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Explaining lacklustre economic growth

| Updated: October 29, 2019 21:22:37

Explaining lacklustre economic growth

This is a continuation of my article "Demystifying why US economic growth is lacklustre" (FE October 15, 2019). I argued that for much of the 1980s and 1990s the US economy grew at 3.0 per cent or more when unemployment rate was estimated at full employment range of 4.0-6.4 per cent. At the peak of the Great Recession of 2008, unemployment rate reached as high as 10.0 per cent in October 2009, which has steadily declined to 3.5 per cent in September 2019 as the economy expanded.

What has been worrisome is that even as the economy keeps adding jobs, output growth remained subdued in contrast to previous post-recession growth pace. Therefore, the second quarter growth rate of 2.1 per cent with unemployment rate of 3.5 per cent, lowest in 50 years, has awakened economists to diagnose the underlying reasons. Depending on who you ask, economists have identified several supply side and demand side factors to account for the inconsistency between anemic growth and low unemployment rate.

The effects of supply side factors can be better perceived by having an insight into the economy's aggregate production function, which describes the technical relationship between input (resources) and output (real GDP) as follows (mathematically and graphically):

Y = f (LB, L, K, M, T)

Where, Y = real GDP, LB= land and building, L= labour, K = physical capital (machine and equipment), T = technology, M = raw materials. For a given amount of LB and  M, the equation takes a concise form:

 Y = f (L, K, T)

Land and building are omitted because they are given for an aggregate production function. However, in case of individual production function, they are included in capital factor (K).  Raw materials are omitted since they bear a constant relationship with the output at all phases of production.


The curve PF0 depicts a short-run production function where labour is the variable input for   given K and T. As L is increased, more GDP is produced along the PF0 with fixed K and T -- albeit with diminishing rate of return (DRR) as productivity of labour decreases. To overcome the DRR phenomenon, production process needs to add higher level of K or T or a combination of both. That shifts PF0 upward to PF1, showing higher level of GDP at every level of labour input.   

In his book, The Rise and Fall of American Growth, Northwestern University economist Robert Gordon attributes slow growth to the slow pace of American innovation (T). He argues that many recent innovations, such as apps like Twitter, Snapchat, Instagram and so on are widely popular among users, yet they are not adding major leap in productivity. "Innovation is occurring only around the fringes of the economy, not at the core areas that account for the most output and most employment", Gordon told Alana Samuels in her October 21, 2016 piece in The Atlantic. Slow technological innovation will cause a slow shift of production function upward. 

The Brookings Institution economist, Robert Litan attributes the slow pace of American innovation to the slow pace of new firms entering the market. He argues that "An economy that's more dominated by big firms is less likely to produce disruptive innovations." Historically though, small, new start-ups tend to produce more innovation than existing big firms. They also hire and draw down more people from the workforce. Dane Stengle, economist at the Ewing Marion Foundation, argues that the monopoly power of big firms may partly be responsible behind the slow entry of start-ups and small firms. This slows down economy's accumulation of K and T, which  slows down growth prospects by slow upward shift of the production function.

There are economists who blame sluggish growth partly to CEOs' Quarterly Capitalism Mentality: This refers to the mentality of company CEOs working under pressure to make quarterly profits ever bigger and bigger or risk being dubbed underperformer and lose their jobs. Quarterly capitalism also known as "short-termism" may also entail the mentality of being spend thrift - sitting on huge cash instead of spending on research and innovations.  Obviously, this mentality leads to lower level of investment in K and T, causing slow shift of the production function and hence sluggish GDP growth. Other supply side factors include labour participation rate and aging population.

LABOUR FORCE PARTICIPATION RATE (LFPR): It is a measure of an economy's active workforce population of age16 and over. LFPR = sum of all employed workers plus those actively seeking employment divided by the total working-age population. The LFPR excludes working age people who aren't seeking work or are unable to work, including full-time students and homemakers, disabled persons, prisoners, and retirees and those in active duty in the armed forces.

LFPR stood at 63.2 per cent as of September 2019, which is updated monthly. Because of the way it is measured, it is deemed an important metric to use when analysing unemployment data. During economic recession, for example, the LFPR falls because many laid-off workers become discouraged and give up looking for jobs. That makes the LFPR a somewhat more reliable figure than the unemployment rate, which is often panned for under-counting true joblessness as it fails to consider those who have unwillingly dropped out of the workforce. The LFPR has been roaming in a narrow range -- approximately between 63 to 66 per cent for the past 10 years; the overall trend points a slow but consistent decline notwithstanding. This decline has been attributed to a broader societal change such as retirement of people born between (and including) 1946 and 1964 - popularly known as baby boomers and an increase in college attendance at the younger end of the age spectrum. Both factors eliminate people from the active workforce which can slow down GDP growth prospects and realisation.

AGING POPULATION: Some economists blame sluggish growth to aging population who voluntarily drop out of the labour force and retire. Loss of experienced workers takes a bite out of the productivity growth. In a journal article, Nicole Maestas of Harvard Medical School, and Kathleen Mullen and David Powell of the RAND Corporation found that "Every 10 per cent increase in a share of a state's population over the age of 60 reduces per capita GDP growth by 5.5 per cent." Why an aging population would lower GDP growth was not persuasively explained by these researchers. One explanation is that as experienced workers drop out of the labour force, young and new workers are deprived of the opportunities of learning from their experienced predecessors.

The most important demand side factors are consumers and business spending, contributing 70 per cent and 17 per cent to GDP (gross domestic product) respectively. Harvard economist and former Treasury Secretary Larry Summers called the slow growth a secular stagnation. He argues that the economy is experiencing stagnation because some of the fundamentals that used to spur growth have changed. That includes higher level of saving by consumers and companies. Obviously, business spending on capital goods coupled with autonomous consumer spending will cause faster growth through increasing aggregate demand.

Finally, there are some controversies about how GDP growth is measured. These controversies claim that many recent inventions and innovations which are occurring in high-tech firms in Silicon Valley and other similar ones around the country are often available free but are not factored into GDP accounting the same way as such advances were counted in manufacturing and transportation. Economist Hal Varian told the Wall Street Journal in the summer of 1916 that the economy may be growing even though the GDP numbers don't reflect that.

All these factors - although are identified in the context of US economy's sluggish growth - indubitably influence the growth prospects of other economies as well. Therefore, understanding the way US economy works is inescapable for all countries globally. However, which factor(s) to emphasise depends on the state of an economy. For example, what would work for US economy may not be appropriate for Bangladesh economy. Infrastructure spending would stimulate aggregate demand and job growth leading to higher consumption spending in most economies. On the other hand, investing in research and innovations to ameliorate lacklustre growth may not be feasible for developing economies.  Labour shortage in the US due to retirement of aging population may be circumvented by increasing immigrant workers while this option is a taboo for most developing economies. Thus, there is no "one size fits all" solution to anemic growth. 

Dr. Abdullah A Dewan, formerly a physicist and a nuclear engineer at BAEC, is professor of Economics at Eastern Michigan University, USA.


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