Growth Accounting for a Liberated Recovery

For several years I’ve argued that economic policy is holding the economy back and that a return to the principles of economic freedom would recreate a fast-growing recovery. It’s the subject of my book First Principles, of blogs and a recent Wall Street Journal column A Recovery Waiting to Be Liberated.

Because the economy has crawled along at such a slow pace for so long during this recovery, it has features of an economy at the bottom of a recession ready for a post-recession acceleration. The resulting gap of unrealized potential creates the possibility of rapid growth for at least 5 catch-up years, if there is a change in policies. And at this stage in the cycle, this means largely supply-side policies.

To see how this would add up, one can use basic growth accounting, noting simply that the growth rate of real GDP is the sum of two components: employment growth and labor productivity growth.

Reversing the decline in the labor force participation rate—it fell every year of the so-called recovery from 66.0% in 2008 to 62.9% in 2014—would cause a 5 percent increase in employment, or 1% annual growth for 5 years. Adding in about 1% for population growth from Census projections, gives employment growth of 2% per year. Some argue that the recent decline in labor force participation is simply due to the baby boom generation retiring, but the decline is larger for teenagers and young adults and has even increased for those of retirement age.

Reversing the recent productivity slump—it’s been growing at barely 1% recently—would bring productivity growth of 2.5% per year, the average over the past 20 years. Some argue that faster productivity growth is a thing of the past. But the IT revolution, which has been key driver of productivity growth during high investment periods, is not over as is clear from the innovative changes coming out of the high tech sector.

If we add these two components together—productivity growth of 2.5% and employment growth of 2%, we get real economic growth of 4.5%, at least for a number of catchup years, or more than double the average growth during the recovery. Economic policy–and again it’s mainly supply side policies now–should focus on these two components.

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