You Can’t Reform Your Way to Rapid Growth

NOTE: The Growth Economics Blog has moved sites. Click here to find this post at the new site.

One of the big advantages of having written this blog for a while is that I can start recycling old material. I’m going to do that in response to the small back-and-forth that Noah Smith (also here) and John Cochrane had regarding Jeb! Bush’s suggestion/idea/hope to push the growth of GDP up to 4% per year. Cochrane asked “why not?”, and offered several proposals for structural reforms (e.g. reforming occupational licensing) that could contribute to growth. Smith was skeptical, mainly of the precise 4% value. Why 4? Why not 5? Why not 3 1/3?

Oddly enough, the discussion of Jeb!’s 4% target is also a good entry point to talking about Greece, and the possibility that the various structural reforms insisted on by the Germans will manage to materially change their situation. But we’ll get to that.

First, what are the possibilities of generating 4% GDP growth in the U.S.? I’m presuming that we’re talking about whether we can boost per capita growth up to 4% per year for some relatively short time frame, because history suggests that sustained 4% growth in GDP is incredibly unlikely. From Jeb!’s perspective, I’m guessing either 4 or 8 years is the right window to look at, but let’s say we’re trying to achieve this for just 5 years.

Here’s where I’ll dig back into the archives, where I talked about the boost to growth that you can get from various structural reforms. Literally copying and pasting from that post, there are two ways to boost GDP growth. Either

  • Actively raise current GDP through increased spending by some sector of the economy.
  • Raise potential GDP and let transitional growth speed up.

Let’s attack the second one first, as several of Cochrane’s proposals involve raising potential GDP through structural reforms, but involve no immediate spending changes.

We can do some quick calculations of the growth effects of structural reforms by using the following equation

\displaystyle  Growth = \frac{Y_{t+1}-Y_t}{Y_t} = (1+g)\left[\lambda \frac{Y^{\ast}_t}{Y_t} + (1-\lambda)\right] - 1. \ \ \ \ \ (1)

This says that growth in GDP has a standard component of {1+g}, where {g} is roughly 2.8% per year: 0.8% from population growth and 2% from long-run growth in per capita GDP. The term in the brackets is the adjustment to growth that we get from being below potential GDP, where {Y^{\ast}_t} is potential GDP, and {Y_t} is actual GDP per capita. The parameter {\lambda} governs how fast convergence from actual to potential occurs, and hence determines the growth kick we get from raising potential GDP. The empirical literature on this has consistently found that {\lambda} is about 0.02, which means relatively slow convergence.

In 2015 U.S. GDP is about 16 trillion, and let’s say that right now, potential GDP is roughly 17 trillion. If that is true, then we should have growth of about

\displaystyle  Growth = (1.028)\left[.02 \frac{17}{16} + .98\right] - 1 = 0.0293 \ \ \ \ \ (2)

meaning 2.93% growth.

Is it plausible to have structural reforms that will boost that 2.93% growth to 4% growth? Well, I don’t know precisely how much of boost to potential GDP we’d get from the structural reforms that Cochrane proposed and that Jeb! would apparently enact. But let’s say that it is a pretty substantial amount, like $3 trillion. This means that potential GDP in the US is now $20 trillion dollars, which is a 18% boost in potential GDP. I am granting here that these structural reforms have a massive effect on potential GDP. I am skeptical that they would actually have such a large effect.

Growth after these massive structural reforms will be

\displaystyle  Growth = (1.028)\left[.02 \frac{20}{16} + .98\right] - 1 = 0.0331 \ \ \ \ \ (3)

or 3.31% growth in GDP. That’s not 4%. That’s not really close to 4%. (In one of those wonderful unintentionally funny coincidences, though, it is almost exactly Noah’s off-the-cuff 3 1/3% growth rate.) Massive structural reforms will not push the economy to 4% growth. And after the first year of growth at 3.31%, growth will keep falling until it settles back towards 2.8% per year. So the reforms will never yield 4% growth.

But won’t the massive structural reforms lead to a wave of investment as people get all excited about the new direction that America is headed? Yes. And that is precisely what the equation captures. The convergence result here is measuring the additional growth we get as people invest more due to their perception that the return on those investments is higher due to the structural reforms. Empirically, the fact that {\lambda = 0.02} means that this tends to happen slowly over a few decades, rather than all at once.

