Commentary: How Fast Can This Hot Rod Go?
In November, 1994, when the unemployment rate was hitting 5.6%, Federal Reserve Chairman Alan Greenspan was pushing the federal funds rate to 5.5%, and Wall Street economists were worried that he wasn't going far enough to head off incipient inflation. In November, 1999, the Fed has once more raised the funds rate to 5.5%. This year, however, the move is widely viewed as insurance. Unemployment is at 4.1%, and the economy is growing at over 4% annually, but nobody's panicking because inflation remains virtually dormant.
What happened in those five years? There has been a gradual, and sometimes grudging, acceptance of the new realities of the Information Revolution. In 1994, when BUSINESS WEEK first raised the possibility that the U.S. was entering an era of rapid productivity growth--the so-called New Economy--there was enormous resistance from economists. Indeed, for many years the notion of the New Economy received little support from the government's official statistics.
But year after year of rapid growth and falling unemployment with little inflation eroded the skepticism. Now, finally, the official data are proving the point, too. On Nov. 12, the Bureau of Labor Statistics released an upward revision of the productivity data, counting software production for the first time as output and making other upgrades.
The new numbers provide dramatic confirmation that the New Economy not only exists but continues to thrive. Average productivity growth in the 1990s, originally calculated at 1.5% annually, now stands at 2%--a rate that few economists expected the U.S. to ever reach again. The past four years are even better, showing an economy able to sustain productivity gains in excess of 2.5% annually, a pace close to that of the halcyon 1960s.
Here's what the newly revised productivity data mean for the economy, for monetary and fiscal policy, and for investors.
What do the new numbers show?
The basic message is that the productivity slowdown that started around 1973 now seems to be decisively over. True, the economy has not quite returned to the stellar pace of the 1960s yet (chart). But productivity growth--measured from the peak of one business cycle to the peak of the next--has clearly jumped. The slow productivity growth of the 1970s and the early 1980s, which so perplexed economists, is looking more like a temporary phenomenon than a long-term trend.
Is this a sudden change?
Certainly productivity growth has accelerated sharply in recent years. But the bls revisions indicate that the New Economy has been evolving since the early 1980s, when companies sharply boosted their spending on information-technology software and hardware (chart). Indeed, sharp upward revisions to reported productivity for the 1980s and 1990s mean that the so-called technology paradox--the apparent ineffectiveness of high-tech spending during that period---may no longer exist.
How fast can the economy grow safely?
Estimated conservatively, the new speed limit--the fastest rate the economy can sustain without igniting inflation--is now at least 3%, compared with 2.3% or so in the 1980s. That 3% figure represents a combination of 2% annual productivity growth plus a 1% increase in hours worked.
But it could be even higher. If the strong productivity growth of recent years persists, the economy could manage 3.5% growth or more without danger of inflation. Indeed, with information technology--a high-productivity-growth industry--taking a larger and larger share of consumer and business spending, overall productivity should in fact tend to rise.
Even now, productivity gains in some of the most innovative industries are still not being picked up by the government statistics. Health care, for example, still shows effectively no productivity growth. Likewise, the media sector--publishing, broadcasting, and printing--is reported with flat or negative productivity gains, because the official stats don't give credit for the tremendous increase in variety from cable television, the Internet, and the proliferation of other media outlets.
How does the current productivity boom stack up against those of the past?
The U.S. has effectively regained its long-term productivity growth rate, which is not shabby at all. For example, in the first half of the 20th century--one of the most innovative periods in history, productivity averaged about 2% annually. That's about what it has been in the 1990s. The biggest productivity gainers, of course, are the computer and semiconductor industries, which are turning out ever more powerful chips and pcs. More broadly, nonfinancial corporations have turned in average productivity gains of 2.7% a year, faster than the pace of the 1960s. That helps explain why corporate profits stay strong even as wages rise.
Which industries are lagging behind?
