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Will the United States Experience a Sustained Boom in the Growth Rate of Labor Productivity?

Blue Planet Studio/Shutterstock

Recent articles in the business press have discussed the possibility that the U.S. economy is entering a period of higher growth in labor productivity:

“Fed’s Goolsbee Says Strong Hiring Hints at Productivity Growth Burst” (link)

“US Productivity Is on the Upswing Again. Will AI Supercharge It?” (link)

“Can America Turn a Productivity Boomlet Into a Boom?” (link)

In Macroeconomics, Chapter 16, Section 16.7 (Economics, Chapter 26, Section 26.7), we highlighted the role of growth in labor productivity in explaining the growth rate of real GDP using the following equations. First, an identity:

Real GDP = Number of hours worked x (Real GDP/Number of hours worked),

where (Real GDP/Number of hours worked) is labor productivity.

And because an equation in which variables are multiplied together is equal to an equation in which the growth rates of these variables are added together, we have:

Growth rate of real GDP = Growth rate of hours worked + Growth rate of labor productivity

From 1950 to 2023, real GDP grew at annual average rate of 3.1 percent. In recent years, real GDP has been growing more slowly. For example, it grew at a rate of only 2.0 percent from 2000 to 2023. In February 2024, the Congressional Budget Office (CBO) forecasts that real GDP would grow at 2.0 percent from 2024 to 2034. Although the difference between a growth rate of 3.1 percent and a growth rate of 2.0 percent may seem small, if real GDP were to return to growing at 3.1 percent per year, it would be $3.3 trillion larger in 2034 than if it grows at 2.0 percent per year. The additional $3.3 trillion in real GDP would result in higher incomes for U.S. residents and would make it easier for the federal government to reduce the size of the federal budget deficit and to better fund programs such as Social Security and Medicare. (We discuss the issues concerning the federal government’s budget deficit in this earlier blog post.)

Why has growth in real GDP slowed from a 3.1 percent rate to a 2.0 percent rate? The two expressions on the right-hand side of the equation for growth in real GDP—the growth in hours worked and the growth in labor productivity—have both slowed. Slowing population growth and a decline in the average number of hours worked per worker have resulted in the growth rate of hours worked to slow substantially from a rate of 2.0 percent per year from 1950 to 2023 to a forecast rate of only 0.4 percent per year from 2024 to 2034.

Falling birthrates explains most of the decline in population growth. Although lower birthrates have been partially offset by higher levels of immigration in recent years, it seems unlikely that birthrates will increase much even in the long run and levels of immigration also seem unlikely to increase substantially in the future. Therefore, for the growth rate of real GDP to increase significantly requires increases in the rate of growth of labor productivity.

The Bureau of Labor Statistics (BLS) publishes quarterly data on labor productivity. (Note that the BLS series is for labor productivity in the nonfarm business sector rather than for the whole economy. Output of the nonfarm business sector excludes output by government, nonprofit businesses, and households. Over long periods, growth in real GDP per hour worked and growth in real output of the nonfarm business sector per hour worked have similar trends.) The following figure is taken from the BLS report “Productivty and Costs,” which was released on February 1, 2024.

Note that the growth in labor productivity increased during the last three quarters of 2023, whether we measure the growth rate as the percentage change from the same quarter in the previous year or as growth in a particular quarter expressed as anual rate. It’s this increase in labor productivity during 2023 that has led to speculation that labor productivity might be entering a period of higher growth. The following figure shows labor productivity growth, measured as the percentage change from the same quarter in the previous year for the whole period from 1950 to 2023.

The figure indicates that labor productivity has fluctuated substantially over this period. We can note, in particular, productivity growth during two periods: First, from 2011 to 2018, labor productivity grew at the very slow rate of 0.9 percent per year. Some of this slowdown reflected the slow recovery of the U.S. economy from the Great Recession of 2007-2009, but the slowdown persisted long enough to cause concern that the U.S. economy might be entering a period of stagnation or very slow growth.

Second, from 2019 through 2023, labor productivity went through very large swings. Labor productivity experienced strong growth during 2019, then, as the Covid-19 pandemic began affecting the U.S. economy, labor productivity soared through the first half of 2021 before declining for five consecutive quarters from the first quarter of 2022 through the first quarter of 2023—the first time productivity had fallen for that long a period since the BLS first began collecting the data. Although these swings were particularly large, the figure shows that during and in the immediate aftermath of recessions labor productivity typically fluctuates dramatically. The reason for the fluctuations is that firms can be slow to lay workers off at the beginning of a recession—which causes labor productivity to fall—and slow to hire workers back during the beginning of an economy recovery—which causes labor productivity to rise.

Does the recent increase in labor productivity growth represent a trend? Labor productivity, measured as the percentage change since the same quarter in the previous year, was 2.7 percent during the fourth quarter of 2023—higher than in any quarter since the first quarter of 2021. Measured as the percentage change from the previous quarter at an annual rate, labor productivity grew at a very high average rate of 3.9 during the last three quarters of 2023. It’s this high rate that some observers are pointing to when they wonder whether growth in labor productivity is on an upward trend.

As with any other economic data, you should use caution in interpreting changes in labor productivity over a short period. The productivity data may be subject to large revisions as the two underlying series—real output and hours worked—are revised in coming months. In addition, it’s not clear why the growth rate of labor productivity would be increasing in the long run. The most common reasons advanced are: 1) the productivity gains from the increase in the number of people working from home since the pandemic, 2) businesses’ increased use of artificial intelligence (AI), and 3) potential efficiencies that businesses discovered as they were forced to operate with a shortage of workers during and after the pandemic.

To this point it’s difficult to evaluate the long-run effects of any of these factors. Wconomists and business managers haven’t yet reached a consensus on whether working from home increases or decreases productivity. (The debate is summarized in this National Bureau of Economic Research Working Paper, written by Jose Maria Barrero of Instituto Tecnologico Autonomo de Mexico, and Steven Davis and Nicholas Bloom of Stanford. You may need to access the paper through your university library.)

