How fast can the economy realistically grow, not just in the near term but in coming years? Potential or "trend" GDP growth has two basic ingredients: growth of the labor force and productivity gains. The more the labor force is growing and the higher the productivity gains, the faster the economy can grow without straining resources and sparking inflation. Right now, slack in both people and equipment is large enough that inflation is unlikely to become a problem in the near term.
Our interest, though, is in where economic growth is likely to converge over time, so let's explore the economy's longer-term potential. Growth of the labor force can be influenced by exogenous forces such as demographics. It also can be determined by how many people believe more jobs are available for them, beliefs that cause them to seek or not seek a job. What interests me, though, are productivity gains. When productivity is high, corporate profits tend to increase, and companies may share some of those income gains with their workers. That can increase economic growth.
Going a step further, what influences productivity gains is business' investment in new technology or equipment. This is what will allow companies to produce more for each hour of labor. And unfortunately, those investments haven't recovered ground that was lost during the recession. Consider the following graphs, which indicate business investment in certain capital expenditure categories:
Orders for machinery have rebounded as manufacturing has enjoyed a renaissance of sorts. However, items that make businesses more productive, such as communications equipment, computers and electronic components, have seen a systematic drop in new orders. The wide-ranging services industries use these items to enhance productivity gains, but these investments have not recovered completely since the recession.
First, though, what do we mean by productivity gains anyway? Is it a worker producing ever more toasters on an assembly line? No, it is sometimes disruptive new technologies that can enable companies to increase output with the same inputs of labor. Think of how the Internet remade the way we shop, bank, travel and obtain information. Then think of the jobs that were created as companies that operate on the Web became prolific, while other jobs, such as travel agents or sales clerks, receded. Consider how much more productive we as a society became when businesses could automate functions or perform other tasks more quickly.
That didn't happen without some investment. Computer servers needed to be bought, self-service retail checkouts needed to be installed. Expensive robotic assemblies at manufacturers needed different -- and fewer -- workers to operate them. These all were the makings of higher output with the same, or fewer, hours of labor. (Simply witness the fact that we've already exceeded total output, as measured by GDP, from before the recession, but with millions of fewer workers.)
When businesses make fewer investments into equipment and software, it means a couple of things. One is that businesses might be more cautious about the future, as we see now with the fiscal cliff. But since these trends have been in place since the end of the recession, it also means that businesses might not expect their output to grow as fast as it had in years past.
When businesses don't expect output to grow as fast, it becomes a self-fulfilling prophecy. The reasons for these lowered expectations are complex and relate to the many well-publicized headwinds the economy faces. Businesses might not invest as much into their businesses, nor do they hire more. Their profits, as we have seen in the recent earnings season, might decelerate a bit, and consumers may find that their incomes aren't growing as much. That doesn't mean a recession by any means, but it does mean that the longer-term potential growth rate of the economy is reduced. Thus, lower business investment is both a cause and an effect of slower growth expectations.