• Modest growth rate contributes to length of economic expansion
  • Low levels of business investment hurting productivity growth
  • Less regulation, lower taxes could help the economy significantly

The U.S. economic expansion is in good condition and will likely last well into 2018 and potentially beyond. More Americans are working today than ever before, household balance sheets are healthy, housing is growing steadily, and equities are setting record highs. Contributing to the longevity of this expansion is that the modest rate of growth we have experienced has not led to any substantial imbalances that could cause a recession. As a result, although interest rates and inflation historically have risen after an expansion of this length, this time they have remained low.

The biggest problem facing the economy is that labor productivity growth, a key driver of rising living standards, has fallen to the lowest level since the early 1980s (see chart). Nearly 17 million jobs have been created in this expansion, but, because wages are not rising as much as they would if productivity was increasing, this has not spurred the type of increases in consumer spending that drive significant GDP growth. In addition, due to the severity of the Great Recession, households now have a higher propensity to save and are not taking on the same levels of debt they once did. Combining these factors leads to this expansion being steady but modest, with GDP growing at about 2% annually.

3Q17-GRD Chart 1


Part of the slowdown in productivity growth is likely due to the fading impacts of the IT revolution. Demographic changes are also playing a role, with the economy increasingly relying on older workers whose productivity is not as likely to rise as much as that of their younger associates. More recently, the makeup of job gains has been skewed toward lower-productivity industries and away from high-productivity ones where technological advances have the most impact. Firms in industries such as information and mining have hired fewer people, while sectors such as education, leisure and hospitality, and healthcare services have hired more.

Perhaps the biggest contributing factor, though, has been the pullback in business investment. The contribution to productivity growth from capital intensity fell from an average of 1.6% between 2000 and 2009 to -0.1% between 2010 and 2016 – a glaring decline (see chart). Despite high levels of corporate cash, low interest rates, and widely accessible capital market funding, business investment has been one of the more disappointing elements of the economic recovery. Since the Great Recession, the level of capital relative to labor and output has been declining or flat. Instead of adding to productivity growth, it has subtracted from it.

So what could turn things around? Several policy changes from Washington could provide the key to spurring capital investment by American businesses. The first is the ongoing effort to reduce government regulation and provide a more favorable climate for investment. Ever-increasing regulation, however well intentioned, has been detrimental to the formation of capital, especially for the average worker. Small businesses surveyed by the NFIB have increasingly cited government requirements as their single most important challenge. Overall, the Competitive Enterprise Institute estimates that nearly 10% of GDP is associated with the cost of federal regulation and intervention.

Likewise, there is bipartisan agreement that the current corporate tax code is overly complex and contains perverse incentives. Capital is mobile, and a higher tax rate hurts America’s competitive position as a place for businesses to invest. Research by the Organisation for Economic Co-operation and Development has found that corporate tax rates have the most adverse impact on business investment and productivity. One study found that a 10% reduction in the current rate could lift annual growth in GDP per capita by 1-2%.

Addressing all these factors would have a favorable impact on potential GDP growth, though increasing capital investment back to precrisis levels still wouldn’t be enough alone to lift growth all the way up to 3%. Historically, productivity advances in bursts for a few years, then settles down, and then advances in another burst. What makes the U.S. economy one of the world’s best is our ability to innovate, and that is usually dependent on both business and government capital spending.

The challenge the U.S. economy finds itself in is a negative feedback loop. Lower productivity per worker drives labor costs up and profits down. With modest demand, businesses don’t see enough ROI from increased capital spending and thus are hesitant to invest in the equipment needed to make workers more efficient or the research necessary for the next technological breakthrough.

Putting all of this in perspective leaves us with a comprehensive assessment of why this expansion has been steady but modest and why it looks likely to continue well into 2018. The longest expansion in U.S. history occurred from 1991 to 2001 (120 months); the current one could potentially turn out to be even longer. With a disciplined Fed, no adverse geopolitical events, and some modest reductions in small and medium business taxes, we might have more than a year left for this expansion. While we want productivity and innovation to grow at better rates, there is an offsetting benefit: this slow and steady expansion is likely to continue.

3Q17-GRD Chart 2


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