“It’s self-defeating to use the wrong monetary policy.” -Ben Bernanke
- What is productivity?
- The Federal Reserve’s flawed growth benchmark
- Excessive monetary policy is crushing productivity
- The prescription for sustainable, durable growth – productivity
“Because it is unclear exactly why productivity growth has slowed recently, it is difficult to be confident about what it will do in the future”. –Bill Dudley June 2015
The recent quote from Federal Reserve Bank of New York President and Vice-chairman of the Federal Open Market Committee, Bill Dudley, inspired us to write this article and explain what Mr. Dudley cannot; why productivity, the key driver of economic growth, is not only slowing but on the verge of declining.
Bill Dudley and the Federal Reserve (Fed), in their efforts to influence economic growth may have created a speculative and consumption driven environment that is crushing productivity growth. This article explains what productivity is, how productivity has suffered at the hands of poorly benchmarked Fed policies and why those in charge of monetary policy must change their views if America is to economically thrive once again.
Productivity is a core economic concept which measures the amount of leverage an economy can generate from its 2 primary inputs, labor and capital. Without productivity, economic growth is purely reliant on the 2 inputs. Given the limited nature of both labor and capital, they cannot be depended upon to produce durable economic growth over long periods of time. Leveraging labor and capital, or becoming more productive, is a function of many factors including innovation, education and financial incentives. In “Innovation – Too much, or too little of a good thing?” we discussed why the plethora of new technologies in the marketplace, are not as productive, especially in the long term, as they may appear. True ground breaking innovation involves time, effort and significant capital and ingenuity. Therefore it is imperative to ask, as we do in this article, is the Fed doing their part and providing pro-innovation incentives?
Labor, or human capital, is largely a function of the demographic makeup of an economy and its employees’ skillset and knowledge base. In the short run, increasing labor productivity is difficult. Changes to skills training and education take time to enact and produce a meaningful effect. Similarly, changes in birth rate patterns require decades to influence an economy. Immigration policies are arguably much easier to amend to foster more immediate growth, but the likelihood of pro-immigration policies these days is not probable.
Within the labor force, the biggest trend affecting current and future economic activity is the so called “silver tsunami”, or the aging of the baby boomers. This cohort of the population, ages 51 to 69 are beginning to retire. As this occurs, they tend to consume less, rely more on financial support from the rest of the population, and withdraw valuable skills and knowledge from the workforce. The outsized number of people in this demographic cohort makes this occurrence more economically damaging than usual. As an example, the old age dependency ratio, which measures the ratio of people aged greater than 65 to the working population ages 18-64, is expected to nearly double by the year 2035 (Census Bureau).
While the implications of changes in demographics and the workforce composition are numerous, they only require one vital point of emphasis: the significant economic contributions attributable to the baby boomers from the last 30+ years will diminish from here forward. As they contribute less, they will also require a higher allotment of financial support, becoming more dependent on younger workers.
Capital includes natural, man-made and financial resources. Over the past 30+ years, the U.S. economy benefited from significant capital growth, in particular debt. The growth in debt outstanding, a big component of capital, is shown (black line) in the graph below. The increase is stark when compared to the relatively modest level of economic activity that accompanied it (green line). The red arrows highlight the exponential rise in the ratio of debt to economic growth.
|Total Domestic Outstanding Credit vs. U.S. GDP
|Data Courtesy: Bloomberg, St. Louis Federal Reserve|
This divergence in debt and economic growth is a result of many consecutive years of borrowing funds for consumptive purposes and the misallocation of capital, both of which are largely unproductive endeavors. In hindsight we know these actions were unproductive as highlighted by the steadily rising debt to GDP ratio shown above. The graph below tells the same story in a different manner, plotting the amount of debt required to generate $1 of economic growth.
|Debt Required for Economic Growth
|Data Courtesy: Bloomberg, St. Louis Federal Reserve|
Since 1980, the long term average growth rate of productivity has stagnated in a range of 0 to 2% annually, a sharp decline from the 30 years following WWII when productivity growth averaged 4%. The most recent productivity report from the San Francisco Federal Reserve shows an annualized decline of .06% versus the prior year. (http://www.frbsf.org/economic-research/indicators-data/total-factor-productivity-tfp/)
The graph below plots 10 year average productivity growth (black line) against the ratio of total U.S. credit outstanding to GDP (green line).
