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.
Gordon, an expert on productivity at Northwestern University, says the economy's potential growth rate for the next two decades will be no better than an annual rate of 2.35%, down from the 2.86% figure for the previous 20 years. As of January, the Fed's official view was that the economy can sustain growth of 2.5% to 2.7%. An updated forecast is due within weeks.
In the short run, as the financial system heals from the self-inflicted wounds of recent years, the economy is likely to perform even more poorly. More than 5 million jobs have disappeared in the past 15 months, and consumers and corporations are focused on paying off debt rather than spending or investing in new productive capacity. Federal Reserve Chairman Ben Bernanke told Congress earlier this week that the economy should bottom out in the next few months before beginning its long climb back to normalcy.
"Even after a recovery gets underway, the rate of growth of real economic activity is likely to remain below its longer-run potential for a while," Bernanke said.
Historically, economies recover more slowly following financial crises than after garden-variety recessions, according to the International Monetary Fund. Today's global downturn, triggered by a financial disruption and synchronized across all major economies, represents the worst possible confluence of circumstances.
"We have to re-evaluate potential growth, given the fact that some of the housing (related) growth was not real and the output of the financial system was not real," says Harvard University's Kenneth Rogoff, former chief economist at the IMF.
The U.S. economy's shrunken horizons are a far cry from the halcyon days of 2000, when new Internet and wireless technologies appeared to promise dramatically improved growth. Then, surging productivity far beyond what Europe and Japan were experiencing contributed to a sense of limitless economic possibilities. Fed officials in early 2000 anticipated potential output growing at an annual rate of 4%, up sharply from just 2.3% in the early 1990s.
Different, but more stable
Now, as the U.S. digs out after twin housing and credit bubbles, significant economic energy is being drained by the crisis and its consequences. The de-leveraging — or debt repayment — process that is underway will be long-lived. As late as 2011 and beyond, corporations still will be confronted with the need to pay off or refinance massive amounts of debt issued during the leverage boom of 2005-07, according to UBS.
The disruption in financial markets that began in 2007 and intensified last fall after the Lehman Bros. bankruptcy canceled or delayed business investments that would have paid off in greater productivity. In January, refiner Valero said it would cut capital spending by $800 million this year. It's in good company: 69% of those responding to a PricewaterhouseCoopers global CEO survey said they planned to trim investment amid the crisis.
The nation's wounded banks also are in no condition to efficiently allocate capital. Operating in some markets with government guarantees against loss while worrying about how their capital bases will hold up amid a continuing downturn, the banks may husband their resources rather than risking them on business ventures. "We're going to go back to a more basic kind of banking — less risk-taking, less leverage," said Desmond Lachman, a former IMF economist now at the American Enterprise Institute.
Across the economy, this reduced appetite for risk may take its toll. From consumers who binged on houses thinking values would only rise to financial institutions that gambled on hopelessly complicated products, investors badly underestimated risk in the pre-crisis years. New government regulations should provide greater stability and safety, but at a potential cost in lost opportunities. It's as if Uncle Sam were moving the nation's portfolio from a riskier, growth-oriented mutual fund to the money market.
Finally, human and financial resources are being reallocated across the economy. A nation that had too many investment bankers and mortgage brokers now must switch focus to other endeavors. Resources will stand idle while that process plays out, further constraining the economy's potential. And eventually, the tax bill to pay for the enormous government borrowing used to battle the crisis will come due.
"I expect slow growth for five to seven years. There will be years of subpar growth, maybe even years of zero to negative growth," Rogoff says.
Thursday's stress-test results will require several major banks, including Bank of America, to raise tens of billions of dollars in new capital. Investors were cheered by test results they interpreted as more positive than originally expected. But there still may be bad news lurking in the financial system. The IMF's recent Global Financial Stability Report said U.S. banks required between $275 billion and $500 billion in new capital — far more than the stress-test conclusion that $75 billion is needed.
The financial system that emerges from the crisis will little resemble the one that caused it. There will be more government regulation, less use of debt, reduced net flows of money across borders and perhaps even smaller institutions. The IMF says "far-reaching changes in the shape and functioning of financial markets" will be required to provide protection against a repeat crisis.
"It will look substantially different. All types of securities markets will be a lot more regulated and less vibrant. … The trade-off will be fewer crises," said Menzie Chinn, associate director of the Robert M. LaFollette School of Public Affairs at the University of Wisconsin.
One area likely to be especially heavily affected: the so-called shadow banking system of hedge funds, investment banks and other non-bank vehicles that held assets worth roughly $10 trillion in 2007 — as much as the traditional banking industry — yet was almost wholly unregulated.
Already, the nation's investment banks have morphed into plain-vanilla banks to obtain government guarantees and protection. New regulations on the national and global level will further limit running room for financial innovators in the years to come, economists say.
But not all the changes will necessarily hurt prospects for growth.
Much of the fancy financial engineering of recent years, which produced difficult-to-fathom products such as collateralized debt obligations and credit default swaps, actually had little impact on productive investment in the bricks-and-mortar part of the economy.
In recent years, the value of derivatives — financial contracts whose price depends upon a second instrument — has soared. One of the defining features of the pre-crisis years, global derivatives, increased in value 303% the past five years. Likewise, U.S. commercial banks increased their derivatives holdings 81%, according to the Peterson Institute.
But in the same period, gross fixed-capital investment in the U.S. rose just 26.4% The vast majority of the financial innovation that gave rise to this crisis represented transactions between financial institutions, ostensibly aimed at reducing their risk, rather than productive investment in job-creating companies.
"The explosion in financial products was interbank. … I'm not sure we're going to miss it," said Posen, a former Fed and European Central Bank consultant.