US Economy: Below Stall Speed or Already Above Potential?

April 29th, 2013

by Franz Lischka

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Ever since the economic growth in the USA fell back below 2% on a year-over-year basis, which was in early 2011, there has been talk of below stall speed (the speed, below which an airplane losses lift and falls down to earth) growth and an unavoidable recession. With good reason: Since WWII every time year-over-year growth in the US had fallen below 2%, a recession followed in due course.

Well, until now. The recession is now almost 2 years late and still it has not arrived. Why? Perhaps the sub-2% growth is just not sub-stall speed anymore. Rather it could be actually already above the potential growth rate that people have been waiting for since the Great Recession. Yes, as strange as it sounds, the 1.8% year-over-year growth in real GDP in Q1 2013 (illustrated here) might be the best we can expect … for perhaps the next 10 years.

The cause may not be the debt crisis and the deleveraging process, but rather simple demographics. The reason why a recession always followed when growth fell below 2% is probably because the unemployment rate only fell when growth was above 2%. This has been the case since the Department of Labor began tracking the data in 1948, with two notable exceptions: the last 2 years!

Now why is that? Blame (or thank) the baby boomers.

In the chart above, the unemployment rate (red line, inverted, so rising line means falling unemployment) can be calculated as:

One minus the employment population ratio (blue line) divided by the labor force participation rate (green line)

The decline in the unemployment rate that started in 2009 was primarily the result of shrinkage in the labor force participation rate (the green line) rather than growth of new jobs relative to the population (the blue line).

Now this trend is usually blamed on people just giving up looking for a job. But I would argue that the speed of the decline in the fourth year of an expansion can't be simply blamed on that and is rather unusual in the long run. Instead, I would argue that the trend is to a large degree a result of demographics.

Have a look at the birth rate:

As you can see, the drop in the birth rate in the mid-1930s during the Great Depression very well corresponded with the top of the labor force 65 years later (the usual US retirement age being 65) at around the turn of the millennium, a time that by some measures could be seen as the peak of the US economy in general, before a decade packed with an unusually high degree of financial and market crises.

The baby boom began in 1946, with a sharp top in the chart in 1947, but it wasn't until 1958 that the rate started to fall.

Guess what happened 65 years after the 1946-1947 boom, in 2011-2012. For a hint, please see above. The answer for me is one that seems quite unbelievable at first glance: The US is not growing below stall speed, rather it is growing above potential. If the unemployment rate is falling 0.7 percentage points with the year-over-year GDP at 1.8%, the growth rate at which the unemployment rate is stable (which will be the long-run equilibrium) in the coming 10 years must be much smaller than 1.8%. (Perhaps not even positive? Well, just a thought.)

Now you could argue that there is a lot of slack in the US economy, so that the growth could be much higher for some time -- until the recovery has erased the underutilization in the economy.

But then please look at the continuing claims (below, right-hand scale in 1000s), the number of insured unemployed, which, by the way, is a good leading indicator to the unemployment rate (left-hand scale).

Continuing claims have now fallen to 3M. At the current speed they will fall to about 2.5M at some point during the first half of 2014. That would then be where it bottomed during the last expansion. At best they could fall to 2M, where it bottomed in the expansions before. That could be by 2015.

The rest (and the larger part) of the unemployed labor force is mostly captured in the long-term unemployed(illustrated in the chart below), which has exploded to unprecedented levels since the Financial Crisis and which is much more structural than cyclical and therefore very difficult to improve just by printing money.

So judging from the continuing claims, by 2015 there could be labor shortages in some areas and industries. After that growth could slow down to a level where the unemployment rate would be stable or would only decrease very slowly.

And that growth could be at a very low level.

I think that hardly anyone has this scenario in their expectations. People probably fear something like a repeat of 2008 … just like generals who always fight the last war. The real problem for the next 10 years could be something completely different, and it can't be solved by another round of QE.

Franz Lischka works as an asset manager in Vienna, Austria.

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