Illustration by Jac Depczyk

AMID the hubbub over a few less-bad-than-expected statistics, America's economic debate has turned to the nature of the recovery. Optimists expect a vigorous rebound as confidence returns, pent-up demand is unleashed and massive government stimulus takes effect. Most observers, including this newspaper, are bracing for a long slog, as debt-laden consumers rebuild their savings, output growth remains weak and unemployment continues to rise. There is, however, something that eventually will have a much bigger impact on Americans' prosperity than the slope of the recovery. That is the effect of the crisis on America's potential rate of growth itself.

An economy's long-term speed limit (its “trend” or “potential” rate of growth) is the pace at which GDP can expand without affecting unemployment and, hence, inflation. It is determined by growth in the supply of labour (the number of workers and how long they toil) along with the speed with which productivity improves. The pace of potential growth helps determine the sustainability of everything from public debt to the prices of shares.

Unfortunately, the outlook for America's potential growth rate was darkening long before the financial crisis hit. The IT-induced productivity revolution, which sent potential output soaring at the end of the 1990s, has waned. More important, America's labour supply is growing more slowly as the population ages, the share of women working has levelled off and that of students who work has fallen. Since 1991 the labour supply has risen at an average annual pace of 1.1%. Over the next decade the Congressional Budget Office expects a 0.6% annual increase.

According to Robert Gordon, a productivity guru at Northwestern University, America's trend rate of growth in 2008 was only 2.5%, the lowest rate in its history, and well below the 3-3.5% that many took for granted a few years ago. Without factoring in the financial crisis, Mr Gordon expects potential growth to fall to 2.35% over the coming years.

That alone is grim news. But has the Great Recession made things worse? In theory, it could do. Slumping investment may slow the pace of innovation. Soaring government debt could raise interest rates. Higher taxes, designed to reduce the debt, might dull incentives to work and invest. More regulation, in finance and beyond, could deter innovation. Workers' skills may atrophy as a result of joblessness. On the plus side, well-targeted government spending on, say, infrastructure or education could boost potential output, while the huge wealth that Americans have lost may induce more of them to work for longer.

History sends mixed signals about how much these effects matter. Surprisingly, the 1930s bode well. Despite the deep slump in growth and investment, America's potential growth rate is reckoned to have risen smartly during the decade, as innovations from nylon to synthetic rubber proliferated, while business processes were fundamentally overhauled. Alexander Field, an economist at Santa Clara University, has called the 1930s the “most technologically progressive” decade of the 20th century.

In the modern era Sweden offers grounds for optimism. Its productivity growth accelerated after the early 1990s financial crash, in part because the government dealt swiftly with the banking mess. Japan, in contrast, saw productivity growth shrivel in the early 1990s. Several studies pin blame for that on Japan's unwillingness to tackle its banking mess. But the process was not irreversible; Adam Posen of the Peterson Institute has argued that by the late 1990s Japan's potential output had risen modestly, thanks to financial reform and broader deregulation. Nor is there much sign that Japan's gaping budget deficits have crowded out private investment. Yields on long-term Japanese bonds slumped from 7% in 1990 to 1% in 2003, and are still only 1.45%, even as gross public debt is heading for 200% of GDP.

Is this cause for optimism about America? Possibly not. Compared with the 1930s, America's workers are more specialised, which makes it harder to shift occupation; they are also more cushioned with social protection, which reduces the urgency to adapt. Workers are less flexible because the housing bust will prevent many from selling their houses to move to where the jobs are. JPMorgan estimates that America's natural rate of joblessness may have risen from 4.75% to closer to 6%.

Today's investment slump may have particularly pernicious effects on productivity because, unlike Japan's, it does not follow a capital-spending binge. During the recent bubble years, America's housing investment boomed, but corporate investment was laid low by the dotcom bust.

Debt burden

Most important, even if Americans become thriftier, soaring public debt may crowd out private investment more than in Japan, which, unlike America, is a creditor country. Already American bond yields are starting to rise. Academics differ about just how much bigger budget deficits and higher public debt affect interest rates, but most agree that they do. A 2004 study suggests that interest rates rise by 0.03% for every 1% increase in the debt/GDP ratio. That ratio is set to rise by 30 percentage points between 2008 and 2011, which implies a 1% higher risk-free interest rate, and commensurately lower private-sector investment. Even if higher private saving blunts the effect, some crowding out is eventually all too likely.

All of these effects can be mitigated by good policies, or exacerbated by bad ones. Sensible approaches to reducing America's long-term deficit, by tackling entitlement spending or reforming the tax code, would minimise the rise in long-term yields and might even boost potential growth. Misguided efforts to prop up declining industries or dictate lending decisions would add to the damage. America is heading for an era of slower growth. Just how much slower is still up for grabs.