Many economists believe that AI is a general purpose technology (GPT), which means that it may have broad effects throughout the economy. But to this point, AI hasn’t been adopted widely enough to be a plausible cause of an increase in labor productivity. In addition, as Erik Brynjolfsson and Daniel Rock of MIT and Chad Syverson of the University of Chicago argue in this paper, the introduction of a GPT may initially cause productivity to fall as firms attempt to use an unfamiliar technology. The third reason—efficiency gains resulting from the pandemic—is to this point mainly anecdotal. There are many cases of businesses that discovered efficiencies during and immediately after Covid as they struggled to operate with a smaller workforce, but we don’t yet know whether these cases are sufficiently common to have had a noticeable effect on labor productivity.

So, we’re left with the conclusion that if the high labor productivity growth rates of 2023 can be maintained, the growth rate of real GDP will correspondingly increase more than most economists are expecting. But it’s too early to know whether recent high rates of labor productivty growth are sustainable.

Glenn’s Presentation at the ASSA Session on “The U.S. Economy: Growth, Stagnation or Financial Crisis and Recession?”

Glenn participated in this session hosted by the Society of Policy Modeling and the American Economic Association of Economic Educators and moderated by Dominick Salvatore of Fordham University. (Link to the page for this session in the ASSA program.)

Also making presentations at the session were Robert Barro of Harvard University, Janice Eberly of Northwestern University, Kenneth Rogoff of Harvard University, and John Taylor of Stanford University.

Here is the abstract for Glenn’s presentation:

Economic growth is foundational for living standards and as an objective for economic policy. The emergence of Artificial Intelligence as a General Purpose Technology, on the one hand, and a number of demographic and budget challenges, on the other hand, generate an unusually wide range of future economic outcomes. I focus on key ‘policy’ and ‘political economy’ considerations that increase the likelihood of a more favorable growth path given pre-existing trends and technological possibilities. By ‘policy,’ I consider mechanisms enabling growth through research, taxation, the scope of regulation, and competition. By ‘political economy’ factors, I consider mechanisms to increase economic participation in support of growth and policies that enhance it. I argue that both sets of mechanisms are necessary for a viable pro-growth economic policy framework.

These slides from the presentation highlight some of Glenn’s key points. (Note the cover of the new 9th edition of the textbook in slide 7!)

Glenn, Harry Holzer, and Michael Strain Analyze the Effect of Changes in Unemployment Benefits during the Pandemic

A job fair in Jackson, Mississippi (photo from the Associated Press)

As part of the Social Security Act of 1935,Congress created the unemployment insurance program to make payments to unemployed workers. The program run jointly by the federal government and the state governments. It’s financed primarily by state and federal taxes on employers. States are allowed to determine which workers are eligible, the dollar amount of the unemployment benefit workers will receive, and for how long workers will receive the benefit.

What’s the purpose of the unemployment insurance program? A document published the U.S. Department of Labor explains that: “Unemployment compensation is a social insurance program. It is designed to provide benefits to most individuals out of work, generally through no fault of their own, for periods between jobs…. [Unemployment compensation] ensures that a significant proportion of the necessities of life can be met on a week-to-week basis while a search for work takes place.”

But the same document also notes that unemployment compensation “maintains [unemployed workers’] purchasing power which also acts as an economic stabilizer in times of economic downturn.” By “economic stabilizer,” the Department of Labor is noting that unemployment compensation is what in Macroeconomics, Chapter 16, Section 16.1 (Economics, Chapter 26, Section 26.1) we call an automatic stabilizer. An automatic stabilizer is a government spending or taxing program that automatically increases or decreases along with the business cycle.

As shown in the following figure, when the economy enters a recession, the total amount of unemployment compensation payments increases without the federal government or the state governments having to take any action because eligibility for the payments is already defined in existing law. So, during a recession, the unemployment insurance program helps to keep aggregate demand higher than it would otherwise be, which can lessen the severity of the recession.

As we discuss in Macroeconomics, Chapter 9, Section 9.3 (Economics, Chapter 19, Section 19.3), the unemployment insurance program can have an unintended effect. The higher the unemployment insurance payment a worker receives and the longer the worker receives it, the more likely the worker is to delay searching for another job. In other words, by reducing the opportunity cost of being unemployed, unemployment insurance benefits may unintentionally increase the length of unemployment spells—the amount of time the typical worker is unemployed.

During and immediately after the 2020 recession, the federal government increased the dollar amount of the unemployment insurance payments that workers received and extended the number of months workers could continue to receive these payments. Under the American Rescue Plan, a law which President Biden proposed and Congress passed in March 2021, workers receiving unemployment insurance benefits received an additional $300 weekly from March 2021 until September 6, 2021. Also, under the law, people, such as the self-employed and gig workers, would receive unemployment insurance benefits even though they had previously been ineligible to receive them. (Note the resulting spike during this period in the total dollar amount of unemployment insurance benefits as shown in the above figure.)

Some state governments were concerned that the extended benefits might cause some workers to delay taking jobs, thereby slowing the recovery of these states’ economies from the effects of the pandemic. Accordingly, 18 states stopped participating in the programs in June 2021, meaning that at that time unemployed workers would no longer receive the extra $300 per week and workers who prior to March 2021 hadn’t been eligible to receive unemployment benefits would again be ineligible.

Were unemployed workers in the states that ended the expanded unemployment insurance benefits in June more likely to become employed than were unemployed workers in states that continued the expanded benefits into September? On the one hand, ending the expanded benefits would increase the opportunity cost of not having a job. But, on the other hand, because government payments to workers would decline in these states, the result could be a decline in consumer spending that would decrease the demand for labor. Which of these effects was larger would determine whether employment increased or decreased in the states that ended expanded unemployment benefits early.

Glenn, along with Harry Holzer of Georgetown University and Michael Strain of the American Enterprise Institute, carried out an econometric analysis to explore the effects ending expanded unemployment benefits early had on the labor markets in those states. They find that:

Among unemployed workers ages 25 to 54 (“prime-age workers”), ending the expanded unemployment benefit program increased the number of workers in those states who moved from being unemployed to being employed by 14 percentage points.
Among prime-age workers, the employment-to-population ratio in those states increased by about 1 percentage point.
Among prime-age workers, the unemployment rate in those stated decreased by about 0.9 percentage point.

These estimates indicate that the effect of ending the expanded unemployment benefit program raised the opportunity cost of being unemployed more than it decreased the demand for labor by reducing the incomes of some household. But what about the larger question of whether households were made better or worse off as a result of ending the program early? The authors find that ending the program early decreased the share of households that had no difficulty meeting expenses. They, therefore, conclude that the effects on household well-being of ending the program early are ambiguous.