The slow growth seems to be mostly coming in the small-business and noncorporate sector. That includes many restaurants, small retailers, and doctors' offices. Within manufacturing, lagging industries include food, furniture, and basic chemicals.
How does the U.S. productivity stack up globally?
Because of differences in statistical methodology, it's difficult to compare productivity across countries. But the growth rate of real gross domestic product per worker has clearly been falling in Japan and France in the 1990s, even while rising sharply during the same period in the U.S. One country where restructuring and investment in technology appears to be paying off is Britain, which has experienced early signs of a renewal of productivity growth in the 1990s.
How does the new speed limit affect monetary policy?
Higher productivity growth allows the economy to expand faster without igniting inflation. It also means that a tight labor market and rising wages do not necessarily require a rate increase, since the cost-savings from higher productivity offsets wage gains. But there are limits. For example, unemployment has fallen by 0.4 percentage points over the last year, drawing down "the pool of available workers willing to take jobs," as the Fed noted when it raised rates on Nov. 16. If this continues, the labor market will keep tightening, eventually prompting more rate hikes and increasing operational costs.
The new speed limit, however, should mean that Greenspan can afford to wait longer before throttling back. Equally important, a higher speed limit gives the Fed more maneuvering room to react to any future financial crises, either domestic or international. Pumping a shot of monetary adrenaline into a troubled financial system, as the Fed did last fall in response to the global crisis, is less likely to have bad side-effects in a healthy economy.
What about fiscal policy?
In the long run, the higher speed limit may have a bigger impact on fiscal policy than monetary policy. In particular, faster growth diminishes the urgency of the Social Security debate, since the latest projections for when the trust fund will go into deficit still assume only 1.3% annual productivity growth over the next 20 years. In the next report, that number should be boosted to 1.7% or higher, significantly increasing projected revenues and reducing the anticipated Social Security shortfall.
What do the productivity revisions mean for investors?
The revised statistics tend to validate the strong performance of the markets in the 1980s and the 1990s. The 1980s bull market began in late '82, just before the time that new numbers show the productivity slowdown starting to abate. And the enormous stock market surge that started in early 1995 coincides almost exactly with the latest period of rapid productivity growth. The conclusion: As long as productivity soars, it's good news for investors.
How long will the productivity boom continue?
There appears to be no reason why the productivity boom should end anytime soon. High rates of investment mean that the stock of equipment and software available to each worker is rising rapidly, boosting productivity. Moreover, the spread of the Internet is forcing companies to move online, which typically leads to job cuts. On Nov. 10, Allstate Corp., the largest public U.S. car and home insurer, announced that it will start selling over the Net, and cut 4,000 of its non-agent staff. General Motors' new online network will likely reduce the number of jobs in its purchasing department. Those stories are being repeated throughout the economy.
All told, there is no sign of a slowdown in corporate restructuring to improve productivity and cut costs. Despite strong growth, U.S. employers announced almost 600,000 job cuts in the first 10 months of 1999, up 11% from the same period in 1998, according to Challenger, Gray & Christmas.
What will happen to productivity in the next recession?
That's the critical question for the New Economy. In the recessions of the 1970s and early 1980s, productivity fell sharply when the economy turned down. If the same thing happens again, both the economy and the stock market will give back much of their recent gains.
But there's a good chance that productivity will stay strong in the next downturn, or perhaps even continue to rise. While some industries have been cutting workers, other companies have grown fat during the boom. But when times turn bad, the laggards will be forced to do the radical restructuring needed to capitalize on information technology and the Net.
One industry ripe for consolidation: Car dealerships. Since 1995, the number of employees at auto dealers has risen by more than 80,000. Over the same period, the number of workers in auto manufacturing actually fell by 15,000. In an era where it's increasingly possible to buy cars online, that sort of indulgence will not be sustainable.
Could the New Economy turn out to be a mirage?
It's possible, but it's getting increasingly unlikely. The share of business investment going to high-tech is rising, suggesting that companies still see a big payoff from info tech. And as long as that's true, the New Economy lives.