest rates will threaten to create a spiraling federal deficit as the government is forced to issue increasing amounts of debt to finance the interest on its current obligations.
If growth returns to its 20th century average, however, the structural deficit could entirely disappear. An economy expanding at 3.5 percent annually will likely be able to support federal obligations to the retired population without raising taxes or creating a structural deficit.
The fiscal crisis can be defused by taking steps today to increase the economy’s growth potential. Investing in workforce productivity, reducing the barriers to innovation and eliminating infrastructure bottlenecks can help incubate faster growth, despite the inevitable demographic decline. Similarly, comprehensive healthcare reform could help contain Medicare and Medicaid costs for future generations. Slow growth may not be an immediate threat to the American economy, but we can’t ignore its future implications.
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