38. Productivity
The growth in our nation’s economic productivity for the decade that spanned 1995 through 2005 averaged approximately 2.7% per annum, as estimated by the Federal government. This is an extraordinarily high growth rate for productivity. The average for the preceding two decades was approximately 1.7% per annum. Last week our government revised the productivity number for 2006 down to 1.6%, a decline of a bit more than an absolute 1% from the preceding decade’s average. This new figure raises the important question of whether the most recent number indicates a long-term drop-in productivity growth or merely a cyclical decline in an ongoing high-productivity environment. To know the answer, we must discuss the underpinnings of the recent period of high productivity growth, and then determine if they are still in place. The free enterprise system contains within itself extraordinarily strong incentives to raise efficiency and effectiveness and continuously improve all areas of the economy. Those incentives explain virtually all of the increase in the standard of living for the entire world in the past few centuries. What changed in the last decade?
Was the 1995-2005 surge in productivity due to federal policy initiatives? If so, are they still in place? If not, does present federal policy have a negative or positive affect on productivity going forward? Were the primary causes of the recent surge in productivity exogenous events? Are they still present? If not, what is a reasonable expectation for future productivity growth?
Let us briefly discuss what productivity is and why it is important in the context of real economics. The productivity measure is merely the change in total output of our economy, divided by the total cost to produce that output, expressed as a percentage increase over the prior year. Labor is by far the greatest cost among the factors of production. For the purpose of our discussion, labor cost is so large (over 70% of total cost) that it can be used as a proxy for total cost. A hot political issue often offered up by aspiring politicians involves legislating wage increases without regard to productivity.
The present political aspirants all want to increase labor’s wages whether productivity increases or not. Some value the importance of wage increases higher than others. Most politicians have never lived in the real economy or met a payroll, so they simply don’t understand that wage increases, absent increases in productivity, cause inflation if the monetary base is provided. Therefore, the wage gains these politicians herald and take credit for today would be lost to inflation that appears tomorrow, when not offset by increased productivity. Although wage increases for labor are desired by all political groups; when wages increase at a greater rate than productivity, it directly increases inflation in the next time period. During the previous decade, labor cost increases were either at or below productivity increases. Therefore, although the wage increases may have been low, they were real increases that stuck. This appears to have changed in 2006 in a troubling way.
Consider the huge influence of our productivity on our welfare. Consider that one percent above trend growth in productivity for 10 years yielded approximately $1.3 trillion in increased production in our economy in year 10. The decade of increased productivity translated to a significant increase in our social welfare. This increase due to productivity was approximately equal to the dollar value of all the direct and indirect payments made by government for medical services in 2005, which was 50% of total medical expenditures in the U.S.! Also, those 10 years of one percent increases in productivity produced approximately $6.5 trillion in new wealth! This huge number could have easily paid for our war expenses and allowed us to pay for over 50% of our $9+ trillion in federal debt. The 1995-2005 period was a lost opportunity for government to right its financial imbalances. The current reduced productivity, if continued, will have profoundly depressing effects on our future welfare.
Politicians of every flavor have endeavored to take credit for the high productivity during 1995–2005. An interesting example was when the Republican Congress in 1994, led by Newt Gingrich, teamed with a Democratic President to create the fiscal checks and balances needed for increased productivity. The Democrats have argued that they balanced the budget and were responsible for the period of high productivity growth which equally overlapped the Clinton and Bush presidencies. The high productivity occurred in the last five years of the Clinton administration and the first five years of the Bush administration. Republicans argued back that the productivity was the residue from the Reagan Presidency and was extended by the Bush tax cuts.
What if the increased productivity was due to neither political party? One thing is clear: this period of above-trend productivity greatly increased our social welfare, and that is reason enough to be interested in what caused the rise in productivity, where we are now with respect to our productivity, and what the future will bring. This heightened productivity allowed for our recessions to be milder (2001–2002) and our expansions to be longer (both 1996–2000 and 2002–2006). We only need to remember the abbreviated expansions and harsh recessions with 10% unemployment of the 1970’s and 1980’s to appreciate our recent good fortune of enhanced productivity growth. Its absence would have a derogatory influence on future business cycles.