You can just scrape 4% growth is you continue to assume that structural reforms to the U.S. economy can add $3 trillion to potential GDP and that the convergence parameter is in fact {\lambda = 0.05}, or more than twice as big as any reliable empirical estimate. Or you could keep {\lambda = 0.02}, and assume that structural reforms were capable of pushing potential GDP to $26 trillion, a 53% increase over potential GDP today. Both are huge stretches, and almost certainly wrong.

It is this same logic that is at play in Greece, by the way. Same convergence equation, same {\lambda}. What’s different? Greece’s trend growth in GDP is probably more like {g = 0.02}, given relatively slow (and probably negative) population growth. Greek GDP right now is about 180 billion euro. What are the possibilities of massive structural reforms, such as those demanded by Germany, generating rapid growth in Greece?

Let’s assume that the Greeks have completely taken the German structural reforms to heart. So much so that Greece simply adopts the entire German legal system, culture, and technology in one giant gulp. This doubles Greek potential GDP to 360 billion euro, which would imply that Greek GDP per capita would be roughly equal to that of Germany.

These sweeping structural reforms will generate growth of

\displaystyle  Growth = (1.02)\left[.02 \frac{360}{180} + .98\right] - 1 = 0.0404 \ \ \ \ \ (4)

or 4% growth in GDP in the first year after reforms. Thereafter, growth will continue to come in below 4% as Greece converges to its new Teutonic economic bliss point.

I know very little about the Greek crisis. I know very little about the terms of the deal that Greece signed. But my limited reading tells me that this is not the kind of growth that will be sufficient for them to crawl out of the hole they find themselves in.

Massive structural reforms are not capable of generating immediate short-run jumps in growth rates in the U.S., Greece, or any other relatively developed economy. They play out over long periods of time, and the empirics we have suggest that by long periods we mean decades and decades of slightly above average growth. Ask the Germans. They’ve been fiddling around with structural labor market reforms since the 1980’s, and when exactly were they able to keep up sustained GDP growth of 5 or 6%?

The U.S. and Greece are not China in 1980 or South Korea in 1960, where you could plausibly imagine that structural reforms could boost potential GDP by a factor of 5 or 6 and generate growth rates of 8-10%. We are nibbling around the edges, by comparison.

Structural reforms don’t generate massive short-term changes in growth rates because they are fiddling with marginal decisions, making people marginally more likely to invest, or change jobs, or get an education, or start a company. By permanently changing those marginal decisions, structural reforms act like glaciers, slowly carving the economy into a new shape over long periods of time. Think of occupational licensing reform. If you enacted that tomorrow, GDP would not move at all. But over the course of the next few years, as new people graduated high school or college, or lost jobs, some of them, on the margin, would now find it worthwhile to become a physical therapist, or a hairdresser, or an interior decorator. They’d presumably be more efficient in these positions than flipping burgers, so the economy would be more efficient and GDP would be higher. But this takes years.

If you want to radically boost GDP growth now, then someone has to spend money now. Take infrastructure spending. Let’s say that miraculously Congress passed a $1 trillion dollar plan to rebuild bridges, ports, roads, and airports around the U.S. Let’s say this is going to be spent $200 billion a year for 5 years starting in 2016.

Now what is growth in 2016? GDP was going to grow naturally at about 2.93%, so we’d have about 16.5 trillion in GDP just from that. Add in 200 billion in infrastructure spending and you get 16.7 trillion in GDP. Now, what is the actual growth rate from 2015 to 2016? (16.7-16)/16 = 0.0438, or about 4.4% growth. This doesn’t even allow for the possibility that there could be a multiplier greater than 1 on the infrastructure spending.

In addition, the beauty of infrastructure spending is that is doesn’t just push us closer to potential, it almost certainly raises potential GDP as well, and keeps the growth rate above average for longer. How much? I don’t know, but I’d personally guess that it raises potential by more than 1-for-1 with the actual spending. But let’s be conservative, and assume that it simply raises potential such that the economy always stays about 1 trillion behind potential GDP. So in 2016 potential is 17.7 and actual GDP is 16.6. What is growth from 2016 to 2017? Well, it grows by about 2.93% again due to being not quite at potential, and then add in another 200 billion in infrastructure spending. That gives us 17.4 trillion in actual GDP. So actual growth from 2016 to 2017 is (17.4 – 16.7)/16.7 = 0.0419, or about 4.2% growth.

