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For this tepid economy, there's only one way out

August 15, 2013: 8:00 AM ET

A stunning government report says the U.S. economy has gone through a frightening structural change since the recession: a reduction in our capacity to grow. Here's what we need to do to turn things around.

By Shawn Tully, senior editor-at-large

130814172757-economic-growth-614xaFORTUNE -- A wonder of America is that, after every downturn, the economy inevitably regains its old, formidable growth trajectory. In good times, the U.S. expands its output faster than any other developed nation. That robust performance in the long periods between recessions is what we count on to consistently raise our standard of living, and what Americans consider normal.

But now, the U.S. faces a future of diminished expectations like nothing witnessed since World War II. Unless business and government take daring, extraordinary measures, the economy is destined to generate sluggish growth that's more than one-third slower than in the past. That scenario will stifle incomes, pressure corporate earnings and stock prices, sap tax revenues required to support the rising ranks of retirees -- and shrink the savings Americans need to buy houses and send kids to college.

Right now, the big economic debate centers on Fed policy -- on how to find just the right level of monetary stimulus to spur the weak recovery, but not cause other problems. Yet more debate has focused on how to calibrate government programs so as to narrow the growing income gap. But for all this debating, our policymakers are missing the historic challenge: ensuring that the entire economy grows briskly so that the benefits reach every constituency, from wage earners to Medicare beneficiaries to investors. We need to encourage a surge in private capital investment and fire gains in productivity. And to do that we first have to streamline and retool regulations and revise our outdated immigration code to welcome millions of talented immigrants. America, it's time to get real!

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Sometimes, of course, we need a good scare to get us thinking realistically about our circumstances: a stern warning about our cholesterol count or blood pressure to get us to change our diet and start exercising. Well, here it is: a Congressional Budget Office report, entitled "What Accounts for the Slow Growth of the Economy After the Recession?"

That report was released back in November and somehow slid under the public radar. That's unfortunate because the CBO study shows in vivid detail what we all know -- or should know -- by now: how disappointing this recovery has been. In the three years following the end of the recession, from mid-2009 to mid-2012, the economy grew less than 7% in total, a remarkable 9 percentage points below the average surge of 16% in previous recoveries. According to the CBO, that disappointing record has two explanations.

The first is temporary -- a "cyclical" downturn caused by everything from continuing trauma from the housing crash to weak consumer spending to fiscal austerity.

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The second is far more serious, and a radical departure from the past: a long-term, structural downshift in our capacity to grow. Put simply, it's a lack of expansion in working-age people and capital investment, the two main forces that drive an economy. That's hurting the economy now, and it will hurt even more in the future by inhibiting the economy's ability to grow when times get better, America's traditional strength. The CBO's forecast: The U.S. is no longer destined to boom when the business cycle turns.

The CBO draws an essential distinction between the economy's current weak performance, and what matters most, its potential to expand in the future. "Potential" GDP growth refers to the pace the U.S. should achieve when the cycle inevitably improves, when employment returns to normal levels, and consumer spending recovers. The size of that potential depends on two main factors, the number of people in the workforce and the economy's productivity (the amount those workers, and the machines they deploy, are able to produce). Productivity, in turn, depends on how much, and how wisely, companies are spending on new plants and computers, and how competent and skilled the workforce proves at making more cars, aircraft parts, and software every hour on the job.

Both the tepid demographic outlook and the mediocre productivity picture are imposing severe limits on America's potential. Consider the country's working-age population, which is growing at just 2.3% a year, half the 5% pace in previous recoveries. Those 71 million baby boomers who swelled payrolls for decades? Yes, they're retiring en masse. And the number of women entering the workforce, another major catalyst, has also plateaued.

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On the productivity side, American businesses are exhibiting more caution than confidence these days. They're not investing nearly as much, nor achieving nearly the gains in output per hour, as in past recoveries.

So how damaging will new demographic and productivity trends be? We may not get a clear sense for a while yet. The CBO reckons that from 1950 until the early 2000s, the U.S. had a potential growth rate of well over 3%, and in most periods, managed to achieve it. And indeed the CBO predicts that, starting in 2014, the U.S. will expand at over 3% annually for a few years more.

Thereafter, get ready for the new normal. Starting in 2019, GDP will expand by a bit over 2%, the CBO concludes in a separate report, released in February. That's around 1.5 percentage points below the average in relatively good times.

The biggest single issue confronting out policymakers and business strategists, frankly, is to change that destiny. We need to reject the "new normal" and get a lot closer to the economy Americans have come to count on, one growing at about a 3.5% clip.

