How deep is our hole and when will we get out?
by John B. Hagens
John has been with IPR since 1990, with activity in all of IPR's businesses. Prior to joining IPR, John was senior vice president for the WEFA Group, with responsibility for the company's U.S. economic forecasting service. Before his ten-year stint with Chase Econometrics (and then WEFA), John had jobs as senior economist for the Carter Administration's Council on Wage and Price Stability and for the Social Security Administration, the latter under a Brookings Institution Economic Policy Fellowship awarded while he was an economics professor at Colby College. John holds an undergraduate degree in mathematics and economics from Occidental College and a Ph.D. in economics from Cornell University.
How deep is our hole and when will we get out?
Friday's U.S. GDP report showed that 2009q4 growth was 5.7%. This was not unexpected, given the improved performance for hours worked that we saw in the last few months of last year and the typically strong showing for productivity growth as the economy begins to recover. Pundits, however, have pointed out that over 50% of the growth was due to the rebuilding of inventories, so it may be a bit premature to pop the champagne corks. Still, while a double dip cannot be ruled out for a number of reasons, we may now be on the road to recovery in the U.S.
How long that road will be depends on how deep the hole is that we're now in and how quickly we will climb out of it. One measure of the depth of the hole is today's unemployment rate, variously measured, compared with "full employment" unemployment. But we can also measure the depth simply with GDP statistics. This technique measures the hole as the difference between actual output and "potential" output. It is reasonable to assume that the economy was roughly producing at full potential just before the onset of the current recession in the fourth quarter of 2007. As the recession proceeded in 2008 and 2009, our hole got deeper and deeper. The faster the potential output of the U.S. economy grows, call it trend growth, the deeper the hole became. If trend growth pushed potential output up 3% per year and actual output dropped 3%, then we would drop 6% below potential. By accumulating all of the gaps since the beginning of the recession between trend GDP growth and the actual growth, we can determine the depth of our current hole. If one assumes that trend growth is somewhere between 2.5% and 3%, then our current hole is somewhere between -7.5% and -8.5% (of potential GDP).
Going forward, if we were to simply grow at trend GDP, say 2.7%, then we would make no progress digging out of the hole and unemployment would stay in the 10% vicinity - we'd be down and stay down. This is what happened in Japan during the 1990s after the bursting of their real estate bubble. A pessimistic, though not unrealistic scenario, is that the U.S. economy will grow at an average 4% per year. At that rate, if trend growth is a not unrealistic 3%, we would dig out of our hole by 1% each year and it would take us 8 years, 2017, to return to full employment. If average growth is a stronger 5% per year and trend growth a slower 2.5%, then our digging out would be 2.5% per year and it would take us 3 years to get back to full employment. My own guess is that we'll be somewhere between these two cases and see average growth of 4.5% and that trend growth is about 2.7%, in which case we'll be back to a fully employed economy in late 2013.