|Debt to GDP Ratio vs 10yr Average Productivity Growth
|Data Courtesy: Bloomberg, St. Louis Federal Reserve, San Francisco Federal Reserve|
Within the graph, note the comparatively weak rate of productivity growth since 1980 and, more importantly, the trend towards zero productivity growth over the last 10 years. Additionally, productivity stagnation started as the debt to GDP ratio started climbing at a faster pace. This graph reinforces the message from the other debt related graphs – over the last 30 years the economy has relied more upon debt growth and less on productivity to generate economic activity.
Given the finite ability to service capital and aforementioned demographic challenges, future economic growth, if we are to have it, will need to be based largely on gains in productivity as reliance on debt and demographics has largely run its course.
The Fed’s Questionable Growth Target
Throughout the last 30 years the Fed has become increasingly proactive in incentivizing economic growth towards their target – the potential economic growth rate. Unfortunately, the Fed’s measure of potential growth rate may be flawed leading to harmful consequences.
To better explain potential growth we quote from an article entitled What Is Potential GDP and Why Does It Matter? Authored by William T. Gavin, Vice President and Economist at the St. Louis Federal Reserve. In the article, Mr. Gavin addresses how the Fed arrives at the potential growth rate as follows: “Instead, they estimate potential GDP by constructing measures of the trend in actual GDP that smooth out business cycle fluctuations”. This concept of relying on prior trends versus future potential is vital to grasp. From the same, article Mr. Gavin further explains: “But why does potential GDP matter? How do we use it? Potential GDP is important because monetary policymakers use the difference between actual and potential GDP—the output gap—to determine whether the economy needs more or less monetary stimulus”.
Said differently, the decisions on how to employ monetary policy are based on a comparison of historical and current economic growth. This method ignores potential changes in growth factors that may cause GDP to deviate from the past.
The graph below shows 7 year averages of the Fed’s potential economic growth vs. actual growth to show the simplicity of the Fed’s potential GDP forecast. Not surprisingly forecasted GDP growth for the next 10 years follows the economic growth trend of the last 10 years.
|Potential GDP vs Actual GDP
|Data Courtesy: St. Louis Federal Reserve|
Unfortunately, one must understand that potential GDP, as measured by the Fed, is not fully factoring in the limited ability to continue to increase debt loads, the demographic headwinds and the fact that productivity growth could likely be negative in the years ahead. The Fed’s measure of potential economic growth is solely a function of past activity and the different environment that produced it.
To better explain the problems of following a faulty trend we compare 2 trends based on baseball legend Barry Bonds career statistics. During Bond’s peak playing years from ages 24 to 35 he posted outstanding statistics which likely would have earned him a seat in Cooperstown. Bonds batting average was consistently .300 or above, as seen below, and he averaged 36 home runs per year during those years. Following his peak years, when most players’ performance drops considerably, Bonds somehow got even better. From ages 36 to 40 his batting average and home run production exploded. During this time frame, Bonds averaged 51 home runs per year. This included his 2001 campaign when he hit 73 home runs, topping Mark McGwire’s then 3 year old record of 70 homeruns and shattering what had been the previous record, Roger Maris’ 61 homeruns in 1961.
|Barry Bonds Batting Average
|Data Courtesy: Baseball-Reference.com|
As we now know, this incredible feat was not based entirely on his natural potential but was greatly aided by a new factor, steroids. The red and green lines above show 2 potential trend lines that could be used to summarize his performance. The red line represents Bond’s relative consistency during a typical professional players’ peak years. The green line shows the effect that steroids had on boosting performance and extending his career, or the deviation from typical potential. The gap between the trend lines is significant and could easily lead one, unaware of the new factor, to arrive at vastly different conclusions i.e. that Bonds had found some secret to increasing his productivity at a time when the typical player of similar age was declining or retired.
