Not all productivity gains are the same

Susan Houseman and I have a new essay, “Not all productivity gains are the same: Here’s why” on the McKinsey “What Matters” website. Here’s the conclusion:

in a global economy, we need to be thinking more about the sources of apparent productivity growth. It matters greatly for wages and employment whether rising value-added per worker is being driven by domestic production improvements, supply chain efficiencies, or by productivity gains abroad.
Industries with the same measured productivity growth may generate those gains from very different sources. One industry may benefit mainly from internally generated productivity improvements, another industry may actively search out supply chain improvements, and a third industry may shift sourcing mainly in response to productivity gains and price drops overseas. These different sources of measured productivity growth yield very different wage and employment outcomes for workers…..

Take a look,

How much of the productivity surge of 2007-2009 was real?

[This post just grew and grew and grew, until it turned into something  ridiculously long. Sorry about that–I’m probably guilty of blog abuse.   If you want, here’s a PDF version. I look forward to comments ]

Summary

In the 2007-2009 period, the U.S. economy experienced its worst recession since the Great Depression. Nevertheless, despite this deep downturn,  the near-collapse of the financial system and unprecedented global economic turmoil,  U.S. productivity growth actually seemed to accelerate in the 2007-2009 period, or at least maintain its previous pace.

The 2007-2009 productivity gain had a major impact on both economic policy and political discourse. First,  it gave the Fed a free hand to feed mammoth amounts of liquidity into the system without worrying about inflation.  Second, it convinced the economists of the Obama Administration that the economy was basically sound, and that the big problem was a demand shortfall. That’s why they expected things to get back to normal after the fiscal stimulus.

However, I’m going to show in this post that the  productivity gain of 2007-2009 is highly suspect.  Using BEA statistics,  I identify the industries that contributed the most to the apparent productivity gain, including primary metals, mining, agriculture, and computers and electronic products. Then I analyze  these high-productivity growth industries in detail using physical measures such as barrels of oil and tons of steel. I conclude  these ‘high-productivity’ industries did not deliver the gains that the official numbers show.

Based on my analysis, I estimate that the actual productivity gains in 2007-2009 may have been very close to zero.  In addition, the drop in real GDP in this period was probably significantly larger than the numbers showed.  I then explore some implications for economic policy.

Overview

I start by giving several  data points.

*From 2007 to 2009,  business productivity rose at a 2.4% rate, according to the official data. By comparison, the productivity growth rate was only 1.2% over the previous two years (2005-2007).

*If you like your numbers quarterly, business productivity grew at a 1.8% annual rate from the peak in 07IV to the trough in 09II.  That’s somewhat faster than the  1.6% growth rate of the previous 3 years.

*Looking at  total economy productivity–real GDP divided by full-time equivalents (FTE)–we see that productivity growth in 2007-2009, at 1.6% per year,  was double that of the previous two years (0.8% per year).

This chart breaks down productivity growth by business cycle, using the official statistics. You can see that the productivity growth of the 2007-2009 period–the worst recession in 70 years–appeared to be basically a continuation of the productivity gains during the boom. You can’t tell from this chart that anything bad happened to the economy.

The strong measured productivity growth during the crisis years reflects a steep drop in employment (-5.7%) combined with an apparently mild two-year decline in real GDP (-2.6%).  Of course, ‘apparently mild’ is still nastier than any post-war U.S. recession, but a 2.6% decline in real GDP translates into a 4.4% decline in per capita GDP, which puts the U.S. at the low end of  financial crises described by Reinhart and Rogoff.

What’s more, the 2007-2009 productivity gain had a major impact on both economic policy and political discourse. First,  it gave the Fed a free hand to feed mammoth amounts of liquidity into the system without worrying about inflation. 

Second, the productivity gains convinced the economists of the Obama Administration that the economy was basically sound and there was nothing wrong with  the ‘supply-side of the economy.  Instead, the Obama Administration concluded that the big problem was a demand shortfall, which is why they expected things to get back to normal after the fiscal stimulus.