So long as we keep up the $200 billion in infrastructure spending, we can get growth of about 4% per year. Jeb!, you’re welcome. Problem solved.

The difference with infrastructure spending is that it does not nibble around the edges or play with marginal decisions. It dumps a bunch of new spending into the economy. And that is the only way to juice the growth rate appreciably in the short run. Structural reforms will raise GDP, and in the long run may raise GDP by far more than immediate infrastructure spending. But that increase in GDP will take decades, and the change in growth will be barely noticeable. You want demonstrably faster growth right now? Then be prepared to spend lots of money right now.

In the Greek situation, the implication is that without some kind of boost to spending now, they are unlikely to ever grow fast enough to ever get out of this hole they are in. If the Germans and EU are serious about keeping Greece in the eurozone and refusing to write down the debt, then they should seriously consider investing heavily and immediately in Greece. Structural reforms, even if implemented with perfection, are highly unlikely to be sufficient. The Greeks don’t have time to wait for the glaciers of structural reform to scrub the economy clean. If the Greeks aren’t allowed to do any stimulus spending, then the EU should do the stimulus spending for them. It is probably the only way that everyone gets what they want.

31 thoughts on “You Can’t Reform Your Way to Rapid Growth

  1. Thanks for bringing the Bush and Greek cases into the same framework.

    Apart from what you’ve said, if the US could plausibly spend $200 bn on infrastructure (not under Bush, of course), Germany cannot control the quality of structural reforms in Greece. The IMF had been trying this in other countries for decades, with no particular success.

  2. “Let’s stop making a fetish of national income statistics and percentage rates of growth”

    http://econospeak.blogspot.ca/2015/04/lets-stop-making-fetish-of-national.html

    Rates of Growth

    by Henry Hazlitt.

    August 25, 1958

    Is it true, as we are now so frequently told, that Communist Russia’s economic “rate of growth” is faster than ours, or that we cannot survive unless we increase our own “rate of growth”? There are at least five main reasons why rate-of-growth comparisons are untrustworthy.

    1—In the midst of daily glib comparisons of national income and particularly “gross national product,” or GNP, it may come as a shock to many to learn that these figures are in large part arbitrary…

    2—It would take a book to describe all the arbitrary judgments and guesses that enter into even our own national income figures…

    3—It may be thought that we can make meaningful comparisons between the Russian economy and our such as pure metals in ingot form, this may be possible. But in most things there are enormous qualitative differences that never get into quantitative statistics…

    4—Prof. G. Warren Nutter has pointed out that there is “a long-run tendency . . . for the industrial growth rates to slow down, or retard, as the level of production gets higher.”

    5—Here we come to a more subtle point. Larger crops often have a smaller total dollar value than smaller crops. (Hence crop-restriction schemes.) But this merely illustrates a wider principle. Economists have pointed out since the time of Adam Smith that it is not “value-in-use,” but scarcity, that determines “value-in-exchange,” or money price…

    Let’s stop making a fetish of national income statistics and percentage rates of growth.

      • Hazel is was a libertarian. Whether he’s a hazelnut is an open question.

      • Re the quote at the top of this comment thread. the blogger pseudoerasmus has said that GNP series data are like hot dogs: you don’t want to know what is in them. True, he was talking about the series that economic historians cook up, but the resonance with Hazlitt is interesting.

        As for economic historians, a very good one, Bob Allen, has described the past century’s “big push” convergence success stories (USSR, Japan) pretty convincingly. Attempting to align Jeb’s proposal with these “proven” strategies might make for a hilarious post.

        But – except for the laughs – we scarcely need it. Dietz’s post covers the same Jeb-vs-reality ground. And he did it with a straight face!

  3. Do you think it adds to your analysis to refer to Jeb Bush as “Jeb!”? I think it diminishes your otherwise great analysis by indicating a clear bias in your political leanings. It’s your blog and you can do as you please, but I can’t see how it adds anything. Just constructive criticism. 🙂

      • I hear you. I’m just constantly fighting an uphill battle to convince my more conservative peers that the proposals being offered by people like Jeb Bush aren’t realistic and love having posts like this at my disposal to make that point. If I send this to them, many will dismiss it for something like that. Regardless, great analysis.

