May 2015 » White paper
The “old normal” returns:
Forecasting long-term U.S.
growth potential
Key takeaways
Izzet Yildiz, Ph.D.
Analyst
Michael J. Atkin
Portfolio Manager
Jo Anne Ferullo, CFA
Senior Investment Director
• Contrary to widely
held expectations of
secular stagnation in U.S.
economic growth, we
expect the U.S. economy
will reassert its strength
over the long term.
Fears of secular stagnation
The pace and sustainability of U.S. economic growth since the financial crisis have
been a source of anxiety and exuberance. A deep contraction in the crisis-induced
recession was followed by strong — but brief — surges in the years since the crisis.
In other words, after moments of respectable performance, economic growth
has appeared to subside, leading policymakers and professional analysts alike to
wonder whether sustainable economic growth — at longer-term, historical levels—
is still possible.
• The key source of U.S.
economic growth is in
innovation and efficiency,
particularly as expressed
in a constellation of
technology industries
and U.S. manufacturing.
A trending idea in the discussion among the more apprehensive analysts of
economic growth, which includes a “who’s who” of economists, senior U.S. policymakers, and market participants across the institutional spectrum, is that U.S. growth
has been fundamentally impaired and that the financial crisis somehow crippled the
economy for the long term. Complicating this idea of fundamental impairment are two
other fears: concern over U.S. demographics and their likely impact on U.S. economic
growth in the years ahead, and a belief that the United States continues to be at risk of
Japan-style deflation.
• Our analysis suggests
that low U.S. bond yields
cannot be explained by
weaker long-term growth
prospects.
Now roughly seven years after the onset of the crisis, U.S. growth feels comfortably
rapid, U.S. inflation is subdued, and Europe rather than the United States appears to be
teetering on the edge of a deflation crisis. The U.S. Federal Reserve has wrapped up its
quantitative easing programs, and markets are attempting to gauge the timing of the
first short-term rate increase. The central uncertainty is whether U.S. economic growth
will prove robust enough to mark a clean break from the era of crisis.
• Aggressive monetary
easing, high savings
rates, and weak growth
prospects outside the U.S.
are depressing global
interest rates; if these
forces abate, we would
expect bond yields to rise
toward historical norms.
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Even if the economy returns to its pre-crisis labor productivity levels, growth is still
likely to be lower over the longer term. However, the yield curve could still see a significant movement upward from current levels, even with slightly lower growth weighing
a bit on bond yields. In our view, there is no stagnation to fear, and consequently, the
extended downward pressure on yields may soon be a thing of the past.
MAY 2015 | The “old normal” returns: Forecasting long-term U.S. growth potential
Growth accounting and industry-level
growth analysis
As part of our ongoing macroeconomic research to
understand the financial building blocks related to
longer-term movements in bond yields, we set out to
determine our view of the long-term prospects for U.S.
economic growth, and judge the merits of the case for
secular stagnation. In pursuit of this inquiry, we adopted
a dual methodology for developing our forecasts for
growth. First, we pursued a growth accounting process
that decomposes growth into its constituent sources,
ranging from the growth of hours to capital investment
in labor and the economy-wide impact of ongoing
technological innovation. Second, we conducted
an industry-level analysis of U.S. labor productivity,
which we used to cross-check our growth-accounting
conclusions. In contrast to concerns over fundamental
stagnation, we find that a return to longer-term historical
patterns is not only possible, it is likely to occur.
Where does growth come from?
Growth = Labor productivity + Growth of hours
Growth has two major sources: labor productivity and the
growth of hours worked. In this context, when we reference the growth in labor productivity or the growth of
hours, we are referring to the percentage change in either
of these two components. Each of these categories has a
number of subcomponents, each of which possesses its
own level of volatility. These sources of economic growth
include demographics, improvements in the efficient
use of labor and capital, the growth of capital per unit of
labor, and the labor force participation rate. Growth, in
other words, has a complex inner structure that responds
to a variety of inputs. Some of these can be shaped and
influenced by fiscal and monetary policy. Others, such
as demographics, exert a kind of inexorable and immutable force. The flip side of this is easy predictability. For
example, we know how many 24-year-olds there will be
24 years hence based on the current birth and mortality
rates as well as emigration trends, which allows for a rare
kind of precision in certain areas of economic forecasting.