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So there's the warning. Now here's the remedy. An excellent study from consulting group McKinsey, "Game Changers: Five Opportunities for U.S. Growth and Renewal," provides a compelling blueprint for how America can reestablish a strong growth trajectory. The solutions, appropriately, focus on massively mobilizing private investment, instead of on heavier doses of government subsidies.

At the heart of the McKinsey study are five "game changers" -- areas where the U.S. can generate extremely rapid growth, providing that policymakers rein in the lengthy, expensive regulatory webs that entangle many companies.

The first is energy. Since 2007, the U.S. has boosted shale oil production by 50% a year, raising production from 3 cubic feet per day to 24 billion. At the same time, the price has plunged from $12 to $4 per million BTU. Natural gas is a feedstock for fertilizers, petrochemicals, iron, steel, and paper production. It's making the U.S. highly cost competitive in all of those industries. For example, Russian-owned Severstal North America is now a major steel producer in the U.S., chiefly because of exceedingly favorable production costs. McKinsey advocates cutting the red tape and regulatory costs that keep promising new projects on hold.

A second big area is trade. To grow at historic rates, the U.S. must gain substantial share in global markets. In recent years, the opposite has been norm. The U.S. trade deficit in manufactured goods has grown from $6 billion in the early 1990s to $270 billion last year. We buy far more autos, chemicals, computers, medical equipment, and appliances than we sell to other nations, and the outlook is getting worse. It doesn't have to be that way: U.S. aerospace exports have doubled since 2009, and the shale gas revolution is making America a big exporter of petrochemicals, a prime example of how one game changer can aid another. McKinsey praises initiatives such as SelectUSA that provide one-stop shopping for foreign companies seeking to produce in the U.S. Another big growth catalyst, if we can summon the will, would be sweeping corporate tax reforms that bring lower rates in exchange for broadening the base -- an effort that can help lure production back from foreign tax havens to the U.S.

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A third area is big data. To restore a consistent, 3%-plus growth rate for the American economy, we'll need to accelerate productivity growth by 30% by 2020. Big data has the potential to improve sales-per-hour in retailing, by accurately forecasting store traffic at different times so that the right number of sales people are always present. Manufacturing output can likewise be boosted with the help of equipment-monetary sensors that fine-tune preventive maintenance. In health care, physician groups can mine medical records to track patients with Type-2 diabetes and work with them to actively manage their medication and diet. That can not only help patients, but also trim corporate health costs.

A fourth area, infrastructure, is the most controversial. McKinsey advocates raising infrastructure spending by one point of GDP over the next eight years, a projected increase of as much as $180 billion. Indeed, a portion of that number is bound to happen because of the pipelines and refineries needed to support the explosion in shale oil, providing onerous regulations don't stand in the way. The more fraught area is state and federal spending on roads, tunnels, water plants, and the like. It's interesting that for all the talk about infrastructure "investment" among politicians, the total amount our governments spent on the nation's capital stock fell by $60 billion from 2011 to mid-2013. It's clear that the U.S. is chronically under-investing in its infrastructure while Americans waste time in traffic and waiting for antiquated commuter trains.

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Finally comes the area that may be most essential to America's growth: enhancing the size and talent of the U.S. workforce. We need to rethink immigration policy. McKinsey correctly advocates greatly raising the number of visas awarded each year to doctors, engineers, programmers, and other well-educated folks who seek to work in America. It's an issue Congress is grappling with today, and it's chiefly an economic issue: If we want to grow rapidly, we'll need a lot more immigrants. McKinsey also chronicles the decline in the ranks of well-educated adults. Today, just 41% of Americans aged 25 to 34 hold college degrees. This nation currently ranks 16th on that measure, behind Japan (56%), Ireland (48%), and the U.K. (45%). For this writer, the best solution is encouraging magnet and charter schools with a proven record of giving high school students the tools and desire to reach for college.

As McKinsey points out, the main thrust needs to come from the private sector. The government's role should be to reform regulations and tax policy to create the best possible environment for entrepreneurship and investment. No, it may not happen. But America has defied the odds before by doing the basics, while Japan and other rivals have lost their way. The right choice is simple -- because we really don't have a choice at all.

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About This Author
Shawn Tully
Shawn Tully
Senior EDITOR-AT-LARGE, Fortune

Shawn Tully has been writing feature stories for Fortune since 1980. He's covered stories as varied as the Vatican's finances, the exile of fugitive commodities trader Marc Rich, and the disastrous merger between Guidant and Boston Scientific. He specializes in banking, federal budget and spending issues, and health care. Tully holds a B.A. in English from Princeton University, an M.B.A. from the University of Chicago, and a master's in Applied Economics from the Universite Catholique de Louvain in Belgium.

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