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Productivity Won't Always Save the Day

By David Wyss With oil prices at a record high and the economy still strong, can inflation be far behind? Weak wage growth and strong productivity have held off inflationary threats for now, allowing the Federal Reserve to tighten gradually. If productivity slows or wages accelerate, will the Fed be forced to speed up its hikes?

Over the last 50 years and also the last 15, productivity growth has averaged near 2.5% per year. But since 1995 it has averaged 3.4%, while from 1980 through 1989 it was a meager 1.5%. At Standard & Poor's we assume growth will revert to its 2.5% mean, but it could miss the mark. A drop in performance to the levels of the 1980s would make the U.S. economy look like Europe and Japan, risking a return to the stagflation of that era. A continuation of 3.4% productivity growth would solve many problems, including the Social Security and budget deficits.

LONG WAVES. In the traditional economic analysis, potential output is determined by capital, labor, and natural resources. However, there remains an "everything else" category that economists call "total factor productivity" and usually identify with technological change. Historically, more than half of productivity growth (output per labor hour) and most of the volatility in that advance is explained by technology.

Some also make a strong argument that energy and equipment are closely related (argued most forcibly by Dale Jorgenson in the late 1970s). Equipment requires energy, so when the relative cost of energy rose in the 1970s, the result was a reduction in effective capital. Recent increases in energy costs may thus cut productivity growth.

Historically, technological change seems to occur in long waves. What data we have suggest that a wave lasts about 20 years. If we date the current wave from the mid-1990s, when productivity growth accelerated, it's about half over.

FEW OPPORTUNITIES. A major puzzle, however, is that the U.S. seems to be riding this technology and productivity wave alone. Of the major industrial countries, none is seeing growth as rapid as in the U.S., although Britain has posted some gains. In past productivity cycles, most countries have sped up or slowed roughly in parallel.

Part of the reason for weaker productivity growth in Europe and Japan is the lower level of investment. The U.S. is no longer supplying its own funds for investment, even within America, but rather is relying on funds flowing in from overseas, including from Europe and Japan. But the very low interest rates in these regions -- even lower than in the U.S. -- suggest that investors don't see much in the way of opportunities there. Funds not flowing to the U.S. would more likely flow to other countries rather than stay home.

Private investment in the U.S. amounted to 16.4% of gross domestic product in 2004, almost exactly the same as the 35-year average of 16.3%. It was also close to the gross private saving rate of 14.9%, which is well below its 35-year average of 17.4%. But when the combined federal, state, and local deficits are included, the gross saving rate for the U.S. reached only 10.5%, nearly six percentage points below private investment. That financing gap is being supplied from outside the country and is the counterpart of the trade deficit.

REMAIN CALM. As the trade deficit narrows, the U.S. will have to either reduce investment or increase saving. Raising the saving rate would be better for long-term growth, but boosting private saving is difficult. Cutting the government deficit enough seems unlikely under current policies.

Weaker investment will cut future productivity growth. The risk would be a repeat of the 1980s, when the need for foreign capital to finance the federal deficit pushed U.S. bond yields to record highs and helped create a decade of weak productivity growth. That episode, however, was accompanied by a rising dollar, as the U.S.'s capital needs and resulting high interest rates attracted foreign inflows. This time, the dollar could instead lose value as the trade gap becomes harder to finance.

Productivity growth provides a cushion between growth in employment costs and input prices and the prices of final goods and services. The strong productivity gains of the last 10 years have allowed inflation to remain calm despite fringe-benefit costs, which have accelerated to 20-year highs.

BOOSTING DEMAND. In the short run, stronger productivity growth works against strong employment growth. Note employment's weak recovery after the 2001 recession. In the longer run, however, rising productivity tends to result in higher employment.

Productivity growth is real income growth. Higher real incomes allow consumers to spend more. The increased return to capital attracts more capital spending, further boosting demand. In the U.S., periods of strong productivity growth have been periods of low unemployment.

Indeed, productivity remains the major determinant of long-term growth. Our forecast a S&P, based on productivity rising at its historical average of 2.5%, is reasonable, but the threat that declining financial inflows from abroad could sap productivity is real. That would make closing the budget deficit and containing inflation a much tougher task. Wyss is chief economist for Standard & Poor's

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