Consider this April 2010 speech from Christina Romer, then head of the CEA. She said:

The high unemployment that the United States is experiencing reflects a severe shortfall of aggregate demand. Despite three quarters of growth, real GDP is approximately 6 percent below its trend path. Unemployment is high fundamentally because the economy is producing dramatically below its capacity. That is, far from being “the new normal,” it is “the old cyclical.”

Perhaps more important from a political perspective, the productivity surge  helped convince the Obama economists that the job loss was ‘normal’ in some sense. That is, the rise in productivity suggests that the financial crisis apparently just accelerated the normal process of  making U.S. businesses leaner and more competitive, and there was no structural problem. In fact, that’s what Romer said in her speech:

In short, in my view the overwhelming weight of the evidence is that the current very high — and very disturbing — levels of overall and long-term unemployment are not a separate, structural problem, but largely a cyclical one. It reflects the fact that we are still feeling the effects of the collapse of demand caused by the crisis. Indeed, at one point I had tentatively titled my talk “It’s Aggregate Demand, Stupid”; but my chief of staff suggested that I find something a tad more dignified.

If productivity was rising, then the job loss was due to a demand shortfall and could be dealt with by stimulating aggregate demand. That, in turn, helps explain why the “job problem”  didn’t seem so urgent to the Obama administration, and why they spent more time on other policy issues such as healthcare and regulation.

[Read more…]

When Did the Innovation Shortfall Start?

I’m responding to the posts by Arnold Kling and Bryan Kaplan critiquing  Tyler’s The Great Stagnation. Let me just throw out some thoughts, from the perspective of someone who thinks that The Great Stagnation is a terrific book.

1. I agree wholeheartedly with Tyler that the current crisis is a supply-side rather than a demand-side problem. That explains why the economy has responded relatively weakly to demand-side intervention.

2. From my perspective,  the innovation slowdown started in 1998 or 2000, rather than 1973–sorry, Tyler.  The slowdown was mainly concentrated in the biosciences, reflected in statistics like a slowdown in new drug approvals, slow or no gains in death rates for many age groups (see my post here),  and low or negative productivity in healthcare (see David Cutler on this and my post here).  This is a chart I ran in January 2010 (the 2007 death rate has been revised up a bit since then)–it shows a steady decline in the death rate for Americans aged 45-54 until the late 1990s.

The innovation slowdown was also reflected in the slow job growth in innovative industries, and the sharp decline in real wages for young college graduates (see my post here). (Young college grads, because they have no investment in legacy sectors, inevitably flock to the dynamic and innovative industries in the economy. If their real wages are falling, it’s because the innovative industries are few and far between).

3. The apparent productivity gains over the past ten years have been a statistical fluke caused in large part by the inability of our statistical system to cope with globalization, including: The lack of any direct price comparisons between imported and comparable domestic goods and services; systematic biases in the import price statistics (see Houseman et al  here, for example); and no tracking of knowledge capital flows. I’ve got several posts coming on this soon.

4. I agree with Tyler that regulation of innovation is a big problem.  That’s why I’ve suggested a new process, a Regulatory Improvement Commission,  for reforming selected regulations.

5. I’m of the view that we may be close to another wave of innovation, centered in the biosciences, that will drive growth and job creation over the medium run.  If we want growth and rising living standards, we need to avoid adding on well-meaning regulations that drive up the cost of innovation.

Can We Grow Our Way out of Debt?

This post is mostly going to be thinking out loud–I don’t come to a definite conclusion yet. The U.S. faces both a short-term and a long-term fiscal crisis. The short-term problem is the current  gap between government spending and government revenues. Arguably that could go away if the economy recovers.The long-term  fiscal crisis is the gap between anticipated spending on Medicare and Social Security, and anticipated revenues from payroll taxes.

