Is American Production Above or Below Trend?

In the world of private equity, a critical component of success involves evaluating what the trend is for a given industry or business. Among economic trends, there’s no bigger trend than GDP, a measure of all final production of goods and services. Is GDP, otherwise known as production, above or below trend?

An Exponential Trend of Real GDP per Person

The following figure looks at real GDP per person in the U.S. from 1948 to 2015 (real GDP simply means the figures are adjusted for inflation). The gray lines represent non-recession years. The red lines represent recession years.

The dotted line running through the real GDP per person figure is an exponential trend.  An exponential trend presumes that growth in the given data will continue at an increasing rate, meaning growth accelerates forever. The assumption of exponential growth has generally been used for almost all of American economic history.

It’s clear to see that if one assumes an exponential trend, as most economists have done in the past, real GDP per person is well below trend.  This suggests that there’s a long expansion ahead before there should be any concern of an economic downturn.

If real GDP per person grows at 3.5% from today until 2021 (nominal GDP of 5.0% if one assumes population growth of 1.5%), then real GDP per person may catch up with trend in 2021 or 2022, placing the next recession six or seven years off.

Obviously, this also implies that private equity probably has another long while to go before any concern of a peak would be warranted.

Switching to a Simple Linear Trend for Real GDP per Person

What if the exponential trend line is no longer useful in evaluating potential American economic growth?

Here’s what the figure looks like with a linear trend. As shown, the picture is quite different.  Instead of being well below trend, real GDP per person is right about on trend.

Obviously, the message is quite different than the first graph.  If real GDP per person is already at trend, then there’s reason for market observers to start talking about the boom and potential peak.

Which Trend is Right?

The next question is obviously – which trend is right? This, of course, is partly science and partly art. If the American economy can experience a boost in productivity growth, then the exponential trend might be right. On the other hand, the linear trend might be more applicable for U.S. economic growth for the foreseeable future.

Causes for the Change in Trend

Among the reasons for the changing in trend economic growth are international competition for skilled labor, the aging of the labor force, the shift to online work, and the hollowing out of America’s dominance in intellectual capital.

First, more-so than in the past, the competition for labor on an international basis is incredibly intense.  Inventors and others are increasingly likely to shift operations to the most desirable location, and the U.S. is no longer the most desirable location.

Second, the American labor force is also aging, putting downward pressure on productivity.

Third, not only is there headquarter-location competition, but there is also a shift towards platforms that are incredibly competitive, most notably the shift to online work.

Fourth, American labor no longer has such a large advantage in intellectual capital.  Lower cost competitors, including workers in China and India, may be shifting the American growth trend lower.

Conclusion

Overall, it depends on what you want to believe when it comes to trending U.S. GDP growth. If one assumes exponential growth is still applicable to real GDP per person, then economic growth is well below what it should be. If, alternatively, one assumes trend growth is now more linear, then real GDP per person is about at trend.

The difference in the message, of course, is obvious.