Productivity: The Linchpin of the Global Growth Struggle


March 18, 2016

Despite three rounds of Quantitative Easing, trillions of dollars of governmental liquidity injections and historically easy interest rate policy, the U.S. has failed to generate the growth recovery following the 2008 recession that most had expected at the outset. While some of this growth slowdown may be explained away as cyclical and thus temporary, recent empirical work highlights a drop-off in productivity growth beginning in 2004 as a more likely culprit. Productivity growth, a measure of output per unit of input, has re-entered the forefront of U.S. economic debate as of late as global wage pressures remain muted despite the U-3 unemployment rate reaching 4.9%. This is somewhat of a surprise to economists because according to the Taylor Model used by the FOMC, as actual output converges on potential output inflationary pressures should increase. Said differently, there has been a strong link between productivity and compensation historically as increases in productivity have improved the value of labor thus increasing the demand for labor. Previous Federal Reserve estimates would have concluded 4.9% unemployment was below the non-accelerating inflation rate of unemployment (NAIRU) and thus should have generated some upward pressure on wages as labor supply slack diminishes. NAIRU is a theoretical threshold at which the economic supply and demand for labor are balanced, which keeps inflation from increasing. It is this confidence in the existence of NAIRU and its impact on wages and inflation that led FOMC Chair Yellen to tighten policy in December. However her faith in NAIRU has looked less than justified at this point as further reduction in labor market slack in 2016 has failed to yield much upward wage pressure. Unfortunately, both productivity and wages have been moving in reverse as of late, as shown by a recent San Francisco Fed paper examining the sluggish rise in wages and compensation.1 The SF Fed research team found that over the past two years, average wage growth across four separate measures of wages (average hourly earnings, employment cost index (ECI) for wages and salaries, median weekly earnings, and compensation per hour) have been hovering around 2.25%. Despite continued robust labor market data, the current measure of this average of indicators pales in comparison to the 3.25% average wage growth seen from 1983 to 2015.

It may be no coincidence then, that during a similar period that saw total compensation fall; productivity growth in the United States has also fallen to an average rate of just 1.2% percent, down from 2.1% between 1974 and 2007.2 This drop off is consistent with the findings of researchers at the New York Fed who estimate that U.S. productivity started to slow in 2004, before the Great Recession. Until recently, a common argument to explain away this slowdown as anything other than economic weakness is that productivity has been mis-measured because output data hasn’t adjusted for better quality and more efficient products produced over the past decade.3 However, in his recent working paper on productivity measurement, Professor Chad Syverson of the University of Chicago argues that this is not the case. Instead, he finds that since the productivity slowdown occurred in dozens of countries with varying technology sector size, the size of the slowdown is unrelated to measures of the countries’ consumption or production of information and communication technologies. His findings show that the decrease in productivity seen over the past decade caused U.S. GDP to be 15% lower than it would have been otherwise. However, since digital technology industries only comprised 7.7% of GDP in 2014, it would be impossible to explain all 15% away as technology related. Ultimately, it may indeed be the case that adjustments need to be made to productivity measures to account for advancements made in technology, but it appears unlikely that these changes are descriptive of the entire fall in productivity seen since 2004.

This concerning trend in falling productivity also helps to explain the recent downward trend in U.S. GDP growth, which has caused some to surmise that potential growth in the U.S. is now lower than before the recession in 2008. Given the lack of inflation the U.S. economy is generating, some market participants explain away the recent bout of poor economic growth by suggesting that the output gap between current growth and potential growth needed several more years to close post crisis. This thesis has not yet proved true as U.S. economic growth has been generally disappointing in the years following 2008. Alternatively, if recent empirical studies are indeed reflective of future conditions, we should expect economic growth to remain stuck in neutral unless the macroeconomic environment changes meaningfully. In his 2014 NBER working paper,4 Robert Gordon concluded that because of slower future output growth and thus less tax revenue, the Congressional Budget Office’s current estimate for the 2024 Debt/GDP ratio is understated by 9% (78% vs 87%).5 The author notes “My estimate of 1.6 percent for the current rate of potential real GDP growth is almost exactly equal to realized actual real GDP growth in 2004-14, implying “more of the same” rather than a radically new economic environment. The 1.6 percent potential growth rate is almost exactly half of the realized growth rate of actual real GDP between 1972 and 2004; of this difference, roughly one-third is due to slower productivity growth and the other two-thirds to slower growth in aggregate hours of work.” His conclusions suggest the U.S economy may eventually have issues servicing a debt burden in excess of 100% of GDP if his projected shortfall is realized. If other developed countries also see similar budget shortfalls due to the fall in productivity, globally monetary policy may be forced to remain easy for far longer than expected.

