President Trump has been nothing if not bold in his promises to generate supercharged economic growth.
When a report showed a strong 3.3 percent growth rate last fall, he said, “I see no reason why we don’t go to 4 percent, 5 percent, and even 6 percent,” and he has spoken wistfully of emerging economies where growth can reach higher than that.
Even if you treat those musings as presidential bombast, his administration is making detailed projections that the economy will expand much faster in the decade ahead than it has in recent years — a forecast that underpins the Trump policy agenda.
The administration forecasts growth in the neighborhood of 3 percent through the next decade, compared with around 2 percent projected by private forecasters and the economists at the Congressional Budget Office and the Federal Reserve. If the administration’s forecast comes true, it will imply an economy 12 percent bigger in 2028 than that projected by the more cautious forecasts — an extra $2.8 trillion in economic activity that year, in today’s dollars.
But when you look closely at the details of the forecast, not all of it quite adds up. To come true, it would require some of the strongest improvements in productivity seen in decades, yet also require that interest rates not react the way they have historically when growth strengthens.
To understand some of the Trump administration’s buoyant assumptions and the apparent contradictions buried within them, it helps to go step by step on where economic growth comes from and how it relates to interest rates, employment and inflation.
Capital spending can fuel higher growth, but not forever
Think of the simplest arithmetic on how a single company can produce more goods and services. There are three ways:
Workers can put in more hours of labor. If the company hires more people, or has current workers do longer shifts, it can increase production.
The business can invest in more capital to make workers more effective. The latest equipment or software can mean each hour of labor creates more stuff.
The business can adjust its management techniques and how it operates to try to get more productivity out of the same workers and equipment.
The same idea applies to the economy as a whole. Growth comes from either more hours being worked, or more capital for each worker, or the third, which is called “total factor productivity.”
The Trump administration leans heavily on the second of these — more capital — as justification for its optimism. With lower taxes on business, as well as regulatory policies that are more favorable to capital, the budget statement says, it will unleash “growth-enhancing policies” in terms of more capital in the economy per worker.
It is indeed plausible that these policies will encourage more capital investment in the next few years, said Joel Prakken, chief U.S. economist at Macroeconomic Advisers, with higher productivity growth as a consequence.
But that should be a one-time adjustment, after businesses increase their capital stock in response to more favorable policies. Once that process is complete and has resulted in higher productivity, there’s no reason to think that capital investment would keep rising as a share of the economy.
In other words, the benefits in terms of productivity growth and economic growth should fade over time, which the administration acknowledges.
“The new tax law would be a one-time shift, spread out over several years, after which there would be a new steady state growth path for labor productivity,” DJ Nordquist, chief of staff at the White House Council of Economic Advisers, said in an email. “Nevertheless, in that new steady state, faster growth than we have seen in recent years can still be expected because of the elimination of excessive regulations, to which this administration is committed and because of our infrastructure plan. This deregulation will have enduring benefits to the rate of growth.”
Some private economists are not persuaded these effects are powerful enough to account for continued strong growth a decade from now. “I try to fit these numbers into a mainstream paradigm and I can’t make them fit,” Mr. Prakken said.
What about other sources of growth?
But even if higher capital investment can’t do all the lifting of generating 3 percent growth, there remain those other two possibilities, of hours worked or total factor productivity, that could help achieve the 3 percent growth forecast even after the lift from tax cuts and capital investment fades.
But demographic trends are putting a lid on potential growth from more hours of work. The retirement of the baby boomers and stabilization of the proportion of women in the work force mean that potential hours worked will rise only 0.4 percent a year in the coming decade, according to the C.B.O.’s forecast (compared with 1.3 percent a year from 1950 to 2016).
Moreover, the Trump administration’s immigration policies, if anything, would tilt that number in a negative direction, as deportations, tighter border security and more restrictive issuance of work visas reduces the potential supply of labor.
Ms. Nordquist argued that Trump administration policies would help increase the labor force, and hence growth potential.
“We think that labor force participation has dropped in the past decade in part because of government policies that discourage work,” said Ms. Norquist, including growth in Social Security disability insurance and the Affordable Care Act. “There is much room for the Trump administration to improve on those policies, for example through marginal individual income tax rate cuts,” citing evidence that older, near-retirement workers may be more likely to work when taxes are lower.
Then there’s total factor productivity, the black-box driver of growth. Economists don’t really understand it, and calculate it only as a residual — it is the number left over after calculating how much a rise in output comes from more hours worked or more capital.
It would be great for the long-term prospects for the economy — and for the Trump administration’s forecast — if total factor productivity started rising faster. But it’s hard to predict, and it doesn’t show much relationship with either corporate taxes or government regulation. For example, it was quite high from 1950 to 1973, when corporate income taxes were between 48 and 52 percent (they were recently cut to 21 percent). And it was quite low from 1982 to 1990, amid the Reagan era tax cuts and deregulation.
The interest rate paradox
Suppose the Trump administration’s growth forecast really does materialize: Tax cuts and deregulation fuel productivity-enhancing capital spending; some good fortune arises in terms of the labor force and total factor productivity; and economic growth returns to its pre-2000 norm of around 3 percent. That would be positive news for the economy. But it also would be likely to have other effects, particularly on interest rates.
Over time, interest rates tend to move in tandem with the nominal growth rate. Part of the reason interest rates have fallen sharply in the last decade is that low growth has translated into what economists call a low “natural rate” of interest and low inflation levels.
But the Trump administration projects similar interest rates to those envisioned by more cautious forecasters, despite projecting higher growth.
It implies something of an immaculate expansion: returning to pre-2000 growth rates without also returning to pre-2000 interest rates.
In the 1990s, for example, G.D.P. growth averaged 3.3 percent per year, and the 10-year Treasury bond yield averaged 6.7 percent. The administration projects economic growth nearly that strong, but rates peaking at 3.7 percent.
Even some who are on board with more optimistic forecasts of growth say that higher interest rates and inflation are likely to accompany it. Allen Sinai, a longtime forecaster, shares the administration’s view that businesses will invest in more capital because of the tax law, thus achieving higher productivity.
But in addition to that, he argues, the economy will be at risk of overheating. He sees inflation rising to between 2.5 percent and 3 percent by late 2019, which could send long-term Treasury bond yields up to 5 percent, well above the 2.9 percent today and the 3.1 percent the administration forecasts for 2019.
“At some point inflation gets high enough, and the market takes interest rates up,” said Mr. Sinai, the chief economist at Decision Economics. And higher rates, it’s worth adding, would raise the cost for the government to service the national debt, in turn making deficits higher.
Ms. Nordquist notes that the forecasts published Monday were developed in November, when interest rates were lower than they are now. “If we were to redo the interest rate forecast today, we would project higher rates,” she said.
The art of the forecast
Have some sympathy for those who build these forecasts. Predicting anything 10 years in advance is inherently hard, and no forecast is ever perfectly correct. As the last 10 years show, there is a lot that is just unknowable about the forces that will buffet the economy.
But you do want those forecasts to line up with what we already know about the economic and demographic forces that will shape the future. And a lot will have to go right for the Trump administration’s forecasts to come true.