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It All Depends on Productivity

By Christopher Farrell "Moreover, with all our concerns about the next several quarters, there is still, in my judgment, ample evidence that we are experiencing only a pause in the investment in a broad set of innovations that has elevated the underlying growth rate in productivity to a level significantly above that of the two decades preceding 1995."

--Alan Greenspan, Economic Club of New York, May 24

Anyone distressed by the dramatic widening in income inequality in the U.S. over the past quarter century had better hope Greenspan is right. The income gap is as wide as it has been at any time since the Great Depression. Inequality is worsening right now with low-wage employees bearing the brunt of a weak economy and slack job market. And the new tax cut, while tilted toward low- and middle-income families this year thanks to the rebate, threatens to exacerbate inequality in the coming years with the gradual decline in the top tax bracket and the eventual elimination of the estate tax.

Inequality typically shrinks when the economy booms and unemployment falls. A strong economy encourages employers to put out "help-wanted" signs and hire anyone willing to work, from welfare mothers to teens. To be sure, it's hardly surprising that the income and job prospects of disadvantaged groups improve during cyclical upturns. Yet an analysis by the Federal Reserve Bank of Boston shows that the gains are unusually impressive during "strong economic periods" of high productivity and low unemployment. ("Rising Tide in the Labor Market: To What Degrees Do Expansions Benefit the Disadvantaged?" by Katherine L. Bradbury, New England Economic Review, May/June 2000.).

The New Economy boom of 1995 to 2000 was just such a period. Growth sizzled at a 4% annual rate, the jobless rate hovered around 4%, and productivity expanded at a 2.8% pace. In a sharp reversal of the previous two decades, the gap between the rich and the poor stabilized. What's more, most of the gains came at the bottom rung of the income scale. Business executives complained constantly about labor shortages, and the unemployment rate for minorities, single mothers, teens, and other groups fell sharply. For instance, the unemployment rate for blacks fell from around 10.5% in 1995 to some 8.1% in 2000. A tight labor market forces employers to pay more for labor.

ONE THEORY. Of course, New Economy skeptics doubt that the rise of information technology and the Internet has led to a sustained rise in productivity growth. They've gotten some recent ammunition as U.S. labor productivity fell in the first quarter of this year for the first time since 1995. The 1.2% drop (at an annual rate) in the measure of how much employees produce for an hour of work was bigger than expected. But the decline was largely driven by the downturn in the economy. Still, if productivity reverts to the 1% or so rate of the '70s, '80s, and early '90s, the long-term growth potential of the economy will hover between 2% and 2.5% a year.

If the economy grows faster than that for any sustained period of time, we'll probably experience production bottlenecks that will ignite a wage-and-price spiral. On the other hand, a moderate 2%-plus expansion -- however welcome it appears right now as the economy flirts with a recession -- isn't strong enough to narrow the wage gap.

But if Greenspan is right that the productivity revival of the late '90s was a paradigm shift, then the economy's true speed limit is closer to 4% than 2%. What's more, the economy is currently turning around with the unemployment rate at a still low 4.4%. The income gap is bound to narrow as low-income workers profit from a red-hot economy even as inflation remains dormant. Here's hoping we're seeing Greenspan's "pause" in investment in innovation. Farrell is contributing economics editor for BusinessWeek. His Sound Money radio commentaries are broadcast over National Public Radio on Saturdays in nearly 200 markets nationwide. Follow his weekly Sound Money column, only on BW Online

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