The decade of enhanced productivity (1995–2005) was keynoted by 1) low interest rates, 2) abnormally high loan creation, 3) above average real estate price gains (bubble), and stock market appreciation (selective bubbles), 4) increasing trade deficits, 5) increasing federal deficits and the resulting rise in federal debt. Some of these conditions were obscured by the enhanced productivity, which in turn allowed for increased consumption that resulted in greater domestic and foreign deficit imbalances. The present period of low interest rates has been extended by high productivity, and the availability of low rates has stimulated increases in consumption against the backdrop of higher productivity. Low rates, which began to decline in 1994, are separate from the Fed’s short-term manipulations of rates. These Fed inspired manipulations to below-market rates, have allowed in essence increasing indebtedness which funded significant appreciation in financial and property assets, and debt-driven consumption in other areas owing to this stimulation by the Fed, which appears to be unsustainable. Furthermore, the recent asset appreciation contributed to a wealth effect, which further stimulated more consumption and ironically more debt creation. This has ushered in a period of global economic growth substantially stimulated by the ferocious consumption appetite of our society, and has been ironically paralleled in the United States by a period of growing indebtedness, leaving a dichotomy of cash-rich corporations and cash-strapped families unable to extend their recent levels of debt funded consumption.
The large productivity gains could have provided an opportunity to save and right our imbalances however it has enabled our increasing consumption. This heightened level of consumption was clearly augmented by significant borrowing encouraged by the Fed’s extended creation of below-market cost of money. The heightened productivity and the artificially cheap and plentiful money in tandem tempted our excesses in consumption, and are neither wise nor sustainable. What caused the prior decade’s abnormal growth in productivity and what are the implications and sustainability of this enhanced productivity for this decade (2005–2015)? It is essential to understand the cause of our recent productivity surge to understand how we got to where we are and to best determine where we are headed.
It is my opinion that the last decade’s productivity surge was mostly a function of the combination of two stochastic events, neither of which was politically or policy driven: I) First, the internet was easily the greatest wealth creator our society has experienced in at least a half a century. Its time saving transport of huge volumes of information drove our productivity in the last decade. However, with approximately 70% of our people presently connected to the net, the marginal benefit to the future productivity contribution of the internet is on the wane. II) The second significant contributor to productivity and explanation for the recent productivity levels, in my opinion, was the great surpluses of production in both the third world (India and China) and the resource rich countries (Russia, Venezuela, Nigeria, Australia, etc.) in the last decade, owing largely to excess capacity and resulting in below normal product prices. Due to these excesses, much of the third world was in virtual depression. We greatly benefited from these conditions by buying many products at below their cost of production. The huge savings from these discounted prices were wealth creating. The excess capacity also kept the price of energy lower do mostly to slack demand in the depressed third world demand, which for a period held down our energy costs. During the last decade our ability to consume low priced products expanded our productivity and welfare. Within the last two years there have been profound declines in the excess capacities in the developing world, including labor and other significant factors of production. Also, the third world has multiplied its own demand for energy and products in general helping to consume the excess capacities of the recent past and approximately doubling the price of global oil as well as many other resources. The by-product of these price increases is increased costs. Given our current economic production the new higher product costs result in reduced productivity.
Therefore, if it is correct that the confluence of these two events, the internet and artificially low costs of goods, largely explains our decade-long, abnormally high experience of productivity, then it is equally correct that high productivity is unlikely to recur in the present decade as both of these influences have waned. What will the effects of a return to average productivity (1.6%) be in two years? Are their risks that productivity could be sub-average? If so, what would the effects be? Finally, what is the likelihood of returning to high productivity in the present decade?
In 2006, labor cost grew at approximately 5% per annum while productivity growth declined to 1.6%. Labor cost was about <3.4%> above productivity. Since labor cost comprises about 65% of all costs, we might expect the <3.4%> increase unmatched by increasing productivity to bleed through to inflation. Wage growth unsupported by growth in productivity will reverse the short-term positive affects of the increased wage. This week we will see PPI, CPI and the cost index. There might be some sign of this in PPI (producer’s prices) before it bleeds through to CPI and Cost Index this week. In any case, it would be likely that labor costs growth in excess of productivity will bleed through to inflation in coming months. Often the initial impression of labor increases is that labor is better off, that is never the case when labor gains don’t correspond to productivity gains. Although it is not politically expedient to argue that wage increases relate to increased productivity if implemented this method of wage increase would protect our welfare. Otherwise their wage increases are always followed by general price rises (inflation), which reduce the buying power of the increased paycheck received by the worker. Leaving him with more nominal dollars but no more welfare or buying power.
