Two lines just crossed on a chart, and they show why, by at least one prominent measure, the Republican tax plan is coming at a mighty strange time.
Congressional Republicans promise their proposed tax plans will turbocharge the economy and complete its long recovery from the Great Recession. But in a little-noticed development, recent economic data indicated that the economy has actually, finally, reached its potential capacity.
For the first time since the end of 2007, the economy, measured as gross domestic product (GDP), is at its (theoretical) potential.
Potential GDP tells us, in rough terms, how big the economy can be. The most popular measure comes from the nonpartisan Congressional Budget Office. The CBO combines estimates of the country’s labor potential—how many people are working or looking for work, and how many hours a week people are working—with estimates of the nation’s capacity to produce goods and provide services.
The government economists use that data to determine how much the economy would produce if most hot dog stands had busy vendors, most cubicle setups had software jockeys with clients to please and most drill presses had drill-press operators and a full list of orders. Most people who want a job have one, and most factories that need workers have them.
The return to potential GDP can be thought of as the true end of the long road back from the Great Recession. Some may have pegged the end of the recovery as the third quarter of 2011, when inflation-adjusted GDP finally passed its pre-recession level, but in truth, GDP was still $616 billion (in 2009 dollars) or about 4 percent smaller than it should have been.
Now, six years later, that gap has been closed entirely. And this might be as good as it gets.
All that extra capacity help the economy grow at an annualized average of 2.2 percent a quarter, adjusted for inflation and seasonality, since the recession ended—well above what economists consider to be possible in the long run. Federal Reserve forecasters put the economy’s long-term growth rate at 1.8 percent at their September meeting. Productivity expert John Fernald, an economics professor at the global business school INSEAD and senior research adviser at the San Francisco Fed, pegged that same rate at 1.6 percent.
A strange time for a stimulus
The good news is that this means we’ve come a long way since the recession. The economy’s looking pretty good. Figures released by the Commerce Department on Wednesday show the economy grew at an annual rate of 3.3 percent in the third quarter, adjusted for inflation and seasonality, somewhat faster than originally reported. But it is unlikely that pace can be sustained, and because there’s not much more room to grow, the ambitions of President Trump and Republicans in Congress carry some big risks.
First, consider that the economy hasn’t spent much time above its potential in recent decades. It requires deft policy to manage growth in an economy that’s nearing capacity while keeping inflation low and simultaneously quashing bubbles or other dangerous distortions. Note that the last three times the economy ran above potential, it was followed by a recession.
But in spite of that history, Trump officials have promised annual growth rates of at least 3 percent, with Trump telling House Republican leaders, “I personally think we can go higher,” than even 4 percent. And that’s why they’re pushing a massive tax bill that would pump $1.3 trillion to $1.6 trillion into the pocketbooks of people and corporations over the next decade.
Certainly, it’s possible that the tax bill could increase the economy’s potential. Corporate tax revisions could make the U.S. more competitive or let companies invest more in research and development.
But economists doubt the tax effort will have that pronounced an effect. That’s why, in a survey conducted by University of Chicago's Initiative on Global Markets, just one of 38 experts agreed GDP would be “substantially higher” under the proposed tax plans than under the status quo (all else being equal).
More realistically, the cuts may increase productivity a bit on the margins as businesses seek to make small improvements to their products and processes, said Gary Hufbauer, senior fellow at the Peterson Institute for International Economics. But the cumulative gain would amount to a fraction of a percentage point of overall GDP.
The Penn-Wharton Budget Model’s analysis is moderately more optimistic, saying the House plan might add between 0.5 percent and 0.9 percent to the GDP, cumulatively, by the end of the decade.
To get a better sense of how dramatically different the administration’s hopes for growth are, consider that the CBO forecasts potential GDP will grow an average of 1.8 percent a year. This is identical to the median Fed estimate. Consider a version of the previous chart, but with 3 and 4 percent growth rates forecast a decade into the future.
It’s possible to exceed potential GDP because it doesn’t measure the full capacity of the economy: it measures where the economy should be when it’s firing on all cylinders—what the CBO calls “maximum sustainable output.” At that point, the economy’s growing as fast as it can without generating so much demand for resources and workers that competition goes into overdrive and prices spiral out of control.
We can break the potential GDP barrier for a while, but think of those high growth rates like putting the pedal to the metal.
It’s fun and even useful in spurts, but if you try to keep it up for the long haul, you are increasing the risks of losing control or crashing.
And we've already been there once. MIT Sloan School of Management professor and former Cyprus central bank governor Athanasios Orphanides has found that, in the 1970s, poor measurement significantly overstated the gap between potential and reported GDP.
This led politicians to stimulate an economy that was already at capacity and thus drive inflation so high that central bankers eventually had to induce a double-dip recession to tame it.
A previous version of this story incorrectly described the rate of growth in gross domestic product. GDP has grown at an average annualized rate of 2.2 percent, adjusted for inflation and seasonality, since the Great Recession ended. It also failed to specify which figures been annualized and/or adjusted for inflation and seasonality.