Why Productivity Growth Matters So Much

 | Dec 28, 2012 | 12:22 PM EST
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One economic theory is that business cycles are caused, at least in part, by technology introductions and their resultant impact on productivity -- this is termed the real business cycle theory. While economists don't all agree on this theory (or others as well), one can conceptually understand how productivity growth has been correlated with episodic bouts of economic growth, or lack thereof. After all, productivity gains are what allow the economy to produce more with given inputs of labor (and capital, in some measures) and are essential to increasing living standards.

Researchers at the Chicago Fed recently documented this relationship. Beginning in 1973, low rates of productivity gains were associated with a moribund economy in the 1970s. Then, beginning in the early 1980s, productivity began to grow, modestly at first, and economic growth responded upward in turn. In the mid-1990s, productivity growth took off in tandem with the tech and Internet boom, and we had a booming economy.

After 2004, however, productivity growth diminished remarkably, as did our economic growth, absent debt-fueled consumer spending just prior to the recession. This slowdown in productivity gains predated the recession, and while the recession was caused by other factors, our slow recovery may relate to lessened productivity gains.

Most estimates of productivity gains focus on output per unit of labor. However, since output is based on not just labor but capital as well, researchers use a broader, more comprehensive measure of productivity known as multifactor productivity. This measure has dropped from about 1.7% on an annualized basis from 1996 to 2004 to just 0.5% since 2004. Researchers postulate that it might be caused by society having already adopted information and communication technology that has been introduced to this point. However, the cause for the slowdown in productivity growth isn't entirely known.

Regardless of why they ebb and flow, productivity gains help to determine the "speed limit" of the economy. Basically, potential economic growth can be thought of as productivity gains plus growth of the labor force and capital introductions. If the economy grows faster than this rate, inflation can result as bottlenecks emerge from more demand for labor and capital than the economy can provide.

Right now, however, there is such a large excess capacity of both capital and labor that we can grow at a faster rate without sparking inflation, until we (hopefully) return to full employment and capacity utilization of plants and as equipment is more fully engaged.

That said, the current slow-growth environment might be explained by sluggish productivity gains. As I wrote recently, it doesn't look like we are investing more in productivity-enhancing equipment. That can hold the economy back.

So when policymakers confer to address monetary policy or consider the effectiveness of previous rounds of fiscal stimulus and wonder why the economy is still growing sluggishly, perhaps a large-scale productivity shock is what we need instead. While Keynesians and monetarists might debate otherwise, the next big technological revolution that businesses can readily deploy just might hold the key to renewed economic vigor, more so than policymakers' actions. That, however, is easier said than done, as one cannot simply create the "next Internet" just by lawmakers' decree or a Fed decision.

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