The two types of GDP growth, explained

Do you really know what GDP growth means?

The Wall Street bull.
(Image credit: Illustrated | AndreyKrav/iStock, jessicahyde/iStock)

The latest GDP numbers are in: The U.S. economy grew 2.9 percent in 2018. Expect plenty of articles picking through which factors contributed the most to GDP growth, why, and how long it can continue. But here's something pretty basic and very important you likely won't see discussed: There are actually two kinds of GDP growth.

As a reminder, GDP means "gross domestic product," and it's the go-to method for measuring the size of the economy at any point in time. The two kinds of growth tend to get lumped into a single figure because they both end with more GDP. But it's actually helpful to distinguish them. The two kinds of growth serve two distinct roles and come with somewhat different policy implications.

The first kind of growth pertains to whether we're using all of the economy's capacity.

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There's what GDP is and what it potentially could be. There's a certain amount of real resources out there — workers, factories, equipment, vehicles, and all the rest — and either we're using them all or we're not. No one knows exactly where that potential GDP threshold lies. There are various methods for estimating it, and a lot of disagreement. But the way to reach it is to pump enough demand into the economy to employ all our resources.

If actual GDP is below potential GDP, that's bad. It means we're missing out on wealth creation. It also means more people who want to work are going jobless, since so much of the economy's resources are just people. That in turn means workers have less bargaining power, so wages stagnate and inequality increases.

Even now, with unemployment at 4 percent, it's possible we're still far below potential GDP. (Unemployment doesn't always reliably count all the potential workers out there.) If you assume actual GDP was the same as potential GDP in 2007 and you just extend the growth trend, then the current gap between actual and potential GDP remains enormous. The Federal Reserve also tries to measure real resources directly, at least in industries like manufacturing, mining, and energy. Remarkably, we're only using 78 percent of those available resources right now.

There's an inverse danger, though. If we actually reach potential GDP, but demand keeps pushing the economy up, we'll get inflation.

That brings us to the second kind of growth: Increasing potential GDP itself. The faster it grows, the more wealth we have the capacity to create.

How do we increase the economy's capacity, as opposed to just employing all the capacity we have? We can add more workers, through either births or immigration. But that increases GDP without necessarily increasing GDP per person — and it's the latter that gets you rising living standards. What we really need is productivity growth: creating new businesses; investing in new equipment and factories for existing businesses; innovating new technologies and business models. Improving the quality of education helps too, since a more educated populace will be a more innovative populace. (Though that occurs over much longer timeframes.)

Unfortunately, how American politics thinks about these two kinds of GDP growth can be pretty weird and misguided.

When most economists and politicians talk about the importance of GDP growth, they usually mean the second kind of growth. Because the first kind of growth improves capacity utilization, but not necessarily capacity itself, it often gets dismissed. (You'll sometimes hear it called "sugar high" growth.) Traditionally, conservatives and centrists have preferred tax cuts, assuming they'll encourage individuals to work harder and businesses to invest more. But there's not much historical evidence that tax cuts reliably do this. Republicans made this case for their 2017 tax cut, for example, and it's been a total dud so far.

Here's another thing many politicians and economists don't like about the first kind of GDP growth: pumping more demand into the economy often requires fiscal stimulus from the national government. That often means deficit spending, which means a bigger debt load. And economists fear more government borrowing will raise interest rates over time, choking off the second kind of GDP growth.

This is deeply misguided.

First, public spending on things like education, research, technology, and infrastructure also grows potential GDP, not just demand.

Second, the federal government, via its central bank, wields enormous control over interest rates. If it wants lower rates, it can lower them. The tradeoff is inflation, and that only becomes a problem when the economy is actually butting up against potential GDP. Below that threshold, the government can deficit-spend as much as it wants. And even if we're pushing above the potential GDP threshold, a stronger economy can carry higher interest rates, just like a stronger person can safely lift more weight.

Finally, there's this: Maybe the best way — and certainly the least appreciated way — to get the second kind of GDP growth is to maximize the first: push the economy all the way to its capacity with demand stimulus. If all workers and resources are being put to use, businesses will be under a lot more pressure to get more value out of the resources they have — i.e. grow productivity. For both people and economies, the way to get stronger is usually by regularly exercising and pushing themselves to their limits.

The next time the GDP numbers come out, ask yourself: Exactly which kind of GDP growth are we getting? Which kind do we need more of? And what do we need to do to get it?

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