Online Extra: Why Productivity Gains May Have Legs

Despite the downturn, chances are good that U.S. companies still have a ways to go in employing new, output-enhancing technology

One of the biggest fears about the current economic downturn is that it'll kill all those wonderful productivity gains corporations have enjoyed since 1995. After all, rising productivity helped boost corporate profits year after year -- and that kept inflation from gathering steam during a time of red-hot GDP growth, despite the tightest labor market in decades.

Although he was skeptical at times over the past five years that the productivity surge would last, even Alan Greenspan has grudgingly become a believer. What Fed chairman wouldn't wish for a trend that helps create noninflationary growth? In January, Greenspan finally proclaimed that the trend rate of productivity growth in the U.S. had probably made a permanent shift, from the 1% to 1.5% annual growth rates that predominated from 1970 to 1995, to a more robust long-term growth rate of 2% to 2.5% annually.

With so much riding on productivity gains, no wonder that the first quarter's decline of 1.2% in nonfarm business output-per-worker (a.k.a productivity) put the fear of God, or at least of inflation, into everyone's hearts. But New Economy bust or not, the U.S. is nowhere near the end of the current productivity revolution, because the economy is most likely nowhere near the end of the tech revolution that led to the rebirth of robust productivity.

"SECULAR CHANGE"? The tech sector will consolidate in 2001 and 2002, but the technologies that sparked new efficiencies over the past half-decade will continue to work their magic for some years yet -- or so most experts believe. The recent productivity downturn simply reflects a short-term dip in the business cycle. Indeed, on Aug. 7, the Bureau of Labor Statistics reported that productivity rose 2.5% in 2001's second quarter.

Of course, when analyzing such things, "you always have to be concerned about whether there has been a secular change in productivity," says Evan Koenig, senior economist and a vice-president at the Federal Reserve Bank of Dallas. "In the '60s and '70s we saw a decline in productivity growth that, in retrospect, turned out to be a reduction in the trend rate of growth." At the time, economists were eager to write off that slowdown as a cyclical trend that would blow over. Some cycle: It has taken a quarter-century to shake.

Which means that it's about time for a cycle that boosts productivity: When the economy booms, companies push existing employees to turn out more before starting to hire additional people. This explains why output-per-worker in the manufacturing sector grew by 9.3% in the fourth quarter of 1999 -- the fastest growth in 17 years -- before dropping to 2.1% some 15 months later, after manufacturers had hired more workers and demand slowed.

"HOARDING LABOR." Actually, that's a modest retreat. Output-per-worker often decreases in a slowdown because companies wait to do truly drastic layoffs until they're really sure that the economy won't bounce back soon. "We're seeing a downturn in productivity growth now because companies think output will increase in the near future," observes Allan Meltzer, professor of political economics at Carnegie Mellon. "We're still at 4.5% unemployment. Companies are hoarding labor because it's hard to get -- so productivity has dropped."

The hard thing for economists is to separate such cyclical movements from the underlying productivity trend -- efficiencies that stay in the system for a decade or longer. Despite the dot-com bust, many economists think the U.S. economy is currently only partly into that decade. "The encouraging thing is that we saw productivity pick up when we were well into an expansion," says the Dallas Fed's Koenig. "It's unusual to have productivity suddenly pick up when you are five years into an expansion."

Indeed, about half of the productivity increases that showed up during the latter half of the 1990s were of this more permanent kind, according to the economic studies of Northwestern University's productivity guru, Robert Gordon. It's true that a big part of those gains reflected the extent to which the tech sector employed its own technology to operate more efficiently -- and that tech is currently being hit hardest by the slowdown. Once technology demand picks up, however, those productivity gains should reappear.

And then the entire economy should benefit. It's reasonably clear that information technology has been the key to the economy's heightened productivity in recent years. "Between 1995 and 1999, IT producers and users showed the largest gains in average annual productivity growth," says Christophe Bianchet, a vice-president and U.S. economist at Credit Suisse Asset Management. Technology producers saw 3.7% average annual gains in their productivity during this period, compared with 2% gains for information technology-intensive industries and 0.43% for industries that don't use much IT.

IS THE PARTY OVER? The question of the moment is whether the efficiencies created by the tech advances of the past five years have already played out. Some experts think they have: "Productivity got a one-time boost from the widespread adoption of the Internet," declares John Lonski, chief economist at Moody's Investor Service. "The Fed's estimate [of a 2% to 2.5% productivity-growth trend] will be high unless some new technology comes along that can lift output-per-hour the way the Internet did [for a brief period]. We may have overinvested in the Net given what its economics justify."

On the other hand, Lonski may well be overestimating the extent to which businesses have already realized the efficiencies made possible by the Net. If most businesses have begun to use it, few do so to the extent that they eventually will. In fact, many companies are only now beginning to create their own intranets, a simple use of Web technology that can reduce the number of people needed for functions such as human resources.

Another efficiency the Web can provide -- one that's still in its infancy -- will come in business-to-business dealings. "Companies are reorganizing using B2B platforms," says Credit Suisse's Bianchet. "These platforms enable you to globally source materials and buy the products you need in the amount you need, when you need them." The time it takes any one person to find such materials will continue to drop dramatically as B2B exchanges gain in acceptance -- thus boosting productivity.

"INSURMOUNTABLE LEAD." Once the economy takes off again, companies will continue to explore what the Net and other new technologies can do for them. That will likely keep the U.S. in a position of economic dominance around the world.

"I hear people say that companies have spent too much on technology, but the mistakes have been small compared with the large increases in productivity we have achieved in this country," says Margaret Patel, investment strategist at Pioneer Funds. "We have taken an insurmountable lead over Europe and Japan in our productivity enhancement." And once the economy perks up a bit, the U.S. should again build on its lead.

By Margaret Popper in New York

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