Economists' Outlook

Housing stats and analysis from NAR's research experts.

The Most Powerful Force in the Universe

We’re experiencing a sluggish economy, high unemployment, and a runaway debt.  Are there any magical solutions?  What about applying Albert Einstein’s “the most powerful force in the universe?”  He once quipped that compound interest was just that.

The concept of compound interest is fairly straightforward.  Put money in bank, for example, and let the money multiply and multiply.  At a 10 percent interest rate, $100 becomes $110 in one year, $121 in two, and so on and so forth, becoming $10,670 in 50 years.  That’s the power.  If the person had withdrawn the yearly interest income of $10 each year, rather than let it sit in bank and multiply, then one would be left with just the original $100 in 50 years (though he would have consumed $500 over the 50 year period.)  When a grandmother shouts “eureka” from the attic after digging up a very old stock or bond certificate with re-invested dividends or compound interests – she’s made a discovery of that most powerful force in the universe.

In terms of the national economy, it means a solid growth in GDP.  Gross Domestic Product is a measurement of all the things produced in the U.S.   GDP has grown by an average of 3 percent each year in the U.S.  That arises from the simple math of a 1 percent rise in population and a 2 percent rise in worker productivity.  That is, more people able to work leads to more production.  More work out of each worker (because of better skills and technology) leads to more production.

  • 1 (population growth) +2 (productivity growth) = 3 (GDP growth)

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But what would happen if productivity rose at a slightly higher 3 or 4 percent? Then GDP can grow at 4 to 5 percent, rather than the historical average of 3 percent. The above chart of actual historical data suggests it is not uncommon for the economy to grow at 5 percent or even faster, though sustaining high growth rate over a decade or more has not yet happened. But other countries have had a high sustained growth, if they are starting from a low point and applying copycat technology from more advanced nations. China is a good example of this; its GDP has been roaring at 10 percent growth for many years. Many analysts believe that China, because of its fast growth, will have higher national income than the U.S. within 10 years, possibly even in 5 years. Note: we are referring to a higher aggregate national income, but not per-person income, where China will continue to lag behind for many foreseeable years.

A seemingly small change in productivity gain can have a huge cumulative impact after many years. Consider the following scenario on the size of the U.S. economic pie under different GDP growth assumptions.

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In 2040, for example, the economic pie or the national income would be $24 trillion if the GDP grew at a 2 percent annual rate, while it would be $57 trillion if GDP flew at 5 percent.  If the federal government takes 20 percent of the pie, then the one-year tax revenue in 2040 could be either $4.8 trillion or $11.4 trillion.  The larger figure will be more than plentiful to cover just about any government program, payoff debt, and then some.

So, how do we turbo-charge the economy and raise worker productivity?  Some will claim that only low tax rates will provide the necessary incentive to work hard and come up with innovative business ideas.  Others will say investments in government infrastructure like high-speed trains and subsidized high-tech education will be essential.  A whacky idea would involve constantly cloning figures like Bill Gates and Steve Jobs.

What is, perhaps, needed is a competition of best ideas.  What about offering a portion of the money currently spent on public education to entrepreneurs to come up with a new educational system?  That is, carve out current existing public education funds for trying out different ways of educating our kids that is completely independent from the current way.  Include for-profit entrepreneurs who may be able to deliver drastically higher results at a lower cost.  We should not be disturbed by the profit motive of entrepreneurs provided that the students, particularly those of low-income families, are able to become highly productive. Get smart, trusted people like Oprah Winfrey, T. Boone Pickens, Warren Buffet and the like to be the judges in the selection process.  This suggestion is just a thought to illustrate the magical power of the compound growth rate.

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