  4. Wait what? And how exactly does this extra $200 billion get funded? It doesn’t seem that surprising that if you “dump bunch of new spending into the economy”, then GDP goes up by at least that much. But when a government increases spending by any amount, that has to be funded by either: taxes (reducing households’ expenditure, and so GDP); borrowing from domestic citizens (reducing some combination of consumption & investment depending on the degree of Ricardian equivalence and substitutability of public debt & capital that you assume, but either way shrinking GDP); or borrowing from foreigners (which has to be repaid with interest in future by taxes on domestic citizens, which reduces etc & so on). I’m completely ready to believe that spending on infrastructure would boost potential GDP, but you don’t seem to subtract the cost of the public investment off your calculation (although maybe I missed it somewhere). Without that, you’re just saying that GDP goes up when there is more stuff, for free!

    • I didn’t say anything specific about that, no, and should have thrown in a note on that.

      1) Pure tax hike. So $200 billion in extra taxes each year for 5 years. The loss of consumption from that $200 billion tax offsets the $200B in infrastructure for GDP, so it’s a wash. No effect.

      2) Government borrows the money from private individuals. Consumption spending will fall by some fraction of the $200 billion, as individuals realize they will have to pay taxes at some point in the future to pay off the debt. Depending on how Ricardian you think people are, that fall in consumption could be anywhere from 0 (people are not forward looking or liquidity constrained) to something like $10-20 billion (people spread the expected cost of the future taxes out over the course of their lives, so C doesn’t drop much). But now you’ve also got C lower by 10-20B every year from now until forever (it’s like potential GDP fell by a little).

      3) Government borrows the money from the Fed (i.e. they print money), who agrees to hold it forever. Consumption spending doesn’t fall at all, so you get the full $200 billion.

      On top of those three options, we have to consider whether the multiplier on that spending is >1, which could jack *up* the actual stimulus. Regardless, to hit 4% growth you’re going to need to induce some kind of massive increase in spending now, presumably by borrowing or printing the money.

      Just as an aside, it does’t have to be the government that does this, it’s just the obvious example given that it was Jeb who mentioned it. If Apple decided to blow its $200B cash pile this year buying stuff, that would *also* induce higher growth.

      • dvollrath, what do you think of a burst of QE raising NGDP by, say, 10%? Do you expect that to have a smaller or larger short-term effect than the proposed infrastructure spending, since private parties tend to be more efficient than government ones? Or do you think the infrastructure burst would have a supply-side effect superior to that of private spending?

        BTW, what policies did Ireland pursue to get its sustained growth in the 1990s? The case of Ireland is especially impressive.

        What you say about institutional convergence has truth. Chile didn’t seem to see a very strong effect from its structural reforms until after Pinochet left.

      • Wait what (again)? Let be clear here – this isn’t just a minor issue. It’s the whole of your substantive claim that there is another way to get a substantial boost in GDP growth. As we both agree, your options 1 & 2 basically wouldn’t do that. And your option 3 sounds great except it violates every single piece of empirical and theoretical research on the topic. Economists disagree on more-or-less everything in monetary economics except for one fact: that a permanent increase in the money supply has *no* long-run effect on output. Expand the money supply by 1%, and prices go up by about 1% in the long run. Output is unchanged. Sure, there are debates about the short-run effect, but the best you get there is a short run increase in growth, followed by a gentle contraction as the output gap closes (I’m thinking of a standard New Keynesian model here). But I don’t think that there is any evidence *at all* that a helicopter drop would expand potential output; it would just expand output. So I don’t think that any of your suggestions to boost growth work here.

        As to the multiplier, (of which most estimates I’ve seen are somewhere between about 0.6 and 1.4, so hardly compelling evidence that this is bigger than 1, but I guess that it might be bigger in times of slack demand or something) these estimates are only ever *impact* multipliers; they’re just about a short-term boost to output from more government spending. I never understand why the multipliers debate is so obsessed with the short run. Extra borrowing eventually needs paying back, so the best you can get it higher growth today in exchange for less in future. Why’s that so great?

        And as an aside, we really should restrict this to just being a policy debate. Sure, Apple *could* spend their cash stockpile. Even if they did, then that’s just saying that extra economic activity increases GDP, which shouldn’t really be that surprising. More pertinently, why is this even a relevant case? Apple might spend that cash. But the government of France might also decide to give the US a year’s supply of baguettes. Or a genie might grant the country their wish of an extra $20bn (although in that case, the public should really ask for a bit more, or for everlasting wishes!). We can all think of things that *might* increase GDP growth, but the only really interesting ones are policy prescriptions, not wishful thinking about what a private company may or may not do with their assets.