The horizon of the “old normal”
We find the pessimism of the “secular stagnation”
school to be misplaced. Projecting a long-term total real
U.S. GDP growth rate of 2.2%, our analysis suggests that
a return to longer-term historical growth trends is well
within the realm of possibility. This result is deceptively
simple — and sounds even a bit unexciting next to the
quarterly GDP prints of 4.6% in Q2 2014 and 5.0% in Q3
2014. The quarterly GDP prints for the full year of 2014
illustrate our view of interim contraction and expansion
of growth: Q1 -2.1%, Q2 +4.6%, Q3 +5.0%, and Q4 +2.2%.
These recent GDP prints are not unlike the release of a
coiled spring: When it is depressed, the spring contracts
and is much smaller than when it is at rest, or in a
neutral state; conversely, when the spring is released, it
expands rapidly, becoming much bigger than when it is
in a neutral state. But all things being equal, the spring
eventually returns to its neutral state —or, in the case
of GDP, it returns to its longer-run, steady state. Overall
GDP growth for 2014 was 2.4%, closer to our long-run
estimate, though admittedly this is merely a short-run
example used to illustrate the point. Interestingly, the
factors that contribute to our long-range forecast
of 2.2%, particularly a factor known as “total factor
productivity” (or TFP) — a measure of innovation and
efficiency-enhancing elements at work in the economy
— reveal an internal dynamism of U.S. growth that most
observers have tended to overlook.
What contributes to changes in labor
productivity?
%∆Capital deepening
%∆Labor quality
+ %∆Total factor productivity
= %∆ Labor productivity
In our growth accounting methodology, the larger of the
two factors contributing to growth is labor productivity,
or the growth in output per hour. Following the economist
Dale Jorgenson, a preeminent scholar of U.S. growth, we
take the key components of labor productivity to be 1:
•Capital deepening: Capital deepening, or the growth
in capital investment per unit of labor, reflects how
workers become more productive to the degree their
labor is accompanied by efficiently spent capital. An
example would be buying a computer for an employee
whose output can benefit from such technology. In
our observations, we find that capital deepening is
subject to a law of diminishing returns. Investments in
technology per employee, for example, tend to have
natural thresholds beyond which no additional labor
1
2
Jorgenson, et al. “A Retrospective Look at the U.S. Productivity
Growth Resurgence,” Journal of Economic Perspectives, Volume
22, Number 1 (Winter 2008), Pages 3–24.
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The volatility of labor productivity
A deeper dive into labor productivity reveals diverging
trends in its components over the past 35 years. While
all three components of labor productivity experienced
a jump in the Internet boom years, the behavior of each
component on either side of that eight-year period varies
considerably (Figure 2). Labor quality, for example,
exhibits the characteristics of a constant, while capital
deepening shows a declining trend. As we extrapolate
forward in time, we expect capital deepening to converge
toward lower levels, primarily because we assume
the U.S. government is not likely to develop large new
spending initiatives that target efficiencies in the areas of
public health, education, or other social services.
productivity benefit is derived from additional capital
investment. If one computer increases an employee’s
output, two computers may marginally improve it, too,
but a third computer probably adds no value.
L
• abor quality: This component is defined as labor input per
hour worked; it reflects changes in the composition of the
workforce, as well as the difference between the growth
in the compensation-weighted index of labor input and
hours worked. For our study, we use labor quality statistics
provided by the EU KLEMS Growth and Productivity
Accounts database, a recently developed standard source
of economic data containing industry-level measures of
output, inputs, and productivity for 25 European countries,
Japan, and the United States since 1970.
In contrast to the relative consistency of labor quality
and the declining trend of capital deepening, the third
component of labor productivity, TFP, exhibits marked
volatility. Considering the three eras of growth, TFP
not only progressed from being a net detractor in the
first era to being a critical positive contributor in the
technological revolution beginning in 1996, but it also
contracted more substantially than either of the two
other components during the financial crisis.
T
• otal factor productivity (TFP): TFP — sometimes
called multi-factor productivity or MFP — measures
improvements in the efficient use of labor and capital.
It includes the effects from changes in frequently
unmeasured inputs, such as innovation, research and
development, and other intangible investments. Replacing
an employee’s computer with a more powerful machine,
for example, adds to TFP. In addition, TFP quantifies the
effects from organizational and institutional change, as
when a firm streamlines its patterns of production and
thereby realizes productivity enhancements.
