Permanently Depressed?

One of the main economic debates of the last few years has been whether weakness is cyclical or structural. If the downturn is due to a temporary (albeit, severe) shortfall in domestic demand, then growth should pick up sharply at some point as the economy returns to its potential. If it’s structural, fiscal and monetary policy can do little to help. Opinions differ, but while the consensus may see the sluggish economy as reflecting mostly cyclical forces, cyclical weakness is more likely to become structural the longer it lasts. Over time, some structural change will occur naturally, but it need not be too disruptive.

Since bottoming in 1Q09, real GDP rose about 10% through 3Q13. That works out to an annual rate of 2.1%. This pace would be nearly ideal if the economy were operating at full employment – but it’s not. The continued slack in the economy has a number of consequences. The typical worker is not seeing much in the way of real wage gains, which limits the pace of growth in consumer spending. More important, the longer this output gap remains elevated, the more likely that the path of potential GDP growth will be lowered.

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Some (notably former Treasury Secretary Larry Summers) have suggested that the economy may need bubbles to return to its potential. Indeed, the previous decade was driven largely by the housing bubble, which helped fuel consumer spending growth through home equity extraction, rather than through growth in personal income. The previous bubble, the tech boom, facilitated a substantial gain in business fixed investment, but wealth effects were not as widespread as in the housing bubble, and the aftermath was nowhere near as severe.

During Alan Greenspan’s tenure as Fed chairman, the view was that the central bank should not even attempt to call a bubble, let alone try and deflate one. That opinion has changed following the collapse of the housing bubble.

Ideally, employment, consumer spending, business investment, bank lending, and foreign trade would all grow at nice sustainable rates, but that’s never going to happen in real life. Still, there’s no reason to believe that the economy has to have a bubble to reach its potential.

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Manufacturing is one area that has experienced a lot of long-term structural change. For most of the last several decades, manufacturing employment has been more or less steady, falling some in recessions and rising back in recoveries. As a rule of thumb, the U.S. would lose about one out of ten factory jobs each year in the 1980s, but would see a new manufacturing job created in its place. The country shed low-productivity jobs and gained high-productivity jobs. Even though manufacturing employment was little changed, factory output rose sharply.

Something else happened in the last two recessions. Manufacturing jobs that were lost were not replaced by new ones. An expansion of foreign trade capacity was likely the culprit. China beefed up its export capabilities, while a larger class of container vessels combined with port expansions to generate a huge increase in U.S. imports. The leading U.S. export at the time? Empty containers back to China.

Some have forecasted a “renaissance” in U.S. manufacturing, but it’s not there yet in the data. The expansion of the Panama Canal (which will double capacity by 2015) and improvements in East Coast ports are likely to facilitate some growth in U.S. exports. Low energy costs will give U.S. firms a competitive advantage. However, most of the manufacturing returning to the U.S. will be capital intensive. So, we may see limited growth in manufacturing jobs over the next decade or two.

Structural change, such as increased foreign trade, will present opportunities as well as challenges. However, a continuation of the wide current account gap remains the biggest risk to long-term U.S. economic growth.

© Raymond James

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