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The Real Problem With The US Economy

October 29, 2012

For the last two hundred years, there has been an incredible trend in productivity growth. On average, the US economy has been able to produce almost 2% more per person per year.

Over time, this seemingly small amount can be significant. For example, over the last 30 years, real GDP per Capita increased 64% – from $26,030 to $42,671. This implies that the standard of living for the average American should be 64% higher.

But as American workers become more productive, the only way the economy can continue the trend is if consumers are able to increase consumption at the same rate. The most obvious way consumption can keep up with production is if wages do. Unfortunately, since the mid-1970′s, they haven’t. I’ve presented this graph before, it shows Employee Compensation as a percent of GDP – and it’s dramatic decline over the last 30+ years.

But even with declining wages, the US economy was able – until 2007 – to keep up with it’s long-term trend.

As I have claimed in the past, the reason the economy was able to keep growing despite falling incomes is because American households made up for stagnant wages by borrowing the difference. Let’s see if the data support my contention.

The following graph shows net borrowing as a percent of GDP. After averaging less than 5 percent per year before 1984, borrowing increased to about 8 percent from the mid-80′s through 2000. It then went to unsustainably high levels in the seven years leading up to the Financial Crisis.

Not-so-coincidentally, net borrowing levels are almost identical to the drop in Employee Compensation. This last graph combines Employee Compensation with net household borrowing and compares it to the GDP output gap (Potential GDP- Actual GDP).

Note: The GDP output gap has been inverted to better show correlation.

The correlation is almost perfect – the correlation coefficient = 0.931.

The economy will not return to normal until wages increase or borrowing resumes. High unemployment and foreign competition should keep wages from rising for the foreseeable future, and high household debt levels will make additional borrowing unlikely. Full employment is probably still several years away.

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