At an Aug. 7, 2007, meeting of the Federal Reserve's policymaking committee, staff economists identified disturbing signs that the economy's growth potential was downshifting to a lower gear.
American workers and factories hadn't been as productive in recent years as initially believed, a realization that caused the Fed's green eyeshade corps to lower fractionally its estimate of the economy's future trajectory.
Now, that esoteric revision is blossoming into a major economic shift that will affect living standards for years. Whatever other costs are borne as a consequence of the financial crisis, the U.S. economy appears doomed to an enduring episode of unimpressive growth. Instead of expanding at an annual rate of roughly 3% to 3.5% without igniting inflation, as it could in the years before the crisis, the U.S. appears capable of growing no faster than 2% to 2.5%.
That may not sound like a huge difference, but the lost output works out to roughly an annual $1,200 per U.S. household. "We'll be growing two-thirds as fast as we were. If you want to know what that feels like, think back to the late 1970s, early 1980s," says Adam Posen, deputy director of the Peterson Institute for International Economics.
Sustainable economic growth depends on a sound financial system. Thursday, the government released the much-anticipated results of its "stress test" of the nation's 19 largest banks. Designed to verify the banks' ability to withstand further economic erosion, the joint Treasury Department-Federal Reserve examination is intended to rebuild investor confidence and lay the groundwork for recovery.
Even if that effort proves skeptics wrong, the crisis is redefining both the nature of the global financial system and expectations for the United States' $14 trillion economy, the world's largest. At issue is the economy's potential or trend rate of growth, a function of productivity, hours worked per employee and the percentage of people in the labor force. Economists use the term as a benchmark to measure an economy's performance: A country that grows slower than its potential suffers high unemployment, while growth above trend invites inflation and is unsustainable. Falling potential output has implications for everything from job creation and stock prices to the funding of government-entitlement programs such as Social Security.
Since 1875, the economy's potential growth rate has averaged an annual 3.4%. But there have been brighter periods: Between 1928 and 1950, the economy's potential jumped to an annual average rate of more than 5% — though actual performance in that Depression-scarred era fell short.
A slow climb
Today, despite encouraging signs that the economy's recent disorienting plummet is slowing, the long-run picture is darker. "Potential real GDP growth has never grown as slowly during the history of the U.S. since 1875 as it is growing today," economist Robert Gordon told a November conference at the Federal Reserve Bank of San Francisco.
Even before widespread dislocations caused by the financial crisis, dips in each major component of potential output growth were depressing the economy's long-run possibilities. Economists for years had expected a decline as the Baby Boom generation, for example, began moving into retirement.