The paper presenting these results can be found here. Warning! The econometric analysis is quite technical.

What Explains the Surprising Surge in the Federal Budget Deficit?

Figure from CBO’s monthly budget report.

During 2023, GDP and employment have continued to expand. Between the second quarter of 2022 and the second quarter of 2023, nominal GDP increased by 6.1 percent. From July 2022 to July 2023, total employment increased by 3.3 million as measured by the establishment (or payroll) survey and by 3.0 as measured by the household survey. (In this post, we discuss the differences between the employment measures in the two surveys.)

We would expect that with an expanding economy, federal tax revenues would rise and federal expenditures on unemployment insurance and other transfer programs would decline, reducing the federal budget deficit. (We discuss the effects of the business cycle on the federal budget deficit in Macroeconomics, Chapter 16, Section 16.6, Economics, Chapter 26, Section 26.6, and Essentials of Economics, Chapter 18, Section 18.6.) In fact, though, as the figure from the Congressional Budget Office (CBO) at the top of this post shows, the federal budget deficit actually increased substantially during 2023 in comparison with 2022. The federal budget deficit from the beginning of government’s fiscal year on October 1, 2022 through July 2023 was $1,617 billion, more than double the $726 billion deficit during the same period in fiscal 2022.

The following figure from an article in the Washington Post uses data from the Committee for a Responsible Federal Budget to illustrate changes in the federal budget deficit in recent years. The figure shows the sharp decline in the federal budget deficit in 2022 as the economic recovery from the Covid–19 pandemic increased federal tax receipts and reduced federal expenditures as emergency spending programs ended. Given the continuing economic recovery, the surge in the deficit during 2023 was unexpected.

As the following figure shows, using CBO data, federal receipts—mainly taxes—are 10 percent lower this year than last year, and federal outlays—including transfer payments—are 11 percent higher. For receipts to fall and outlays to increase during an economic expansion is very unusual. As an article in the Wall Street Journal put it: “Something strange is happening with the federal budget this year.”

Note: The values on the vertical axis are in billions of dollars.

The following figure shows a breakdown of the decline in federal receipts. While corporate taxes and payroll taxes (primarily used to fund the Social Security and Medicare systems) increased, personal income tax receipts fell by 20 percent, and “other receipts” fell by 37 percent. The decline in other receipts is largely the result of a decline in payments from the Federal Reserve to the U.S. Treasury from $99 billion in 2022 to $1 billion in 2023. As we discuss in Macroeconomics, Chapter 17, Section 17.4 (Economics, Chapter 27, Section 27.4), Congress intended the Federal Reserve to be independent of the rest of the government. Unlike other federal agencies and departments, the Fed is self-financing rather than being financed by Congressional appropriations. Typically, the Fed makes a profit because the interest it earns on its holdings of Treasury securities is more than the interest it pays banks on their reserve deposits. After paying its operating costs, the Fed pays the rest of its profit to the Treasury. But as the Fed increased its target for the federal funds rate beginning in March 2022, it also increased the interest rate it pays banks on their reserve deposits. Because most of the securities it holds pay low interest rates, the Fed has begun running a deficit, reducing the payments it makes to the Treasury.

Note: The values on the vertical axis are in billions of dollars.

The reasons for the sharp decline in individual income taxes are less clear. The decline was in the “nonwithheld category” of individual income taxes; federal income taxes withheld from worker paychecks increased. People who are self-employed or who receive substantial income from sources such as capital gains from selling stocks, make quarterly estimated income tax payments. It’s these types of personal income taxes that have been unexpectedly low. Accordingly, smaller capital gains may be one explanation for the shortfall in federal revenues, but a more complete explanation won’t be possible until more data become available later in the year.

The following figure shows the categories of federal outlays that have increased the most from 2022 to 2023. The largest increase is in spending on Social Security, Medicare, and Medicaid, with spending on Social Security alone increasing by $111 billion. This increase is due partly to an increase in the number of retired workers receiving benefits and partly to the sharp rise in inflation, because Social Security is indexed to changes in the consumer price index (CPI). Spending on Medicare increased by $66 billion or a surprisingly large 18 percent. Interest payments on the public debt (also called the federal government debt or the national debt) increased by $146 billion or 34 percent because interest rates on newly issued Treasury securities rose as nominal interest rates adjusted to the increase in inflation and because the public debt had increased significantly as a result of the large budget deficits of 2020 and 2021. The increase in spending by the Department of Education reflects the effects of the changes the Biden administration made to student loans eligible for the income-driven repayment plan. (We discuss the income-driven repayment plan for student loans in this blog post.)

Note: The values on the vertical axis are in billions of dollars.

The surge in federal government outlays occurred despite a $120 billion decline in refundable tax credits, largely due to the expiration of the expansion of the child tax credit Congress enacted during the pandemic, a $98 billion decline in Treasury payments to state and local governments to help offset the financial effects of the pandemic, and $59 billion decline in federal payments to hospitals and other medical facilities to offset increased costs due to the pandemic.

In this blog post from February, we discussed the challenges posed to Congress and the president by the CBO’s forecasts of rising federal budget deficits and corresponding increases in the federal government’s debt. The unexpected expansion in the size of the federal budget deficit for the current fiscal year significantly adds to the task of putting the federal government’s finances on a sound basis.

How Did the United States Reduce the Debt-to-GDP Ratio after World War II?

Main Gun Mount Assembly Plant, Northern Pump Co. Plant, Fridley, Minnesota, 1942. (Photo from the Franklin D. Roosevelt Presidential Library & Museum.)

To fight World War II, the federal government had to dramatically increase spending. As the following figure shows, total federal spending rose from $6.8 billion in 1940 to a peak of $100.1 billion in 1944. National defense spending made up most of the increase, rising from $2.8 billion in 1940 to $97.3 billion in 1944.