Although this welfare gap between declining productivity and increasing labor cost could be mitigated by a recession, recession in and of itself really doesn't close the gap between increasing labor costs and lower productivity when the causes are structural and not cyclical. After the unemployment rate increases during the recession due to labor layoffs, productivity per worker does not increase. Remember that GNP is negative during a recession by definition therefore it doesn’t matter if the cost of labor is constant or even declines during a recession if production declines. The present environment of low productivity is structural, impermeable to the business cycle, and will not bode well for financial assets if it persists. Productivity can not be increased by taking on more debt to fund consumption.
We must remember that over the last 25 years financial assets have grown from 8% of the S&P Index to 28%. Assets to financial institutions evidence increased private and public debts. Much of this debt was recently borrowed in an increased productivity environment. Presently with Fed funds at 5.75%, the profit margins for lenders in general have been compressed. Initially banking attempts to make up for the declining margin in increased loan volume however invariably quality declines and banks must pull back and retrench. In a low-productivity environment with labor cost increases, inflation will bleed through, thus making it unlikely that the Fed can lower Fed funds. Hence, there would be no relief for the banking system which in this environment finds small margins of profit on its loans coupled by a more risk-full credit environment and a reduced quality of credit. The risk profiles for business in a low productivity world also will expand. Therefore, it can be expected that spreads between government debt and corporate debt, which were recently at generational lows, will continue to expand to reflect the new and increasingly risk-full lower productivity environment.
Over the last two weeks there has been a lot of attention on failures largely confined to the sub-prime lenders; however, there has been no factual context that supports that the sub primes might be the canary in a coal mine for the financial sector. Admittedly, though, the system is presently awash in liquidity, that is to say the availability, cost, and velocity of money are plentiful to meet our various borrowing appetites. However, the present conditions of excess liquidity are highly dependant on three factors over the next two years that will largely determine the availability of future liquidity in the system and may not remain accommodative. Private, public and foreign trade borrowings are fixed indebtedness that will remain if liquidity should dry up in the next couple of years or sooner. This potential of lost liquidity would place upward pressure on interest rates and would be profoundly more serious than the current debacle in sub-prime lending in the context of our present borrowing habits. Any change in the world’s appetite to purchase US debt will trigger this form of heightened rates and liquidity drain. Hence the Fed will be unable to grow the monetary base in a low interest rate environment with a lower demand by foreigners to invest in our debt this would quickly drain liquidity from our markets and increase rates as well. Recently, in December, Treasury reported that investment inflows had dropped to approximately $15.5 billion in the face of our relatively constant monthly trade deficit of approximately $70 billion however in January the reported inflows returned to over $70 billion. Although the foreign monthly investment number vary, if the average inflow of investment funds doesn’t offset the outflow of trade imbalances and if the imbalance persists, it will put huge downward pressures on the dollar and upward pressures on inflation and interest rates. Yet another way to reach a bad welfare conclusion and declining productivity from our risk-full debt funded consumption patterns.
Also, of note, last week’s growth in employment contained approximately 36,000 increases in government hires, a troubling trend of government debt-sponsored employment growth with little if any social objection. Labor growth that occurs as a function of business demand is accretive to welfare while government debt financed hiring meets no market test and is of little if any welfare value. It should be noted that the total economic gain in employment from 2000–2005, as recently reported in a Business Week article, can be fully explained by growth in only three areas, all directly or indirectly related to government. Both direct fiscal stimulation as well as debt expansion owing to government monetary stimulation of loans has driven a lopsided economic employment growth. The employment increases occurred in the following areas: 1) Approximately 1.7 million in medical services, 50% of which is directly government funded; 2) Direct government hiring of approximately 260,000; and 3) Home construction and lending labor increases of approximately 200,000 hires due to politically promoted lax lending standards and the artificial lowering of interest rates to stimulate loan demand which is presently unraveling. Outside of government stimulated labor increases the US economy has been eerily silent for more then half a decade.