Basis for Monetary Policy
Fortunately, monetary policy is not based off tainted baseball statistics. However, like in the Bonds example, there are new and changing factors in an economy that alter its potential growth rate. By failing to consider these factors and how such factors could alter their benchmark, the Fed runs the severe risk of conducting inappropriate monetary policy.
The following graph illustrates how an erroneous potential growth rate would greatly change the Fed’s perception. Assume the true annual potential growth rate since 2000 was 0.50% less than the official Fed potential growth rate. Under this reasonable scenario, economic growth as measured by GDP (red) would have exceeded the hypothetical potential growth rate for 4 consecutive years prior to the financial crisis of 2008/09 and again over the last 3 years. When actual growth is above the “true” potential of an economy, the economy is pulling forward consumption from the future. When the future comes consumption needs have already been met and slower growth is inevitable.
|Potential GDP, Actual GDP and Proxy Potential GDP
|Data Courtesy: St. Louis Federal Reserve|
Let us now consider that economic growth has failed to reach the Fed’s measure of potential GDP (blue line) since 2007. This is despite unprecedented stimulus in the form of a zero interest rate policy and the quadrupling of the money supply. One must question whether or not the target is correct. Maybe the so called “new normal” sluggish economic growth is the economy’s real potential and not the higher growth rate of years past.
We believe the potential growth rate is less than that which is targeted by the Fed. To what extent, is unclear. The widely followed Taylor Rule supports our analysis, to some degree, as it currently shows a glaring discrepancy between the current Fed Funds rate (.25-.50%) and that prescribed by the rule (2.92%). If the Taylor Rule and our thesis are correct, the potential growth rate of the U.S. economy may be much lower than the Fed thinks, and therefore monetary policy is not just “accommodative”, as described by Chairwoman Janet Yellen, but egregiously excessive.
The Fed, by chasing an erroneous GDP growth target may have generated economic growth beyond that which would have otherwise been produced by keeping interest rates too low for too long and performing multiple rounds of quantitative easing. These actions increased the Fed’s measure of potential growth, creating a vicious cycle in which they repeatedly over-stimulate to meet an erroneous target. As this continually occurs, the gap between true potential and the Fed’s measure widen, leading to larger and larger policy errors.
Excessive Stimulus is Crushing Productivity
Worse yet, Fed monetary policy used to promote economic growth relies upon changes in interest rates and money supply to increase debt and drive consumption. Lower interest rates and QE have also spurred a strong preference for speculative investments, such as stocks, real-estate, and junk bonds, at the cost of productivity generating investments. Recent bubbles in technology, real estate, and stock valuations, to name a few, are signs of the speculative fever the Fed’s actions enabled. Low interest rates have also encouraged corporations to use valuable assets or borrowed funds to buy back stock instead of investing in growth-enhancing innovation. Globally, low rates in the U.S. led many investors to borrow in dollars to fund questionable projects over-seas. In other words, trillions in capital has been misallocated with little benefit to productivity growth. While such actions may have caused one-time increases to GDP, they are neither producing sustainable economic gains nor has the debt incurred been paid down.
If we are correct and the Fed is overestimating the potential growth rate, then by default they are also applying excessive stimulus to the economy.
Prescription for Real Growth
There are many reasons productivity growth has stagnated, and the Fed is certainly not solely responsible. Yet Fed officials, as witnessed by Mr. Dudley’s comments, treat productivity as an uncontrollable residual of capital and labor. They would be well-advised to take a different tack and use their enormous power to have a positive effect on productivity. Without productivity growth, economic growth in the future will be extremely limited as capital and labor cannot contribute nearly as much as they have in the past.
The Fed, along with government, needs to properly incent productivity. The Fed should start this arduous task by removing excessive stimulus which will take the speculative fervor out of markets and allow asset bubbles to deflate. Although painful in the short term, it will allow capital to flow to more economically, productive uses that have been starved of capital. Congress, for their part, should reconsider current Fed mandates and discuss means in which the Fed can incent productivity growth.
Ingenuity, not debt, made America an economic powerhouse. If we are to resume down that path we need the Fed to end their “self-defeating” policies and in its place we must demand ingenuity from them.
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