Part of the increased spending was paid for by increases in taxes. Total federal tax receipts rose from $6.2 billion in 1940 to $35.8 billion in 1945. Individual income taxes rose from $1.0 billion in 1940 to 18.6 billion in 1945. Tax rates were raised and the minimum income at which people had to pay tax on their income was reduced. From the introduction of the federal individual income tax in 1913 until 1940, only people who had at least upper middle class incomes paid any federal income taxes. Following the passage by Congress of the Revenue Act of 1942, most workers had to pay federal income taxes. In 1940, 7.4 million people had to pay federal individual income taxes. In 1945, 42.7 million people had to. For the first time, the federal government withheld taxes from workers paychecks. Previously, all taxes were due on March 15th of the year following the year being taxed. Milton Friedman, who in the 1970s won the Nobel Prize in Economics, was part of the team at the U.S. Treasury that designed and implemented the system of withholding income taxes. Withholding of individual income taxes has continued to the present day.

Although large, the increases in federal taxes were insufficient to fund the massive military spending required to win the war. As a result, the U.S. Treasury had to greatly increase its sales of Treasury bonds. Recall from Macroeconomics, Chapter 16, Section 16.6 (Economics, Chapter 26, Section 26.6 and Essentials of Economics, Chapter 18, Section 18.6) that the total value of outstanding Treasury bonds is called the federal government debt, sometimes called the national debt. The part of federal government debt held by the public rather than by government agencies, such as the Social Security Trust Funds, is call the public debt. In order to gauge the effects of the debt on the economy, economists typically look at the size of the public debt relative to GDP. The following figure shows the public debt as a percentage of GDP for the years from 1929 to 2022.

The figure shows that the ratio of debt to GDP increased sharply from 1929 to the mid-1930s, reflecting the federal budget deficits resulting from the Great Depression, and then soared beginning in 1940. Debt peaked at 113 percent of GDP in 1945 and then began a long decline that lasted until 1974, when debt had fallen to 23 percent of GDP. The ratio of debt to GDP then fluctuated until the Great Recession of 2007-2009 when it began a steady increase that turned into a surge during and after the Covid-19 pandemic. (We discuss the causes of the recent surge in debt in this blog post.)

What caused the long decline in the ratio of debt to GDP that began in 1946 and continued until 1974? The usual explanation is that the decline was not primarily due to the federal government paying off a signficiant portion of the debt. The public debt did decline from a peak of $241.9 billion in 1946 to $214.3 billion in 1949 but there were no significant declines in the level of the public debt after 1949. Instead the ratio of debt to GDP declined because GDP grew faster than did the debt.

Recently in a National Bureau of Economic Research Working Paper, “Did the U.S. Really Grow Out of Its World War II Debt?” Julien Acalin and Laurence M. Ball of Johns Hopkins University have analyzed the issue more closely. They conclude that economic growth played a smaller role in reducing the debt-to-GDP ratio than has previously been thought. In particular, they highlight the fact that for significant periods through the 1970s, the Treasury was able to pay a real interest rate on the debt that was lower than market rates. Lower real interest rates reduced the amount by which the debt might otherwise have grown.

As we discuss in Money, Banking, and the Financial System, Chapter 13, Section 13.2, in April 1942, to support the war effort, the Federal Reserve announced that it would fix interest rates on Treasury securities at low levels: 0.375 percent on Treasury bills and 2.5 percent on Tresaury bonds. This policy continued after the end of the war in 1945 until the Fed was allowed to abandon the policy of pegging the interest rates on Treasury securities following the March 1951 Treasury-Federal Reserve Accord. Acalin and Ball also note that even after the Accord, there were periods in which actual inflation was well above expected inflation, causing the real interest rate the Treasury was paying on debt to be below the expected real interest rate. In other words, part of the falling debt-to-GDP ratio was financed by investors receiving lower returns on their purchases of Treasury securities than they had expected to.

Acalin and Ball conclude that if the Treasury had not done the relatively small amount of debt repayment mentioned earlier and if it had had to pay market real interest rates on the debt, debt would have declined to only 74 percent of GDP in 1974, rather than to 23 percent.

Sources: The debt and GDP data are from the Congressional Budget Office, which can be found here, and from the Office of Management and the Budget, which can be found here.

Bad News from the Congressional Budget Office

In 1974, Congress created the Congressional Budget Office (CBO). The CBO was given the responsibility of providing Congress with impartial economic analysis as it makes decisions about the federal government’s budget. One of the most widely discussed reports the CBO issues is the Budget and Economic Outlook. The report provides forecasts of future federal budget deficits and changes in the federal government’s debt that the budget deficits will cause. The CBO’s budget and debt forecasts rely on the agency’s forecasts of future economic conditions and assumes that Congress will make no changes to current laws regarding taxing and spending. (We discuss this assumption further below.)

On February 15, the CBO issued its latest forecasts. The forecasts showed a deterioration in the federal government’s financial situation compared with the forecasts the CBO had issued in May 2022. (You can find the full report here.) Last year, the CBO forecast that the federal government’s cumulative budget deficit from 2023 through 2032 would be $15.7 trillion. The CBO is now forecasting the cumulative deficit over the same period will be $18.8 trillion. The three main reason for the increase in the forecast deficits are:

1. Congress has increased spending—particularly on benefits for military veterans.

2) Cost-of-living adjustments for Social Security and other government programs have increased as a result of higher inflation.

3) Interest rates on Treasury debt have increased as a result of higher inflation.

The CBO forecasts that federal debt held by the public will increase from 98 percent of GDP in 2023 to 118 percent in 2033 and eventually to 198 percent in 2053. Note that economists prefer to measure the size of the debt relative to GDP rather than in as absolute dollar amounts for two main reasons: First, measuring debt relative to GDP makes it easier to see how debt has changed over time in relation to the growth of the economy. Second, the size of debt relative to GDP makes it easier to gauge the burden that the debt imposes on the economy. When debt grows more slowly than the economy, as measured by GDP, crowding effects are likely to be relatively small. We discuss crowding out in Macroeconomics, Chapter 10, Section 10.2 and Chapter 16, Section 16. 5 (Economics, Chapter 20, Section 20.2 and Chapter 26, Section 26.5). The two most important factors driving increases in the ratio of debt to GDP are increased spending on Social Security, Medicare, and Medicaid, and increased interest payments on the debt.

The following figure is reproduced from the CBO report. It shows the ratio of debt to GDP with actual values for the period 1900-2022 and projected values for the period 2023-2053. Note that the only other time the ratio of debt to GDP rose above 100 percent was in 1945 and 1946 as a result of the large increases in federal government spending required to fight World War II.

