Commentary: The New Economy Lives On

The Fed sees the productivity dip as a bump in the road

By Rich Miller

No policymaker has studied the inner workings of the New Economy more closely than Alan Greenspan. The Federal Reserve chairman was among the first to recognize in 1995 that the economy was about to embark on a productivity-driven boom. The productivity take-off wasn't visible at first in the official statistics. But Greenspan's own soundings of business leaders and careful reworking of the data convinced him that something momentous was about to happen. So he ignored the warnings of inflation worrywarts at the Fed and kept interest rates low, allowing the New Economy to blossom and grow far faster than anyone had thought possible.

Now the official data are suggesting that the productivity miracle is about to go up in smoke. In what some analysts saw as a death knell for the New Economy, the Labor Dept. reported on May 8 that worker productivity, or output per hour, fell in the first quarter for the first time in six years. Unit labor costs, the flip side of productivity growth, spiked, rising at their fastest rate in three years. New Economy skeptics immediately seized on the data as evidence that the productivity phenomenon was a mere mirage pumped up by a stock market bubble that has now gone bust. "These numbers should put to rest the notion that there was a tech-driven miracle in U.S. productivity in the last few years," says Ian Shepherdson, chief U.S. economist at Valhalla (N.Y.) consultants High Frequency Economics.

Once again, though, Greenspan isn't buying what the official data seem to be saying. He thinks reports of the demise of the productivity miracle are premature and that tech-led improvements in corporate efficiency are far from over. Productivity growth accelerated to close to 3% per year from 1995 to 2000, roughly double the level of the previous two decades. Greenspan and his fellow monetary mandarins are convinced most, if not all, of that improvement will prove permanent. "We may see weak productivity numbers in some quarterly reports," Chicago Fed President Michael Moskow said on May 4. "But over the longer term, average productivity growth should continue at relatively high levels."

HIGH STAKES. A lot is riding on Greenspan & Co. being right. If indeed the slowdown in productivity growth is just a blip, then the economy should be able to shake off its current bout of weakness and resume growing at a 3 1/2% pace next year, helped, of course, by generous interest rate cuts by the Fed. But if the monetary gurus are wrong, then look out below: The Fed's big dollops of liquidity--including an expected further half percentage point rate cut on May 15--will only serve to pump up inflation by boosting labor costs. The result: an ugly stagflationary brew of weak growth and rising inflation.

Fortunately, the odds of the Fed getting it right are pretty good. There's plenty of evidence to support the view that the underlying, or trend, rate of productivity growth is still high--and likely to remain so. For starters, productivity slipped last quarter mainly because of a statistical anomaly involving self-employed people whose hours worked soared after declining sharply in the final three months of last year. Over the past year, productivity has grown 2.8%, about in line with the boom time gains.

Productivity numbers, moreover, tend to jump around a lot from quarter to quarter, and even from year to year, in response to the ebbs and flows of the economy. What's important for the long-term health of the economy is not these temporary ups and downs in productivity but its underlying rate. Even in the golden economic era of the 1960s, when productivity growth also averaged close to 3% annually, it still swung wildly from year to year. In 1969, for instance, productivity was mostly flat as growth slowed from close to 5% the previous year to 3%. But because the underlying rate stayed strong, it quickly recovered, averaging an annual 3% the following four years.

There's good reason to believe the same sorts of swings are occurring now. Chris Varvares, president of St. Louis consultants Macroeconomic Advisers, reckons that about 90% of the deterioration in productivity growth from more than 3% last year to zero today can be explained by cyclical, transitory factors. "The first-quarter numbers are not inconsistent with trend-productivity growth between 2 1/2% and 2 3/4%," he says.

The steep rise in unemployment over the last six months, to 4.5% in April, seems to back that up, says J.P Morgan Securities Senior Economist James Glassman. In the past, such a big jump in unemployment only occurred when the economy was in a recession. But growth over the past six months has averaged about 1.5%. That's exceedingly modest by New Economy standards, yet in line with the average that prevailed from 1973 to the mid-1990s. The ability of companies to pare their payrolls so aggressively while still meeting the demands generated by a growing economy suggests that the productivity of the workers they're retaining is high.

Of course, companies have not only been cutting back on workers, they have also been trimming investment. If taken too far, that could crimp structural-productivity growth. But economists say the cutbacks would have to be lot sharper than they have been to date to put a big dent in productivity. Why? Because the level of investment is still sky-high by historical standards, even after the recent cutbacks. In the first quarter, for instance, companies invested the equivalent of $539 billion annually in information-processing equipment and software, according to government figures. While that was some $20 billion lower than the fourth quarter, it was still far higher than the $433 billion actually invested in all of 1999. Those outlays are boosting the economy's capital stock and making it more efficient.

PRICES SLASHED. Thanks to a steep fall in high-tech prices, the companies that are continuing to invest are getting more for their money. Faced with a sharp slowdown in demand, tech companies have slashed prices in a bid to move unwanted inventory. Computer prices in the first quarter plunged at a 28.5% annual rate, the biggest drop in almost three years. That's bad for the bottom line of computer and other high-tech companies, but good for their customers and the economy.

All that high-tech investment has enabled companies to retool and boost efficiency. And the process has just begun. A survey released on May 1 by the National Association of Purchasing Management found that some three-quarters of purchasing executives at manufacturing and nonmanufacturing businesses believe that they can still wring significant efficiencies by applying technology to the way they carry out their business.

That's the sort of on-the-factory-floor intelligence that Greenspan loves to collect. And it's helping to convince him that, despite the naysayers, the New Economy is alive and well.

Miller covers the Fed in Washington.

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