February 2003

Productivity Gains Signal Better Times Ahead

By ROBERT PEGG

Productivity, the amount of goods and services produced by Americans in each hour worked, has been growing rapidly, according to the U.S. Department of Labor. Productivity has been positive for the last five consecutive quarters in the U.S., a much stronger performance than usual in times when the economy is soft. The strong growth in productivity that today's economy is experiencing, however, does not mean a quick upturn in the near future. Instead, it suggests that a significant share of the increase in economic efficiency achieved during the boom times of the late 1990s will continue over the longer term.

In trying to explain the better productivity numbers, a few economists have observed that companies today are more willing to quickly lay off thousands of employees than in previous economic slumps. In some past recessions, many companies have tried to hold on to workers because hiring and training new ones is costly when the recession is finally over. Thus, when demand for goods and services fall, leaving less work for the same number of workers, productivity often drops. Now the practice of retaining people may be a thing of the past, thereby artificially boosting the productivity numbers that we are seeing today. Fortunately, most economists believe that most of the productivity gains are for real and not induced only by hiring and layoff practices.

Nonetheless, the recent surge in the nation's productivity has been unusually strong, given that the economic recovery has been modest by historical standards. The question is whether this means that the "new economy" has come through the recession essentially intact, or does it mean that subsequent to a sharp drop in corporate profits, companies have had no choice but to cut back payrolls?

Comments by Federal Reserve Chairman Alan Greenspan suggest that he expects productivity growth to remain brisk for at least another 10 years as more efficient use of information technology spreads through the economy and as previous productivity-enhancing technologies pay off. The adoption of electricity, for example, from the late 19th century shows that it takes time for companies to reorganize the means to more efficiently in order to reap the benefits of new technologies.

Almost all economists agree with Greenspan's claim that structural or basic productivity growth in the U.S. has increased significantly. The controversial issue is by how much. Early last year, many economists argued that American structural productivity growth was poised to advance in the 3.0 percent to 3.5 percent range per year. However, that estimate now appears somewhat too optimistic, since average productivity growth in the six years since 1995 has recently been revised downward. Nevertheless, that range still is at least 1.1 percentage points above the average rate of productivity growth experienced in the previous decades of the 1970s and 1980s.

The Federal Reserve Board has been at the forefront documenting economic gains from America's surge in productivity growth. Typically, labor productivity is split into two components for analytical reasons: capital deepening, meaning that workers are using more machines; and what is referred to as multi-factor productivity growth, in which existing resources of capital are used more efficiently. Economists feel that the latter is a better gauge of true productivity gains in the economy. Studies have found that outside the computer industry, multi-factor productivity was essentially flat after 1995, which surprised many analysts. Corporate profits depend not only on labor productivity, but also on growth in capital productivity, which fell in the late 1990s because of over investment. So apparently, most of the productivity gains in the late 1990s can be attributed to workers using more machines.

Divining the future path of productivity growth is hazardous. Unless return on investment significantly improves, companies may remain reluctant to invest in new information technology equipment and in new research and development projects. That position could harm future productivity innovationsÑthe key to longer-term productivity gains. The best guess is that productivity will grow about two percent in the longer-term. The good thing is that a two percent annual average growth is still a worthwhile improvement on previous decades and will help boost living standards. On the other hand, two percent growth in productivity doesn't mean that economic recessions will be a thing of the past.

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.