The increased deficits and debt over the next 10 years are being driven by government spending increasing as a percentage of GDP, while government revenues (which are mainly taxes) are roughly stable as a percentage of GDP. The following figure from the report shows actual federal outlays and revenues as a percentage of GDP for the period 1973-2022 and projected outlays and revenues for the period 2023-2033. Note that from 1973 to 2022, outlays averaged 21.0 percent of GDP and revenues averaged 17.4 percent of GDP, resulting in an average deficit of 3.6 percent of GDP. By 2033, outlays are forecast to rise to 24.9 percent of GDP–well above the 1973-2022 average–whereas revenues are forecast to be only 18.1 percent, for a forecast deficit of 6.8 percent of GDP.

The increase in outlays is driven primarily by increases in mandatory spending, mainly spending on Social Security, Medicare, Medicaid, and veterans’ benefits and increases in interest payments on the debt. The CBO’s forecast assumes that discretionary spending will gradually decline over the next 10 years as percentage of GDP. Discretionary spending includes federal spending on defense and all other government programs apart from those, like Social Security, where spending is mandated by law.

To avoid the persistent deficits, and increasing debt that results, Congress would need to do one (or a combination) of the following:

1. Reduce the currently scheduled increases in mandatory spending (in political discussions this alternative is referred to as entitlement reform because entitlements is another name for manadatory spending).

2. Decrease discretionary spending, the largest component of which is defense spending.

3. Increases taxes.

There doesn’t appear to be majority support in Congress for taking any of these steps.

The CBO’s latest forecast seems gloomy, but may actually understate the likely future increases in the federal budget deficit and federal debt. The CBO’s forecast assumes that future outlays and taxes will occur as indicated in current law. For example, the forecast assumes that many of the tax cuts Congress passed in 2017 will expire in 2025 as stated in current law. Many political observers doubt that Congress will allow the tax cuts to expire as scheduled because to do so would result in increases in individual income taxes for most people. (Here is a recent article in the Washington Post that discusses this point. A subscription may be required to access the full article.) The CBO also assumes that defense spending will not increase beyond what is indicated by current law. Many political observers believe that, in fact, Congress may feel compelled to substantially increase defense spending as a result of Russia’s invasion of Ukraine in February 2022 and the potential military threat posed by China.

The CBO forecast also assumes that the U.S. economy won’t experience a recession between 2023 and 2033, which is possible but unlikely. If the economy does experience a recession, federal outlays for unemployment insurance and other programs will increase and federal personal and corporate income tax revenues will fall. The CBO’s forecast also assumes that the interest rate on the 10-year Treasury note will be under 4 percent and that the federal funds rate will be under 3 percent (interest rates on short-term Treasury debt move closely with changes in the federal funds rate). If interest rates turn out to be higher than these forecasts, the federal government’s interest payments will increase, further increasing the deficit and the debt.

In short, the federal government is clearly facing the most difficult budgetary situation since World War II.

Are We at the Start of a Recession?

On Thursday morning, April 28, the Bureau of Economic Analysis (BEA) released its “advance” estimate for the change in real GDP during the first quarter of 2022. As shown in the first line of the following table, somewhat surprisingly, the estimate showed that real GDP had declined by 1.4 percent during the first quarter. The Federal Reserve Bank of Atlanta’s “GDP Now” forecast had indicated that real GDP would increase by 0.4 percent in the first quarter. Earlier in April, the Wall Street Journal’s panel of academic, business, and financial economists had forecast an increase of 1.2 percent. (A subscription may be required to access the forecast data from the Wall Street Journal’s panel.)

Do the data on real GDP from the first quarter of 2022 mean that U.S. economy may already be in recession? Not necessarily, for several reasons:

First, as we note in the Apply the Concept, “Trying to Hit a Moving Target: Making Policy with ‘Real-Time’ Data,” in Macroeconomics, Chapter 15, Section 15.3 (Economics, Chapter 25, Section 25.3): “The GDP data the BEA provides are frequently revised, and the revisions can be large enough that the actual state of the economy can be different for what it at first appears to be.”

Second, even though business writers often define a recession as being at least two consecutive quarters of declining real GDP, the National Bureau of Economic Research has a broader definition: “A recession is a significant decline in activity across the economy, lasting more than a few months, visible in industrial production, employment, real income, and wholesale-retail trade.” Particularly given the volatile movements in real GDP during and after the pandemic, it’s possible that even if real GDP declines during the second quarter of 2022, the NBER might not decide to label the period as being a recession.

Third, and most importantly, there are indications in the underlying data that the U.S. economy performed better during the first quarter of 2022 than the estimate of declining real GDP would indicate. In a blog post in January discussing the BEA’s advance estimate of real GDP during the fourth quarter of 2021, we noted that the majority of the 6.9 percent increase in real GDP that quarter was attributable to inventory accumulation. The earlier table indicates that the same was true during the first quarter of 2022: 60 percent of the decline in real GDP during the quarter was the result of a 0.84 decline in inventory investment.

We don’t know whether the decline in inventories indicates that firms had trouble meeting demand for goods from current inventories or whether they decided to reverse some of the increases in inventories from the previous quarter. With supply chain disruptions continuing as China grapples with another wave of Covid-19, firms may be having difficulty gauging how easily they can replace goods sold from their current inventories. Note the corresponding point that the decline in sales of domestic product (line 2 in the table) was smaller than the decline in real GDP.

The table below shows changes in the components of real GDP. Note the very large decline exports and in purchases of goods and services by the federal government. (Recall from Macroeconomics, Chapter 16, Section 16.1, the distinction between government purchases of goods and services and total government expenditures, which include transfer payments.) The decline in federal defense spending was particularly large. It seems likely from media reports that the escalation of Russia’s invasion of Ukraine will lead Congress and President Biden to increase defense spending.

Notice also that increases in the non-government components of aggregate demand remained fairly strong: personal consumption expenditures increased 2.7 percent, gross private domestic investment increased 2.3 percent, and imports surged by 17.7 percent. These data indicate that private demand in the U.S. economy remains strong.