More than any other factor, we believe TFP has
the capacity to make or break growth in the United
States. But in our analysis, we see TFP heading toward
being a potentially stable positive contributor to labor
productivity, and therefore growth, over the long term.
When we consider the components of U.S. growth
since the late 1970s, three distinct eras present themselves: 1978–1995, 1996–2004, and 2005–2010. On this
view, visible trends include a decline in the growth of hours
and a fairly volatile contribution to growth from labor
productivity (Figure 1). In addition, the 2005–2010 period
starkly registers the impact of the 2008 financial crisis
and the ensuing recession’s well-documented impact on
employment — and, hence, the negative growth of hours.
Furthermore, the immediately preceding period of 1996–
2004 just as clearly reflects the dawn of the Internet age
and a massive increase in capital deepening (Figure 2).
Figure 2: Volatility of TFP within
labor productivity
3.0%
2.5%
2.0%
1.5%
1.0%
Figure 1: Historical components of U.S. growth
0.5%
0.0%
4.0%
3.5%
-0.5%
1978–1995
Labor quality
3.0%
2.5%
2.0%
Source: Putnam research, 2014.
1.5%
1.0%
0.5%
0.0%
-0.0%
1978–1995
Hours
1996–2004
2005–2010
Labor productivity
Source: Putnam research, 2014.
3
1996–2004
Capital deepening
2005–2010
TFP
MAY 2015 | The “old normal” returns: Forecasting long-term U.S. growth potential
The inner workings of TFP
According to our research, most of the innovation and
efficiency that comprises TFP has historically come
from four economic areas in the United States: retail,
manufacturing, finance, and information and communication technology (ICT). Other areas of the economy,
such as the government, health care, and education,
have historically been negative contributors to TFP. In
other words, 37% of the economy is producing most of
the innovation and efficiency that can drive sustainable
growth in the United States.
crisis. Though it did not completely offset the declines
in retail and manufacturing, ICT has proven to be, since
1996, the strongest source of innovation and efficiency
in the U.S. economy.
Plateauing TFP in manufacturing and retail
Before we delve further into ICT to examine the key
sources and trends of its contribution to growth, we
think it is worth considering the fate of retail and manufacturing in the United States.
Manufacturing offered a key support to TFP after
2000, but by 2004, this contribution reached a plateau.
Notably, our research reveals similar trends in other
developed countries. In our view, the root cause of limited
growth in the United States as well as in other developedmarket manufacturing TFP can be found in globalization,
which shrunk manufacturing’s share in overall output. To
the degree globalization increased cross-border competition beginning in the latter half of the 1990s, it rapidly
created substantial cost-cutting pressures for companies
in a broad swath of industries around the world. The
introduction of cost controls and labor reductions clearly
took their toll on this segment of the global economy. The
percentage job loss in manufacturing over the ensuing
10 years in the United States, for example, ranged from
20% to more than 40% in most states, with some of the
most populous regions seeing between 30% and 40%
declines. In this way, even as manufacturing continued
to increasingly support TFP until 2004, manufacturing’s
share of GDP declined after 2000.
Within that 37%, an even smaller share of the
economy is consistently delivering innovation and efficiency. When we examine industry-level data for TFP,
we find that its key sources have undergone a number
of important changes over the past two decades. The
retail and manufacturing components, for example,
almost tripled their contributions to the TFP portion of
productivity from the first growth era to the Internet
age, but these contributions all but disappeared in the
2005–2010 period (Figure 3). TFP in finance, moreover, appears in our analysis to be highly dependent on
financial markets’ performance. When times are good,
the trend is for industry players to spend more and less
efficiently; when times are bad, costs are cut and labor
is rationalized, giving an artificial and cyclically fragile
boost to the sector’s TFP contribution.
Figure 3: Total factor productivity in the U.S.
is largely explained by four industries
For its part, U.S. retail was a critical engine of U.S.
growth at the start of 1990s, and it remained a strong
contributor to TFP until approximately the year 2000.
One of the drivers of this strength in the United States,
we believe, was the rise of big-box retailers. Companies like Walmart were able to deploy a variety of ICT
innovations, including inventory management systems
and operations management software, increasing their
already-powerful economies of scale.