        Before I come across as too much of a hater, let’s remember that we are really on the same side here! 🙂 You think that structural reform won’t give 4% per year, but that some government spending and/or magic might. I think that neither of these would work (except, of course, for magic – I fully believe in that). I’m also a long-time reader of the blog and a big fan. I just happen to think that you are wrong for half of this post!

      • Sigh… Typo in my previous response. Meant to say “But I don’t think that there is any evidence *at all* that a helicopter drop would expand potential output; it would just raise prices.” Damn Keynesian/Freudian slip…

    • Absolutely – which is why I put the baseline growth rate at 2.8%, 2.0% for per capita growth, and 0.8% for population growth.

  5. Reblogged this on DAMIJAN blog and commented:
    MUST READ: Za vse papagaje (ki brez trunka lastnega pomisleka ponavljajo za mednarodnimi organizacijami, kot so OECD,IMF, EK) ali zgolj sanjače o čudežnem efektu strukturnih reform tukaj Dietz Vollrath zelo enostavno in z mehansko formulo razloži, da vse te čudežne strukturne reforme na kratek rok nimajo efekta, ampak da delujejo na zelo dolgo rok. V nekaj desetletjih lahko dvignejo rast BDP nekoliko nad dolgoročnim povprečjem, toda kratkoročno ne dodajajo ničesar. Če želi država povečati rast BDP na kratek rok, je edini način, da nekdo začne trošiti več. In ta učinek na rast (tudi brez multiplikatorja) je nakajkrat večji od učinka kakršnihkoli masivnih strukturnih reform.

  6. Great post, thank you!

    About Greece, you are neglecting the fact that reform is also meant to improve competitiveness, either by lowering inflation even more or through quality effects. And it’s important in a country with a fixed rate regime and a share of export higher than in the US (33% against 14% according to world bank data).

    In that regard, PK’s recent post (http://krugman.blogs.nytimes.com/2015/07/22/the-half-lives-of-others-wonkish) gets to the point.

    Maybe also, given the politics, structural reform improves the likelihood of a spending boost (through EU structural funds, etc…).

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  9. This article seems like it proves that no country can ever have more than 3.1% growth. I don’t think pushing potential GDP to +53% is as heroic an assumption as you think; GDP has grown by 50% seven times since 1850.

    • Yes GDP has grown by a factor of 20 since 1850 (roughly). But in 1850, potential GDP was *not* 20 times higher than actual GDP (they didn’t know about airplanes or computers or have central electricity or transistors or container shipping or synthetic fertilizers, etc…). Both potential and actual GDP have grown by about a factor of 20 over that period.

      You can get >3% growth if you start *way* below potential. Think China, which managed 8-10% growth because it was catching up from so far back. But once you are relatively close to the potential (like Greece), it is just hard to grow fast.

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  11. Excellent post. What I would like to do is connect it with a couple of older posts of yours regarding TFP/technological growth in consumption/investment sectors and relate them to Greece.

    The IMF anticipates that structural reforms will manage to increase Greek TFP growth to reach the highest rates in Europe (which correspond to Ireland). Yet the Greek economy is much more service oriented than Ireland or Germany. It has a service sector share of 78% rather than 69%. Its industry (including energy) is 13% rather than 23-25% while its high/medium-high technology manufacturing sector share is 2% rather than 12-13% (see OECD STAN indicators).

    As you so elegantly put it, you ‘buy time’ when you buy services, not a thing. You cannot have a high TFP growth tourism/restaurant sector without lowering quality. Nor can you achieve higher productivity in most parts of the public sector without putting more children in one classroom, or assigning more beds to one nurse.

    Ultimately, the only way to ‘increase TFP’ is to change the economy’s structure away from SMEs and in favor of large stores/service providers. That might help achieve higher productivity but will most definitely increase structural unemployment.

    • I think that’s a nice way of thinking about it. TFP growth is not a single thing, it is the summation of TFP growth at micro-level firms (or individuals), so the composition of those firms/individuals matters a lot. Yes, I think it is quite possible that being service-oriented makes it even harder for Greece to achieve rapid TFP growth as the IMF expects/hopes/wants.

  12. I may be missing something, but what is stopping the US ($17t GDP) from putting a mere $200b per year into its infrastructure?

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