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The path to inclusive growth: Raising the economy’s speed limit by boosting the ‘big two’

(Jeff Roberson/AP)
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One of the most important economic debates of the day is how to achieve more economic growth that reaches more people. Breaking it down, on one side you find economists with demand-side solutions, and on the other, those with supply-side solutions. This post tries to unite them, while separating the supply-side wheat from the chaff.

To telegraph the two punchlines, the path to faster, more inclusive growth requires us to boost demand enough to raise the “big two” supply-side variables: labor supply and productivity growth. Second, these are policy variables, meaning they’re not immutable but will respond to helpful and hurtful policy actions and non-actions.

In Washington, supply-side policy has come to mean something quite different than boosting the big two. Instead, it connotes increasing growth by cutting taxes on rich people based on the faith that they’ll create more economic activity (and create it here, not abroad). To put it mildly, that faith is misplaced. You know what happens when you cut taxes on the rich? They get richer. Full stop. Trickle down is the supply-side “chaff.”

It (supply-side) has also come to mean “dig, dig, dig:” increase the supply of fossil fuels and thus lower the cost of energy. Put aside the environment for a second, something we should all be loath to do. While “dig, etc.” makes more sense than the tax-cut fairy dust and oil at $30/barrel is helping to boost consumer spending, it’s far from the inclusive growth game-changer we seek. Cheap oil, it turns out, is not an unequivocal good, especially when we add back in its environmental costs.

Now, from the chaff to the wheat.

The reason the big two are so important is that they sum to the growth rate.* When you hear economists invoke the concept of “potential growth” or the economy’s “speed limit,” this sum: labor force + productivity growth=GDP growth — is what we’re talking about. We’re now ready for a revealing, if unsettling, picture.

The top line shows the expected trend of real potential GDP predicted before the downturn. The next one down shows the most recent version of that expectation, and the lowest line shows actual GDP. If you’re wondering what the heck happened to reduce the speed limit so much, you’re asking exactly the right question. You might also be wondering why our actual GDP is like a runner who can’t seem to reach a goal line that’s moving towards her.

Well, now that you get the math of the big two, you know that both the lower speed limit and the slow actual growth must be due to some combination of less labor supply and slower productivity growth. In fact, both have declined significantly, and while part of that is to be expected — our aging demographics is clearly a factor in diminished labor supply — part of it is due to neglectful policy that has repressed demand, held back job growth, reduced investment, ignored large trade deficits and most recently, tilted against the phantom menace of inflationary pressures.

The implication is that if we push back on all these pressure points, we could move that middle line up. There are real, supply-side constraints as to how far up, but that’s a high-class problem. Right now, let’s focus on boosting labor demand to pull more people back into the job market and increasing productivity growth, i.e., raising the growth rates of the big two with the goal of not just faster growth, but more inclusive growth.

How do we do that? Isn’t the economy already at full employment?

No it’s not, and I’ve got some great stuff on that loaded for later this week (prepare to have your minds blown if you think 5 percent is the lowest unemployment rate consistent with stable inflation). For now, recognize that the underemployment rate, while also coming down, remains elevated by millions of part-timers who want more hours of work. It’s about 10 percent, and I calculate that at full employment, it should be closer to 8.5 percent.

There’s room for the labor force participation rate to come up too if more decent job opportunities for those displaced by globalization or stuck in neighborhoods without jobs, for example, were to come on line. As I describe in detail in my latest book, that would take helping our manufacturers penetrate export markets which in turn calls for more attention to fighting back against those who manage their currencies to boost their trade surplus and our trade deficit. It will take upskilling and direct job creation in jobless neighborhoods.

Research I’ll feature soon underscores the importance of these ideas going forward. The composition of the future labor force will be majority minority, and while educational upgrading will help, we’re talking about groups of people who: a) tend to have higher un- and non-employment rates but b) whose labor supply is a lot more responsive to stronger labor demand.

Also recognize that these measures I’m describing won’t just lead to higher growth. Full employment and direct job creation deliver greater bargaining power to those who’ve suffered a deep deficit of that critical force for many decades. And that, in turn, enforces more inclusive growth.

That’s labor supply. What about productivity, which is a much tougher variable to move? Here, recent work by economist Josh Bivens is highly instructive. First, he tees the issue up in exactly the right way:

…we need to seriously consider the possibility that productivity growth (normally thought of by economists as a supply-side phenomenon) is just the last casualty of the chronic demand shortfall that brought on the Great Recession and which was never filled in sufficiently to push the economy back to full health.

That link in there is to a piece of mine (okay, we’re getting a little circular here, but there aren’t a lot of economists making these connections) wherein I argue that at full employment, higher labor costs force inefficiencies out of the system, driving up productivity. Think about that: full employment can boost both of the big two. It can pull people into the labor market and squeeze inefficiencies out of the macroeconomy, all the while pushing back on inequality.

Josh points out that too little investment and R&D is also in play here, but which policies will increase productivity-enhancing capital deepening? One way is to keep the cost of borrowing down meaning that especially absent inflationary pressures, the bar for raising rates at the Fed should be very high. But a more direct way, especially given our public infrastructure needs and very low interest rates, is to offset the market failure of too little private investment with greater public investment.

Getting back to energy for a moment, I’d add public policies that incentivize investment in renewables, like a tax on carbon, as another way to both increase labor demand and investment, along with the environmental benefits, of course.

It’s tempting to take the economy’s “speed limit” as given, as dictated by forces beyond our control, like an aging workforce or the vagaries of innovation. But a look at the figure above shows that over relatively short time periods, the speed limit can fall quite significantly. There’s no reason to assume this is asymmetrical, especially when you recognize the damage done by the heavy hand of austere fiscal policy, disinvestment in public goods and R&D, and dysfunctional government enamored of supply-side tax cuts.

Let’s at least try to boost the big two and raise the speed limit. I’m strongly convinced that with better policy we can do so, but even if I’m wrong, it would still be great to get caught trying.

*You want the algebra? Sure: Y=Y/h*h, where Y=output and h=hours of work, which I’m broadly calling “labor supply” above. Take changes in natural logs and you have additive growth rates.

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