U.S. Productivity: the problem plaguing the economy

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Productivity growth shapes the economy; it powers growth, boosts household incomes and improves living standards. However, the country is in the middle of a productivity slump, which has deepened since the 2008‑09 financial crisis. Even the technology boom has failed to unlock significant efficiency gains. Unless productivity improves, the US will struggle to break out of its low-growth trajectory.

The importance of productivity has been thrust back into the spotlight recently. In July Janet Yellen, the chair of the Federal Reserve (Fed, the central bank), called it the “most important factor determining continued advances in living standards”. Jeb Bush, the favourite to win the Republican presidential nomination, said that Americans would “need to work longer hours” to push the real GDP growth rate up to 4%. But the evidence is grim: labour productivity growth, as measured by the output of goods and services per hour worked, was just 0.3% year on year in the second quarter of 2015. As a result, the five-year rolling average of productivity growth slumped to its lowest level in more than 30 years.

Productivity hits 30-year low

Four-decade-long slump in productivity

There is an old economic adage that productivity is not everything, but in the long run it is almost everything. Sustained economic expansions are built on three factors: changes in capital (physical and human); the size of the workforce; and improvements in productivity. In the US, capital accumulation has typically been the least important of these factors, and we expect this to remain the case. Growth in the workforce, meanwhile, has slowed as one-off boosts from higher female participation and the rise of the baby boomers have not been repeated. As a result, productivity growth will be the key driver of US economic growth in the coming decades.

The bad news is that the US is in the middle of a productivity slump that has lasted for four decades. A 250‑year boom, spurred by the industrial revolution and life-altering inventions such as the internal-combustion engine, the electric fridge, plumbing and the telephone, came to an end in the 1970s. Since then, annual productivity growth has averaged just 1.5%, except for the period from 1995‑2003, when it doubled to over 3%, before falling back once more. The question, then, is whether US productivity growth will be closer to 1.5% or 3% in the coming years. The answer will determine the living standards of millions of Americans.

Where is the technology boom?

There is no conclusive explanation for why productivity growth has slowed since the 1970s. Even more puzzling is that the slowdown has coincided with the dawn of the computer age; Moore’s Law holds that the processing power of a silicon chip has almost doubled every 18 months. This explosion in automation ought to have had some effect on workers’ output. Several prominent economists claim that there has been no such productivity slowdown, and that the data understate advances in technology. As early as 1987 Robert Solow said that “you can see the computer age everywhere but in the productivity statistics”. Hal Varian, chief economist at Google, maintains that the US has a measurement problem, not a productivity problem. However, this is an unconvincing explanation for the recent productivity puzzle; statistics have always struggled to keep pace with new inventions, and there is no evidence that these problems are any worse now than in the past.

A more convincing argument is that advancing technology will lead to greater productivity, but that we have yet to see the benefits. Inventions spur efficiency gains, but at a lag; research suggests that it can take 15 years for advances in technology to lead to significant productivity improvements. Time is required, not only to understand how to use new technology but also to reorganise companies to take full advantage. This is especially true in the case of the US, which generally invents new technology rather than importing it from elsewhere. There is still time, then, for the information technology boom to drive a wave of productivity improvements. Driverless cars could reduce time spent in traffic, drones and 3‑D printing could drastically shorten supply chains, and robots could cut the cost of manufactured goods and services.

Cyclical factors exacerbate productivity problems

The financial crisis in 2008‑09 has worsened the productivity slowdown, partly because US firms have altered the manner in which they respond to recessions. During previous downturns companies tended to retain workers, and output per worker would dip. It was more valuable to keep experienced workers rather than firing them and training replacements when the economy recovered.

Recent recessions have bucked this trend, however, and productivity has become more pro-cyclical. Firms are more willing to sack workers in downturns and push retained workers to increase output. Lower inflation has made it more difficult for companies to cut real wages in response to weaker demand, so they lay off more workers. Thus, in 2009‑10, unemployment rose sharply and productivity jumped temporarily, but productivity growth was slower during the recovery, as companies gradually hired more workers who they had to train.

productivity spiked in the recessionThis pro-cyclical trend was exacerbated by the reluctance of firms to invest in the immediate aftermath of the financial crisis. The reduction in business investment reduced firms’ ability to take advantage of new technologies and ideas. However, these problems will dissipate as the US economic recovery continues. Annual business investment growth bounced back to an average of 6.5% in 2011‑14, and this will eventually contribute to a faster expansion in the economy’s productive capacity.

There is no great stagnation

When looking to the future, it is tempting to extrapolate current technology trends or use anecdotal evidence to support a viewpoint on the economy’s productivity potential. For example, it is appealing to posit that replacing human-operated vehicles with self-driving ones will not lead to as many efficiency gains as moving from horse to automobile, and that videoconferencing is not as big an advance as the telephone. Moreover, in order for new inventions to boost productivity, they must raise production. Listening to Spotify on an iPhone or playing Angry Birds on an iPad lifts utility but not productivity, as they do little to increase output.

However, history shows that productivity growth is unpredictable, and tends to ebb and flow. In the midst of the mini-productivity boom in 1995‑2003 Alan Greenspan, the then Fed chair, said that there was a “distinct possibility that total productivity growth rates will remain high or even increase further”. Instead, productivity growth quickly sank back down to earth. It appears unlikely that technological progress has plateaued but, equally, it is unclear why productivity growth would accelerate significantly in the coming years.

Rebalancing the global economy

The outlook for productivity may improve as the recovery continues; the Fed, for one, has built this into its economic projections. But if this fails to happen, the repercussions will be extensive and severe. The growth trajectory of the economy, incomes, inflation and long-term interest rates will shift to a lower path. Corporate profits will slow and the country’s competitiveness will be eroded.

The Economist Intelligence Unit forecasts a modest improvement in US productivity in the coming years but no return to the elevated gains that were enjoyed in the years before 1970. Instead, slower growth in the US in the coming decades will coincide with the rapid rise of Asia, and the centre of gravity of the global economy will drift eastward. The US will remain one of the biggest economies in the world but it will be overtaken by China, and India will gain ground. This might provide a silver lining for the US. As China and India develop, they will invest more in the type of research and development that is relevant to the US. The next American productivity boom, then, might be far in the future, and it might be powered by inventions dreamed up on the other side of the world.

China, US and India surge ahead of the pack in coming decades