So, should we conclude that the economy will shrug off the decline in real GDP during the first quarter and expand during the remainder of the year? Unfortunately, there are still clouds on the horizon. First, there are the difficult to predict effects of continuing supply chain problems and of the war in Ukraine. Second, the Federal Reserve has begun tightening monetary policy. Whether Fed Chair Jerome Powell will be able to bring about a soft landing, slowing inflation significantly while not causing a large jump in unemployment, remains the great unknown of economic policy. Finally, if high inflation rates persist, households and firms may respond in ways that are difficult to predict and, may, in particular decide to reduce their spending from the current strong levels.

In short, the macroeconomic forecast is cloudy!

Source: The BEA’s web site can be found here.

Glenn on Economic Growth and Its Social Consequences

Adam Smith bronze statue on Royal Mile Market square in front of Saint Gilles Cathedral in Edinburgh, Scotland.

Growth matters. A lot. A slightly higher rate of economic growth, sustained over time, can make the difference between a big increase in living standards and relative stagnation. Whether we can still generate strong and steady growth is a “$64,000 question” for the economy — the question. Nobel Prize–winning economist Robert Lucas famously observed that once economists think of long-term growth, it is hard to think of anything else. A pro-growth policy agenda is a good idea because growth is a good idea.

But a deeper question remains: Is public support for growth guaranteed? Oren Cass of American Compass refers to growth and economists’ fealty to economic participation for all as “economic piety.” This critique resonates for a simple reason: Forces that propel growth invariably leave a wake of economic disruption for people in many places and political disruption for the nation. A serious discussion of pro-growth policy must account for that disruption.

A conventional pro-growth policy agenda can be enhanced by support for openness to markets, ideas, and new ways of doing things, and for the ability of firms to adapt to change. Such an enhanced agenda would center on infrastructure broadly defined, development and dissemination of better management practices, and reduced barriers to competition.

Yet the political process, and even many a conservative, is openly skeptical of such an agenda. This skepticism is rooted not in disagreement over the future of scientific advances or of organizational adaptation — but in a concern that growth’s benefits be shared broadly. Addressing this skepticism head-on is essential for rebuilding social support for growth and for countering well-meaning but potentially harmful policies.

The system that needs defending is a mature and successful one. Adam Smith, the great proponent of the “invisible hand” (not the visible hand of a state-directed economy), saw openness and competition as worth the candle. His 1776 publication of The Wealth of Nations came before what we would recognize today as industrial capitalism, though technological change and globalization were features of economic debates in the aftermath of Smith’s ideas.

Smith’s radical insight is central to economic policy today: National prosperity (the “wealth of a nation”) is represented by consumption of goods and services by its people — i.e., their living standards. The goal of the economy in Smith’s telling was to make the economic pie as large as possible. His advocacy of free markets and competition rested on their ability to boost consumption possibilities.

Two centuries later, Nobel laureates Kenneth Arrow and Gérard Debreu added the jargon and mathematics of contemporary economics to formalize Smith’s intuition. While individuals and firms act independently, competitive markets lead to an efficient allocation of resources and a maximized economic pie. Friedrich Hayek, another Nobel laureate, hailed the virtue of a decentralized competitive price system in maximizing economic activity.

Smith’s radicalism draws from his attack on mercantilism—the economic orthodoxy of the day—which stressed a zero-sum view of trade and state intervention to promote and protect certain firms and industries. (Sound familiar?) His second radical insight was that the “nation” did not mean the sovereign and the well-connected. In Smith’s view, individuals as consumers—all people—were kings. Finally, channeling the sympathetic concern espoused in his earlier classic, The Theory of Moral Sentiments, Smith championed mass participation in the productive economy as a precondition for human flourishing.

It is fair to say that Smith lacked a theory of per capita growth in the economy over time; indeed, he wrote before the massive increase in living standards attendant upon the Industrial Revolution. After 1800, per capita income in the United Kingdom — and the United States — witnessed a 30-fold increase. There have also been major improvements in the quality of goods and services that such a statistic doesn’t quite capture. And, of course, many of today’s offerings — from smartphones to computers to air-conditioning — were not available even in 1900, let alone 1800.

That lacuna in Smith’s theory partly reflects technical difficulties in modeling growth. Higher output can come from growth in inputs such as labor and capital, but what determines their growth? Today’s economists highlight population growth and society’s willingness to work, save, and invest. Still more important is growth in productivity, or the efficiency with which inputs are used to produce goods and services.

Smith’s pin-factory example — in which output rose with the specialization of tasks — links how things are done with the level of productivity. But what factors determine productivity growth over time? Today’s economic analysis focuses on technology and the process of generating ideas. Since economic growth is still crucial for people seemingly marginalized by capitalism, it’s worth asking whether the economic foundations expressed in The Wealth of Nations are still relevant today. Where does growth come from now? And do those sources still require openness and competition?

The short answer is that they do, but to see why, we need to focus on the ideas of two prominent economists after 1800: Edmund Phelps and Deirdre Nansen McCloskey.

Phelps, a Nobel laureate, has done much to connect growth to Smith’s foundational ideas. He starts with Smith’s emphasis on a great many individuals (not the state or privileged firms) searching for new and better ways of doing things. This relentless search produces innovative ideas, processes, and goods that drive growth — but only if the political economy allows openness. Smith’s messy, “bottom up” version of the market therefore puts mass innovation at the heart of economic growth. Phelps’s argument reflects how Smithian societies committed to openness are best able to prosper and promote growth.

This argument has two important applications. The first is to debunk the sometimes fashionable view of secular productivity decline — that we have run short of new things to discover and exploit. The second is to give an answer to economies struggling with growth in a period of structural changes from technology and globalization. Slowdowns in innovation are likely not due to scientific barrenness but to walls against openness and change — that is, fears of disruption.

Phelps’s concern with economic dynamism draws him to Smith’s arguments against mercantilist tinkering in the economy. Like Smith, he worries about the hidden costs of tinkering with competition by blocking change from the outside and by enabling rent-seeking on the inside. These “corporatist” policies — fashionable among some conservatives at present — inevitably embolden vested interests and cronyism, slowing change and growth. Even seemingly small interventions can subtly diminish innovation, a point to which I’ll return.

Yet such a critique must acknowledge the political consequences of disruption. Dynamism is messy. It creates growth in the aggregate, but with many individual losers as well as individual gainers.

