Commentary: Was Turbocharged Productivity a Fluke?
By Charles J. Whalen
If the New Economy can be summed up in one word, it would be "productivity." After two decades of growing at only 1.4% per year, labor productivity, or output per hour, soared to a nearly 3% annual rate from 1995 through 2000. That rise has been a crucial factor in helping the U.S. enjoy an optimal combination of rapid expansion, low unemployment, dormant inflation, rising profits, and decent wage gains.
But the latest economic reports offer disturbing hints that this productivity increase may be short-lived. Output per hour is expected to show a small increase for the first three months of 2001--perhaps as low as a 0.5% rate, according to Morgan Stanley chief economist Stephen S. Roach. The evidence? The March employment report, released by the Bureau of Labor Statistics on Apr. 6, showed that hours worked rose at a nearly 1% annual rate in the first quarter, even as economic growth weakened. That's a recipe for a small increase in productivity, or even a decline, say some forecasters.
SQUEEZE. Why is that so worrisome? A sharp reduction in productivity growth, if sustained, will hurt corporations by boosting costs and squeezing profits. If many businesses try to pass these costs on in the form of higher prices, inflation could result. That would make the Federal Reserve's job of managing the economy much more difficult. Slow productivity growth would also indicate that the tech slowdown, through reduced capital spending, is harming the economy more than most economists expected.
Moreover, the ability of productivity growth to stay strong in the face of a slowing economy will shed light on a key question: To what extent do the productivity gains of the 1990s represent a long-lasting change, vs. a temporary response to unsustainably high levels of growth? The central idea now driving Fed policy is that such gains will be "structural," and represent a long-term improvement that will allow the economy to grow at higher average rates than many economists had believed possible. Indeed, in testimony before Congress on Mar. 2, Fed Chairman Alan Greenspan emphasized the accumulating evidence that the increases in productivity growth are "more than transitory."
But if productivity sags with the economy, that would support the view that much of the productivity gains were "cyclical," or temporary. If that's true, estimates of long-term sustainable growth rates will have to drop.
A single quarter of anemic productivity growth doesn't indicate that the New Economy productivity surge is over. One-quarter fluctuations "can often be more statistical accidents than real changes," says David A. Wyss, chief economist at Standard & Poor's Corp.
But if the slow productivity growth continues for more than a couple of quarters, that's bad news for companies that are already facing tough times. With unemployment still low, average hourly earnings already rose at an annual rate of 4.3% in the first quarter of 2001. And if competitive pressures continue to prevent businesses from raising prices, profits will take an even worse hit than they have so far.
Slower productivity growth also crimps the Federal Reserve's monetary policy. The Fed is assuming that productivity gains, together with recent cuts in interest rates, will let the economy avoid recession. But if productivity growth drops sharply, then the Fed will be forced to choose between cutting rates further, to prevent a downturn, or keeping monetary policy intact to control inflation.
Perhaps the biggest danger is that an extremely weak productivity number in the first quarter could be just the first of many. The productivity boom of the 1990s was built on soaring business investment in information technology, which reduced costs and increased output. But forecasters now expect capital spending to actually fall in the first quarter. If capital spending doesn't pick up, Fed officials admit they will have to trim their productivity estimate.
The New Economy--and the five years of soaring productivity that came along with it--was no mirage. But keeping the productivity boom going in a weak economy may turn out to be harder than expected.
Whalen covers the economy from New York.