Question: What Is the Ideal GDP Growth Rate?
Answer: The ideal GDP growth rate is one that is sustainable, so that it stays in the expansion phase of the business cycle as long as possible. GDP is the economy's gross domestic product, which is the entire economic output for the past year. The GDP growth rate compares how much more (or less) the economy produced than the quarter before.
You'd think the more growth, the better. However, the ideal GDP growth rate is like a body temperature of 98.6 degrees. Obviously, if your temperature is lower than the ideal, you know you're sick. If it's too low, you're near death. But a higher temperature can also mean you're sick. If it's over 100, you have a fever. If it's above 104 degrees for any period of time, you're deathly ill.
If the economy grows too slowly, or even contracts, of course it's not healthy. But, if it grows too fast, that's not ideal, either. In fact, if GDP growth starts spiking above 4% for several quarters, it usually means there is an asset bubble of some kind. In the business cycle, the phase that follows expansion is the peak.
Soon afterwards follows contraction. That's because when the economy grows too fast, it overheats. There's too much money chasing too few real growth opportunities. Investors start putting good money into not-so-good investments. When those investments start losing money -- and they always do -- confidence is lost. Panic ensues, investors start selling, causing even more investments to lose money. It doesn't end until prices are low enough to stop the madness and attract investors again.
Sure enough, in 1999-2000, there was irrational exuberance around high technology stocks. By 1999, U.S. GDP growth was 5.2% in the third quarter, and a whopping 7.4% in the fourth quarter. In 2005-2006, the asset bubble was in housing. Here again, the economy grew 4.2% in the first quarter of 2005, and 5.1% in the first quarter of 2006. During both bubbles, GDP growth spiked above 4% for several quarters in a row.
When GDP growth is above the ideal, it can also cause inflation. During 1999-2000, U.S. inflation was 2.7%-3%. Between 2003-2005, it was 3%-4%.
Once the bubble burst, the economy enters the contraction phase of the business cycle. GDP growth usually falls off sharply, and goes into negative territory, which signals a recession. During 2008-2009, U.S. GDP contracted in five quarters. Between 2000-2002, it only rose above 2% in one quarter, and shrank in two quarters.
Healthy Rate of Growth Is 2%-3%Therefore, economists agree the ideal GDP growth rate is more than 2%, but less than 4%. In between the two recessions, the annual economic growth rate was ideal:
- 2.5% in 2003.
- 3.9% in 2004.
- 3.2% in 2005.
- 2.7% in 2006.
- 2.0% in 2007.
However, annual growth rates can mask a great deal of variability. Looking back, clues of the impending financial crisis of 2008 were revealed by looking at these less-than-ideal quarterly GDP growth rates. For example, the annual growth rate for 2006 looked great at 2.7%, but the quarterly rates warned of the impending economic weakness in the second half of the year. The economy grew a mere .1% in Q3, and an anemic 2.7% in Q4. In fact, this was right after the housing boom hit its peak. The Subprime Mortgage Crisis was the culprit.
In 2007, it looked like the economy was going to recover, and the damage would be confined to housing. Then, growth dropped significantly in Q4:
- Q1 0.5%
- Q2 3.6%
- Q3 3.0%
- Q4 1.9%.
- Q1 -1.8%
- Q2 1.3%
- Q3 -3.7%
- Q4 -8.9%.
Obama Inherited an Unhealthy EconomyThe new President launched the Economic Stimulus Program in March 2009 and try to restore confidence, and spur the economy into health. Before it could be implemented, the first two quarters in 2009 were still negative:
- Q1 -6.7%
- Q2 -0.7%
- Q3: 1.7%
- Q4: 3.8%.