1.5%
1.0%
0.5%
0.0%
-0.5%
1978–1995
Manufacturing
1996–2004
ICT
Finance
R&W
However, as these retail giants spread during the
1990s into densely populated areas, particularly in the
northeastern United States and California, a plateau in
their TFP contribution naturally took shape. The markets
reached a saturation point. The top eight U.S. retailers
now dominate the most densely populated areas of
the country. From this point, it is increasingly difficult to
raise the quotient of innovation and efficiency across
their vast operation networks.
2005–2010
Others
Source: Putnam research, 2014.
On closer inspection, we find the true engine inside
TFP to be ICT. Unsurprisingly, this area, which includes
a constellation of technology industries, experienced
significant growth through the first decade of the
Internet age. But this area also continued to deliver
strong results in the period that includes the financial
4
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The keys to growth: An industry-level
assessment
Peeling back the layers of U.S. growth, we have found
that the growth of hours worked is in decline, as the
labor participation rate has yet to recover to pre-crisis
levels, and that U.S. growth increasingly rests on the
strength of labor productivity. Within labor productivity,
we have determined that one of the largest absolute
contributors, capital deepening, is in decline, and that a
second factor, labor quality, has been relatively constant
over the past three decades. The third element, TFP,
appears to be a vital component of economic growth,
but it has also proven to be the most volatile source due
to large-scale macroeconomic and industry-related
change, including globalization and the evolving nature
of retail and wholesale activity in the United States.
We have also found that the core of innovation and
efficiency — and, hence, the core of TFP and the future
potential of U.S. growth — appears to reside in ICT. But
this, too, requires investigation.
To pursue this part of our study, we conducted an
industry-level analysis of labor productivity, independent of our previous growth-accounting methodology,
and in this way constructed an industrial base for
checking our growth forecasts. As with the prior
method, labor productivity is composed of the same
three components: TFP, capital deepening, and labor
quality, with total labor productivity equaling the sum of
the various industries we examined.
In assembling this industry-by-industry view across the
same three periods of growth we identified in the first part
of our study, it becomes apparent that an industry’s share
of GDP does not correlate with its contribution to labor
productivity (Figure 4).
Figure 4: The labor productivity of economic sectors does not match their share of GDP in all cases
GDP share %
GDP share %
Social
24.4
Construction
4.3
Real estate
12.7
Transport
2.9
Retail/wholesale
11.9
Food/lodging
2.9
Professional
10.6
Electric/gas
2.1
Manufacturing
10.0
Mining
1.7
Agriculture
1.0
Finance
7.9
ICT
7.5
Labor productivity sector breakdown
12
Labor productivity (%)
10
8
1978–1995 LP
6
1996–2004 LP
4
2005–2010 LP
2
Long run LP
0
-2
-4
ICT
Manufacturing Finance
Retail/
wholesale
Real
estate
Agriculture
Mining
Electric/
gas
Source: Putnam research, 2014.
5
Construction Transport
Food/
lodging
Professional
Social
MAY 2015 | The “old normal” returns: Forecasting long-term U.S. growth potential
Social spending (public administration and defense, health, education, social work, etc.), for example, has the largest GDP
share — twice as much as the next-largest industry by share of GDP (real estate). And yet, although it is more than three times
the size of ICT in terms of share of GDP, we calculate its long-run labor productivity to be zero percent versus ICT’s 8%.
As Figure 4 shows, ICT has historically generated the largest percentage of labor productivity relative to all other
industries, although volatility of this factor is high almost regardless of which industry one examines. An exception is
the social spending component, which has historically remained quite flat, ranging from zero percent to 0.3% — with
the positive endpoint of this range occurring during the 2005–2010 period. Interestingly, social spending in the United
States is virtually always a lower contributor to labor productivity than anywhere else in the developed world (Figure 5),
suggesting an area of the U.S. economy that has ample room for long-range improvement.
Figure
5: U.S. social service labor productivity is lower than that of most other developed countries
3.0%
2.5%
2.0%
1.5%
1.0%
0.5%
0.0%
-0.5%
1978
1981
1984
1987
1990
1993
1996
1999
2002
2005
2008
-1.0%
-1.5%
United States
United Kingdom
France
Germany
Japan
Source: Putnam research, 2014.