The lack of a concrete recovery in output growth post 2008 has given voice to critics who claim that this fall in productivity is a function of secular stagnation and not merely a more drawn out recovery. The term secular stagnation was coined by Alvin Hansen in 1938 after the Great Depression and refers to a period that results in poor economic progress as a result of limited investment opportunities or periods that require negative real interest rates to achieve full employment. Recently, former Treasury Secretary Larry Summers has revived the secular stagnation mantle as a way to explain the poor levels of output growth globally that have persisted since 2008. In his current iteration of secular stagnation, it is argued that post-recession industrialized economies suffer from an imbalance stemming from an increased propensity to save at the expense of the propensity to invest. As a result of this excess level of savings, overall demand decreases, reducing growth, inflation and the real rate of interest. While the validity of this theory is hotly contested, it is somewhat supported when examining U.S. nominal interest rates and M2 money velocity, which both sit at or below the lowest level seen in the last 50 years.

History suggests there are a number of potential remedies to escape a future of maligned productivity growth. However, these methods which center on an increase in capital expenditure in one form or another have been largely passed over post 2008 in favor of share buybacks or other, potentially less efficient uses of capital. One such example of increased capital expenditure helping to break stagnant productivity occurred in the late 1930’s as a public investment boom financed by the U.S. government caused a spike in productivity as factories retooled for World War II. The U.S. would ultimately spend roughly $350 billion on the war which not only boosted the war effort, but boosted the post war economy by approximately tripling of GDP between 1940 and 1950. Unfortunately, there aren’t many similarities to draw between the post WWII growth boom and today’s economy; as the figure below shows, firm’s capital expenditures have fallen to levels usually seen during economic slowdowns, suggesting a more defensive private sector mentality. Moreover, in 2014, according to the Conference Board’s Total Economy Data Base, the growth of total factor productivity (TFP) hovered around zero for the third straight year, down from 1 per cent in 1996-2006. This lack of willingness to spend capital to boost growth at a firm level, combined with the stagnant growth in the labor force, shown below does not bode well for future growth.

Despite seemingly clear evidence that current tepid levels of productivity growth should be expected to persist, suggesting slow potential growth in the future, the average YoY forecast for 2016 GDP growth remains around 2% according to Bloomberg Data. This notion that 2016 growth with be roughly equal to 2015 growth is tough to square with the global macro backdrop. In a scenario where the Federal Reserve still maintains a hiking bias in 2016, which is still the markets base case despite downward revision to amount of total hikes, current GDP growth should not exceed GDP growth during periods of maximum monetary accommodation. This is because on the margin, higher borrowing costs decrease the supply of money available which constricts credit and thus economic growth. Conversely, if the Fed opts to leave rates unchanged, it is most likely because of shocks to global inflation or growth which would also suggest risks to 2% GDP growth in 2016. In either case, it seems that this notion of stagnant productivity weighing on U.S. growth has only just entered the conversation and has yet to capture the minds of market participants at large. However, given that the U.S. economy has failed to exceed 2.5% YoY real GDP growth in the last decade, it may be time to move away from previous thinking and towards a new understanding of the post crisis economy.

Real Gross Private Domestic Investment: Fixed Investment: Nonresidential: Equipment

Source: The Federal Reserve Bank of St. Louis

Gross Domestic Product

Source: The Federal Reserve Bank of St. Louis

Employment Cost Index: Total Compensation: All Civilian

Source: The Federal Reserve Bank of St. Louis

Industrial Production Index

Source: The Federal Reserve Bank of St. Louis

Personal Saving as A Percentage of Disposable Personal Income

Source: The Federal Reserve Bank of St. Louis

Gross Private Saving

Source: The Federal Reserve Bank of St. Louis

Velocity of M2 Money Stock

Source: The Federal Reserve Bank of St. Louis

1 Daly, Mary C., Bart Hobijn, and Benjamin Pyle. “What’s Up with Wage Growth?” Federal Reserve Bank of San Francisco. Mar. 2016.

2 Kahn, James, and Robert Rich. “The Productivity Slowdown Reaffirmed Liberty Street Economics.” Liberty Street Economics. Federal Reserve Bank of New York, 15 Mar. 2016.

3 Syverson, Chad. 2016. “Challenges to Mismeasurement Explanations for the U.S. Productivity Slowdown.” Working Paper 21974. National Bureau of Economic Research.

4 R. J. Gordon, “A New Method of Estimating Potential Real GDP Growth: Implications for the Labor Market and the Debt/GDP Ratio,” NBER Working Paper No. 20423, September 2014

5 Gordon, Robert J.” NBER Reporter 2015 Number 1: Research Summary. National Bureau of Economic Research, 15 Mar. 2016

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