September 2002
By ROBERT PEGG
One important consequence of the economic recession has been the unusual behavior of business productivity. Usually, productivity declines during a recession and expands during a recovery. However, during this recession, productivity has continued to expand. In the last six months, for example, economic output has been relatively stable. On the other hand, hours worked have fallen sharply, and as a result, productivity, or output per hour, has increased robustly.
Productivity growth of three percent or better per year generally is considered positive. However, in the last quarter of 2001, productivity rose at an annual rate of 7.7 percent. In the first quarter of 2002, it grew at an astounding rate of 8.2 percent, the best performance in two decades and then dropped to 1.6 percent. Historically, the U.S. economy has shown itself prone to sudden shifts in productivity growth, which affects the stock market and the economy. The productivity growth rate tumbled in the 1970s, heralding a bear market and a sustained period of economic stagnation. The unexpectedly sharp increase in productivity growth in the mid-1990s was accompanied by surging stock prices and rising wages.
The relationship between productivity and corporate profitability is not fully clear. The telecommunications industry is a case in point. In that industry, the increased output of services created a glut of capacity, which in turn led to increased competition and lower prices. That was good news for consumers, but bad news for investors in the industry. Conversely, profits can grow without productivity growth. If one company, for example, can grow at the expense of another, it may become more profitable. However, total industry output divided by total labor hours in the industry may not change that much.
The key to productivity growth depends on what made the company grow. If growth resulted from labor-saving technology, which reduced costs and allowed the company to become more competitive, one would probably see a productivity increase at the industry level because a larger component of industry output would be generated using more efficient technology. However, if increased sales resulted from a marketing blitz, there may not be a change in the way labor was utilized, and aggregate productivity would remain unaffected.
Trying to predict how fast productivity will rise is among the most difficult tasks faced by economists. The good news is that there are reasons to be optimistic that productivity growth will remain strong in this nation. Despite the recent economic downturn, average productivity growth over the last five-year period was about 2.9 percent per year, the best annual rate since the 1960s. Companies have been able to sustain these gains even with the high-tech bust. By contrast, productivity growth was 1.2 percent annually during the recession of the early 1990s. Corporate spending on technology and equipment still is 75 percent higher today than it was in the mid-1990s.
Naturally, just because productivity growth did well in the past few years doesn't mean that it will continue. In the years ahead, the high costs of military and anti-terrorist spending could take away resources that otherwise would go to productivity-enhancing investments. Nonetheless, many economists think that recent surge in productivity growth results from a combination of a better-educated and more experienced workforce, as well as better ways of doing business and using information technology. If that's the case, the productivity gains should be longer lasting.
The emerging consensus among economists is that the nation's economy can maintain annual productivity increases between two percent and 2.5 percent per year. Hopefully, greater productivity growth will translate into enough profits to fuel the capital investment that will be required for the next business cycle. A one-half point increase in productivity growth, for example, translates into $300 billion more in the nation's gross domestic product. The benefits of an extra $300 billion for the economy are hardly chump change. With federal taxes consuming 20 percent of the nation's economic output, higher tax revenues, stimulated by productivity gains, would mean a real boost to a budget already straining. That could be just what the doctor ordered.
About the author: Mr. Pegg is president of Kirkbride Asset Management, the New York City-based investment advisory firm which serves businesses, institutions and private individuals.