ICT and manufacturing: Bastions of productivity
Looking across the 13 sectors in our illustration, we find the total long-range labor productivity figure to be 1.6%. Growth of
hours worked, we find, will add an additional 0.6%. Thus, two thirds of our 2.2% long-range economic growth rate will be
composed of labor productivity. Of that figure, we expect 0.9% — or 56% of all labor productivity — will be generated by two
industries: ICT and manufacturing, which supply 0.6% and 0.3% contributions, respectively (Figure 6).
Figure 6: Sector contribution to total labor productivity
0.7%
0.6%
0.5%
0.4%
0.3%
0.2%
0.1%
0.0%
-0.1%
ICT
Manufacturing Real estate
R&W
Finance
Transport
Agriculture
Source: Putnam research, 2014.
6
Professional
Food
Mining
Electric/gas
Social
Construction
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While the four main components of ICT — electrical/optical equipment, publishing (think videos and digital music
and books), telecommunications, and IT/software — have historically all played important roles, the dominating force of
productivity within this area comes from electrical and optical equipment.
Figure 7: Labor productivity in information and communications technology has four main components
GDP
share %
1978–1995
LP
1996–2004
LP
2005–2010
LP
Long run
LP
Contribution
of ICT to LP
Electrical and optical
equipment
1.9%
10.0%
20.5%
15.5%
18.5%
0.3%
Publishing
1.5
3.5
4.7
1.4
3.4
0.1
Telecommunications
2.4
3.7
5.2
6.3
6.3
0.2
IT and others
1.7
11.0
8.9
3.8
3.0
0.1
Total ICT
7.5
6.2
9.8
7.0
8.0
0.6
Source: Putnam research, 2014.
Semiconductors, computers, handheld devices, and other high-tech optics have together comprised the strongest
source of labor productivity in the United States, and not just historically in the Internet’s heyday. Indeed, by our analysis,
we are in the early innings of this increase in labor productivity, which we expect will converge to its 1996 trend of 18.5% —
which translates into 0.3 percentage points of the total 2.2% long-term growth rate we envision for the United States.
Figure 8: Labor productivity in electrical and optical equipment (moving average)
25%
20%
15%
10%
5%
0%
1978
1981
1984
1987
1990
1993
1996
1999
2002
2005
2008
Source: Putnam research, 2014.
Some areas of ICT, in fact, appear to be in decline, even as optical/electrical equipment labor productivity continues
to improve greatly. Labor productivity in software, for example, is feeling the drag of global outsourcing, while we expect
the productivity inherent in telecommunications to converge toward a pre-financial-crisis average.
What does 2.2% long-range growth mean for bond markets?
Our growth accounting and industry analysis show labor productivity and total GDP growth to be progressing toward respectable levels. Even more than the 2.2% figure, we find the key drivers of growth to have displayed resiliency to 2008 and its
aftermath. Although retail is slowing and finance is under regulatory pressure, productivity in ICT and manufacturing continues
to drive growth on a strong and sustainable path.
Most assessments of the “equilibrium” level of interest rates rely on a handful of factors: real growth, inflation expectations,
and the term premium. If real growth converges more closely with our estimation of 2.2%, the Federal Reserve is able to
manage inflation to meet its target of 2.0%, and there is a modestly positive term premium, then it is easy to imagine that
7
MAY 2015 | The “old normal” returns: Forecasting long-term U.S. growth potential
10-year Treasury yields would have a fair value closer
to 5%. The fact that Treasury yields are so far below this
level indicates there can be a large and persistent gap
between market prices and “fair value.”
In the case of Treasuries, this gap reflects many
factors: the impact of financial regulation and incentives
for financial institutions to hold the highest-quality
paper; the impact of central bank behavior (recall
that foreign central banks are the largest holders of
Treasuries); and the fact that global interest rates are
being held down by economic weakness and high rates
of saving in many parts of the world. It is an important
conclusion of our research that the explanation for
the low level of yield is to be found in these factors; and
critically, the distribution of current economic growth
does not reflect a high likelihood that U.S. real growth
potential has been fatally undermined by the financial
crisis and its aftermath.
The goal of our research was to explore the potential
for growth stagnation and whether the U.S. economy
could possibly return to pre-crisis levels of growth. While
we do not believe that the higher levels of growth experienced pre-crisis and certainly over the past few quarters
are sustainable over the long term, we do believe that
respectable, longer-term levels of growth supported by
“old normal” levels of labor productivity on the order of
2.2% is achievable.
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