McCloskey, an economic historian, has similarly identified the continuous, large-scale, voluntary, and unfocused search for betterment as the source of new ideas that can produce economic growth. She sees this “innovism” as primarily a cultural force, preferring the term to the more familiar “capitalism,” and connects innovism to economic liberalism. Echoing Smith, she emphasizes how an open economy allows individuals—from the moderately to the spectacularly talented—to “have a go.” This economic liberalism allows competition to enshrine liberty and mass flourishing.

In McCloskey’s telling, growth depends on a liberal tolerance and openness to change, which encourage many people to be alert to opportunity. Sustaining that tolerance as structural shifts bring economic misfortune to many individuals, however, requires more than devotion to Smith.

Therein lies the current economic-policy rub. Economists’ theories of growth bring to mind a coin: Sunny descriptions of growth and dynamism are “heads,” and hand-wringing over disruption is “tails.” As I observed earlier, growth is messy. It can push some individuals, firms, and even industries off well-worn and comfortable paths.

But Smith offers more in defense of growth than paeans to laissez-faire. Though he is sometimes caricatured as being anti-government in all cases, Smith was principally opposed to mercantilist privileges for specific businesses and industries and to the governmentalization of social affairs. He wanted government to provide what economists today call “public goods,” such as national defense, the criminal-justice system, and enforcement of property rights and contracts the institutional underpinnings of commerce and trade. He also favored support for infrastructure to keep commerce flowing freely.

But Smith went further: To prepare workers and enrich their lives, he called for government to provide universal education, and he drew a connection between education and liberty as well as work in a free society. But boosting participation in today’s economy—participation that provides support for growth—will require a bit more.

Not surprisingly, political reaction to economic disruption brings about — pardon the econ-speak—a “demand” for and “supply” of policy actions. Job losses, firm failures, and diminished industry fortunes bring about a demand for help, for adaptation. The political process responds with a supply of ideas in one of two forms: walls or bridges. Walls are protections against disruption or change. Bridges, ways to get somewhere or back, prepare individuals for the changed economy and help those whose economic participation has been disrupted reenter the workforce.

Proposals for walls are familiar. They can be physical, of course, but they needn’t be. Conservative populists advocate limits on trade and technology, in order to advance industrial policy. Some progressives advocate universal basic income. All these policies would diminish the prospects for economic advances.

The most prominent sort of wall today is what I call “modern corporatism.” It assumes that Smith was wrong: The “wealth of a nation” lies not in consumption or living standards (and so ultimately in growth) but in jobs, good jobs, even particular good jobs, with good manufacturing jobs the very paradigm. The sort of tinkering with the market that drew Smith’s ire may actually be a necessary way of recentering economic policy on jobs, so the theory goes. Opportunities for work, and for the dignity it can bring, are surely important.

A gentle industrial policy devised by social scientists who are worried about jobs is not the answer. It results in state tinkering for special interests, precisely the kind of thing that prompted Smith’s criticism of mercantilism. Moreover, as University of Chicago economist Luigi Zingales argues in A Capitalism for the People, it risks a vicious cycle: A little bit of tinkering becomes a lot of tinkering—and anyone who cannot justify special privileges is left out, calling into question social support for growth. Nevertheless, industrial policy has caught the attention of elected officials on the right, from Donald Trump to Josh Hawley to Marco Rubio. While national security and the border can be exceptions as concerns, advice from Milton Friedman to the party of Ronald Reagan this is not.

That said, economists’ invocation of Smith as a proponent of let-’er-rip laissez-faire is neither faithful to Smith nor particularly helpful to individuals and communities buffeted by disruption. With today’s rapid and long-lasting technological change and globalization, “having a go” requires support for acquiring new skills when they are needed.

That is why we need more bridges. Bridges take us somewhere and bring us back. The journey to somewhere is about preparation for new opportunities. The journey back is about reconnecting to the productive economy when economic forces beyond our control have knocked us away.

Economic bridges have three features. The first is that they help people overcome a specific challenge on their way to economic flourishing — they don’t provide that outcome directly. The second is that wider society builds the bridge, through private organizations, governments, or public–private partnerships, as globalization and technological change have introduced significant risks that individuals by themselves cannot avoid. The third feature is that they avoid restraints on openness to changes in markets and ideas.

We once did better, much better. During the Civil War, President Abraham Lincoln worked with Congress to pass the Morrill Act, directing resources to the development of land-grant colleges around the country, extending higher education to citizens of modest means, and enabling workers to develop skills for new industries, particularly in manufacturing. As World War II drew to a close, President Franklin D. Roosevelt and Congress came together to enact the G.I. Bill, helping to educate returning troops for a changing economy.

Supporting economic growth and undergirding broad participation in the economy require similarly bold ideas. To begin, community colleges are the logical workhorses of skill development and retraining, and their presence in regional economies makes them attractive partners for employers. Yet community colleges have seen their state-level public support wither. The Biden administration calls for free tuition, which would boost demand but provide no support for community college to offer a practical education and an emphasis on completion. Amy Ganz, Austan Goolsbee, Melissa Kearney, and I proposed an alternative approach based on the land-grant-college model. We proposed a supply-side program of federal grants to strengthen community colleges — contingent on improved degree-completion rates and labor-market outcomes. To further encourage training, the federal government could offer a tax credit to compensate firms for the risk of losing trained workers. It could also increase the earned-income tax credit for workers with or without children.

New ideas are also needed to promote workers’ reentry into the workforce. Personal reemployment accounts, for example, would support dislocated workers and offer them a reemployment bonus if they found a new job within a certain period of time. The “personal” refers to individuals’ choosing from a range of training and support services. Another idea is to beef up support for place-based assistance to areas with stubbornly high rates of long-term nonemployment. Such support could be integrated with an increase in the earned-income tax credit and the supply-side investment in community colleges. Building on the decentralized approach in the land-grant colleges and grants to community colleges, expanded place-based aid would be delivered via flexible block grants encouraging business and employment.

Broad public support required for growth and dynamism requires both bridge-building and a political language that frames it. Growth, opportunity, and participation are good, and we do not need a new economics. But phrases like “transition cost” and “inevitable economic forces” must give way to bridges of preparation and reconnection.

‘Why did nobody see it coming?” a quizzical Queen of England questioned a quorum of economists at the London School of Economics about the global financial crisis as it emerged in late 2008. How could major disruptive forces build up over time and yet escape the attention of experts and leaders?