In recent years both Fannie and Freddie fully participated in the huge expansion of mortgage credit by issuing liberal standards for credit including no down payment mortgage loans in order to artificially increase home ownership for political interest among a group unable to support the loans. These proactive actions by government through debt financing were unveiled under the cover of our past period of exceptional productivity whereby politicians benefited by giving away unsustainable loans to endear themselves to their constituents. Now these policy behaviors will yield numerous debt failures and will prove to be unsustainable in a lower-productivity economy. Politicians will twist these failures blaming the loose lending standards on unethical lenders when in fact it was political pressures on Fannie and Freddie five years ago to increase home ownership supplemented by the Fed’s below market rates that launched and fueled this extended period of permissive lending and excessive borrowing resulting in the present mess in the home mortgage market. The vary politicians that are now squawking foul play by lenders were the cause of the liberal lending standards that caused the problem to begin with.
Therefore, both the productivity of labor as well as the quality of future jobs must be weighed against the present full-employment environment with nominal wage increases that, if history repeats, will prove transient in a low productivity environment. Future rising costs will eliminate the temporary nominal wage gains. Of equal concern, the government has been a huge and improper stimulator of both public and private consumption operating under the cover of higher productivity. Now during a period of lower productivity, these policies are likely to be painfully unsustainable. Our government has been opportunistic in their recent excessive use of both below-market interest rates and direct money growth on the monetary side to stimulate consumption buy excessive debt financing. While excessively relying on debt financing to subsidize and extend entitlement transfers and pay for run of the mill pork barreling activities on the fiscal side. Both these Monetary and Fiscal stimulants have been imprudently bolstered during the past decade of enlarged productivity. Recent rate increases by the Fed are offered as an offset to the prior excesses of liberal monetary policy contrasted by debt financed fiscal policy also engineered by the Federal Government have become a dubious legacy of our brief decade of increased productivity.
It does not appear that productivity gains are likely to come from our labor force in the present decade or the foreseeable future. Do we have any visibility to another Internet type technological breakthrough that would propel productivity in the future? No; however, a significant technological breakthrough although not visible is always possible. However, it is unlikely that the present labor force imbued with a high expectation of consumption will be willing to add adequate productivity to offset its wage increases, hence labors recent 5% gain in nominal wage may be repeated and will prove vacant of welfare to the degree it is not offset by productivity increases in the next period. Average and/or sub-average productivity growth will prove problematic in an increasingly higher labor cost environment, and will be augmented by the government’s entitlement compounded from baby-boomer retirements and supplemented by general deficit spending. Also, consumption expectations prevent labor from producing adequately to offset its expected wage increases. Such wage increases will prove fleeting as buying power declines due to price pressures on goods and services in the next time frame.
In net, productivity has been, is and will continue to be extremely important in determining our future welfare. A period of lower productivity will have the effect of making our system more vulnerable to cycles as well as economic shocks. It will mean that the economy will grow slower, incurring an opportunity cost and measurable future lost welfare. A weaker economy owing to lower productivity will leave our people more extended financially and hence susceptible to broad and sweeping socialistic policies that will overtime worsen a given problem. The risk that lower productivity will be wrongly construed to satisfy aspiring politicians bid for power may unfold as soon as the 2008 election year, during which the negative influences of low productivity are increasingly likely to bleed through to the economy and have a negative impact on our welfare. These are profoundly significant developments to our future welfare, the causes of which, in part, lie with the loss of the increased productivity of the previous period. As they unfold, they are likely to be misunderstood and serve the more narrow agendas of self-interested political power aspirants.
Understanding the importance of productivity to our present and future welfare is increasingly important in a time of import dependence, debt overextension and lower productivity when it may become increasingly expedient for political aspirants to misrepresent it. Understanding the likely primary causes of our recent decade long experience with enhanced productivity is a benefit particularly in light of future decisions we will make regarding our present account imbalances.
It is true that a decade of politicians in both parties missed a golden opportunity to correct our significant account imbalances during the period of above average productivity which spanned both democratic and republican administrations equally. This is disturbing. However, for these opportunistic political operates to use our high productivity to promote their agendas through fiscal expansion and monetary stimulation resulting in unsustainable consumption and risky debt creation is unconscionable and can not be tolerated given governments sacred fiduciary obligation.