The question on the table: Could an acceleration of U.S. productivity growth (for whatever reason) enable us to grow our way out of the short-term and long-term fiscal problems? Or, more generally, could an acceleration of U.S. productivity growth boost the U.S. national savings rate, enabling us to save our way out of the fiscal problem?

In the past, I’ve answered this question with an resounding yes. I still think it’s yes, but the answer is more complicated than I thought.

The main reason why it should be possible to grow our way out of debt: An  increase in productivity growth–especially one that is not expected–makes the U.S. wealthier and gives Americans higher incomes. One might expect that could increase savings, especially since  higher-income, richer households are more likely to save (see, for example, the Fed’s Survey of Consumer Finances).  Or to put it a different way, income grows faster than consumption can adjust.

The reasons why it might not be possible to grow our way out of debt:

1) Empirical: During the 1990s and early 2000s, productivity growth accelerated, but consumption accelerated more, so that the savings rate dropped and the trade deficit increased.

2) Empirical: The per-capita cost of health care has grown faster than per-capita GDP in the past (see, for example, the CBOs long-term budget outlook).  Assuming that relationship continues in the future, that implies an acceleration of per-capita GDP growth will actually increase the fiscal gap.

3) Legal: Social Security benefits are keyed to average real wages–so if growth accelerates, and wages rise in response,  so do Social Security benefits. That means it is very difficult to grow our way out of Social Security issues.

Let’s take these in reverse order.

3) Definitely true. As I’ve written in the past, the Social Security formula probably needs to be adjusted so that benefits don’t quite track real wages.

2) The long-term excess growth of healthcare costs is very interesting. It’s been variously blamed on institutions that make it hard to control costs;  the excess cost of new medical technologies;  and environmental and social factors (such as increased weight). I personally believe that it represents economic consequences of the innovation shortfall in life sciences that I’ve discussed before–commercially important innovations in areas such as biotech have been few and far between. I would expect that if the pace of successful innovation in the life sciences picks up, that would bring down the rate of growth of health care costs, but there’s no way to test that until it happens.

1) This is the hard one, as far as I am concerned. Take a look at this chart:

I’ve chart ten-year nonfarm business productivity growth against the net national savings rate (productivity growth on the left scale in blue, net national savings rate on the right hand scale in brown). What we see is that the two lines roughly parallel each other, as we would expect, up until the late 1990s. Net savings starts to rise as the productivity acceleration begins. Then, poof,  productivity growth and net savings go in opposite directions. Despite the unanticipated acceleration of productivity–which boosts output per worker–the savings rate collapses.

Taking this chart at face value is bad news for the “grow our way out of debt” thesis. For one, we had a big acceleration of productivity growth, and the debt problem got worse. To put it another way, we produced more output than expected, and savings went down. Second, it’s hard to imagine that we can get productivity growth up much faster than 3% a year.

But let’s think a bit more about what might explain this surprising divergence. Really, there are four possible explanations:

A) Americans might just be profligate, and quickly ramp up their spending when their income increases (this includes healthcare spending, so it takes in #2 above).

B)The derangement of the financial system and the housing market led people to think that they were richer than they really were (the syndrome of the lottery winner who goes broke).

C) Net savings is mismeasured, and we are really saving more than it seems (spending on education, for example, is counted as consumption).

D) Productivity growth is mismeasured, and the productivity acceleration was really less than it seemed.

If American profligacy is the primary problem, then we are probably out of luck…hard to change. If financial excess is the main problem, then financial reform could be a key factor for helping us grow our way out of debt. If underestimates of savings is the main problem, then we have no problem (because the U.S. is really better off than it seems). If overestimate of productivity growth  is the problem, then what happened was that we thought we were richer than we really were, and this led to overspending. (I suspect, for example, that the models for subprime defaults implicitly depended on real wage growth, which is linked to productivity growth).

I personally lean towards D,  as I’ve written before. But like I said, I’m not as sure as I once was that we can grow our way out of debt…and that’s just sad.

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