Of the disruptive structural changes accompanying economic dynamism, one might ask a similar question. Growth matters. But that growth is one side of a coin whose flip side is disruption is known, certainly to economists. Why has our political discourse not emphasized this basic point?

Why did we not see fatigue with change coming among the people who most had to bear its ill effects?

However foolishly, we did not. Some so-called conservatives today have responded by saying that we should limit change. Surely a better response is that we should seek ever more growth by allowing unfettered change, but also facilitate the establishing of ever more connections in a growing economy. That classical-liberal answer has the better place in American conservatism — and in American economic life.

— This essay is sponsored by National Review Institute. Originally published h ere.

Hoover Institution Podcast with Lawrence Summers and John Cochrane

Lawrence Summers (Photo from harvardmagazine.com.)

In several of our blog posts and podcasts, we’ve discussed Lawrence Summers’s forecasts of inflation. Beginning in February 2021, Summers, an economist at Harvard who served as Treasury secretary in the Clinton administration, argued that the United States was likely to experience rates of inflation that would be higher and persist longer than Federal Reserve policymakers were forecasting. In March 2021, the members of the Fed’s Federal Open Market Committee had an average forecast of inflation of 2.4 percent in 2021, falling to 2.0 percent in 2022. (The FOMC projections can be found here.)

In fact, inflation measured by the CPI has been above 5 percent every month since June 2021; the Fed’s preferred measure of inflation—the percentage change in the price index for personal consumption expenditures—has been above 5 percent every month since October 2021. Summers’s forecasts of inflation have turned out to be more accurate than those of the members of the Federal Open Committee.

In this podcast, Summers discusses his analysis of inflation with four scholars from the Hoover Institution, including economist John Cochrane. Summers explains why he came to believe in early 2021 that inflation was likely to be much higher than generally expected, how long he believes high rates of inflation will persist, and whether the Fed is likely to be able to achieve a soft landing by bringing inflation back to its 2 percent target without causing a recession. The first half of the podcast, in particular, should be understandable to students who have completed the monetary and fiscal policy chapters (Macroeconomics, Chapters 15 and 16; Economics, Chapters 25 and 26). Background useful for understanding the podcast discussion of monetary policy during the 1970s can be found in Chapter 17, Sections 17.2 and 17.3.

Glenn’s Opinion Column on the Economics of an Increase in Defense Spending

Glenn published the following opinion column in the Wall Street Journal. Link here and full text below.

NATO Needs More Guns and Less Butter

Russia’s unprovoked invasion of Ukraine has challenged Western assumptions about security, economics and the postwar world order. In Europe and the U.S., public finances have long favored social spending over public goods such as defense. While President Biden doubled down on his proposal to increase social spending during his State of the Union address, Russia’s aggression highlights the shortcomings of this model. Western democracies now face a more uncertain and dangerous world than they did two weeks ago. Navigating it will require significantly higher levels of defense and security spending.

But change will be difficult, and the magnitude of what needs to be done is sobering. The U.S. currently spends 3.2% of gross domestic product on defense—roughly half of Cold War spending levels relative to GDP. An increase in spending of even 1% of GDP would amount to about $210 billion. That’s about 5% of the total federal spending level using a 2019 pre-Covid baseline. While Covid spending was large, it was transitory. Defense outlays would be much longer-lasting, an insurance premium or transaction cost for dealing with a more dangerous world.

The U.S. is not alone. Germany’s announcement of €100 billion in additional defense spending this year represents an increase of just over 0.25% of GDP, leaving Berlin still under the 2% commitment agreed to by North Atlantic Treaty Organization allies. Increasing Europe’s defense spending merely to the agreed-on level would require significant outlays. Such spending increases would occur against the backdrop of elevated public debt relative to GDP, brought on in part by heightened borrowing during the Covid pandemic and the earlier global financial crisis. High levels of public debt make it unlikely that countries will want to pay to increase their defense spending with new borrowing.

Paying for higher levels of defense spending will force most governments either to raise taxes or cut spending. Tax increases raise risks to growth. The larger non-U.S. NATO economies are already taxed to the hilt. Tax revenue relative to the size of the economy in France (45%), Germany (38%), Canada (34%) and the U.K. (32%) doesn’t leave much room to tax more without depressing economic activity. The U.S. has a lower tax share of GDP—about 17.5% at the federal level and 25.5% in total—but its patchwork quilt of income and payroll taxes makes tax increases more costly by distorting household and business decisions about consumption and investment.

A significant tax increase in the U.S. would need to be accompanied by fundamental tax reform, dialing back income taxes (as with the 2017 reduction in corporate tax rates) and increasing reliance on consumption taxes. A broad-based consumption tax could be implemented by imposing a tax at the business level on revenue minus purchases from other firms (a “subtraction method” value-added tax). Alternatively, the tax system could impose a broad-based wage and business cash-flow tax, with a progressive wage surtax on high earners. These consumption-tax alternatives would be efficient and equitable in a revenue-neutral tax reform. And they are crucial in avoiding decreases in savings, investment and entrepreneurship that accompany a tax increase.

Since the 1960s, spending on Social Security, Medicare and Medicaid has come to dominate the federal budget. Outlays for these programs have almost doubled since then as a share of GDP to 10.2% today, and the Congressional Budget Office projects they will consume about another 5% of GDP annually by 2040. Spending offsets to accommodate higher defense spending would surely require slowing the growth in social-insurance spending. As with tax increases, there are trade-offs. It is possible to slow the growth of this spending while preserving access to such support for lower-income Americans. Accomplishing that will require focusing net taxpayer subsidies on lower-income Americans, along with undertaking market-oriented health reforms. Such changes require serious attention.

The U.S. and its NATO allies will face a challenging set of economic trade-offs and political realities in achieving higher defense spending. The challenge will be exacerbated by additional private investment needs in a more dangerous world of investment risks, skepticism about globalization, and cybersecurity threats.

In the U.S., the failure of the 2010 Simpson-Bowles Commission’s proposed spending and tax reforms to spark a serious discussion is a warning sign. So, too, is the antipathy of Democratic and Republican officials alike toward creating the fiscal space necessary to accommodate greater defense spending. Such challenges don’t cause threats to vanish. They require leadership—now.