Productivity: The Real Story

Its growth is slowing, but many of the New Economy gains will survive

Guns or butter? Security or consumption? That's a choice the U.S. hasn't faced since the cold war ended more than a decade ago. During the 1990s, it seemed the tech-fueled economy would grow so fast that the U.S. could afford both rising consumption and whatever defense spending was deemed necessary. And firing up much of that growth was a sharp rise in productivity: From 1995 to 2000, productivity growth averaged 2.5% annually, about a percentage point higher than the 1.4% productivity pace from 1975 to 1995.

There's little doubt that at least some of the productivity gains of the late 1990s are turning out to be short-lived. The dot-com boom and the stock market bubble of 1999 and early 2000 clearly overstated the strength of the economy and the size of its efficiency gains. Moreover, falling profits and tight capital markets have companies cutting back on capital spending, which will slow productivity gains. And the specter of terrorism is effectively imposing a tax on companies, forcing them to build up inventories and spend more on security. That, too, will be a drag on productivity, at least for a time.

Yet despite these changes, the factors that helped propel the productivity boom of the 1990s are not likely to disappear. The economy remains far more globalized and market-oriented than it was 10 or 15 years ago. Exports and imports are now about 24% of gross domestic product, and it would take repeated disasters to knock them down to the 19% share that prevailed during the slow-growth period from 1975 to 1995. Expected increases in defense outlays and recovery assistance should leave government spending on goods and services at less than 19% of GDP, still well below the level of the previous two decades. And even business investment, while weaker than it was during the tech splurge, is expected to stay substantially higher than it had been earlier.

The downturn is also forcing companies to tighten their operations and reorganize in ways unthinkable during the good times. That means layoffs and consolidations, but it also includes taking advantage of the best ideas from rivals to cut costs. "What happens in a recession is competitive intensity increases," says Bill Lewis, director of McKinsey Global Institute, which recently published a new study on productivity. Such measures could help counteract the terrorism-related hit to productivity.

"BETTER THAN IT WAS." Indeed, there's growing consensus among many economists that the U.S. can now sustain productivity growth of about 2% annually. That's below the super-charged productivity rates of the late 1990s. But the good news is that 2% is faster than the sluggish years of the 1970s and 1980s. "That's better than it was before the boom," says Cynthia Latta, chief U.S. economist at DRI-WEFA, which is forecasting a long-term productivity growth rate of around 2%. Indeed, that's almost exactly the long-term historical productivity growth rate of the past 50 years.

The same result was found by the McKinsey study, which looked at the productivity experience of individual industries rather than macroeconomic data. McKinsey concluded that roughly half of the productivity gains of the New Economy boom are clearly sustainable. That likely puts the expected productivity growth rate at around 2% or so over the next five years.

Similarly, within the Federal Reserve, policymakers from Chairman Alan Greenspan on down are convinced that the productivity pickup is real and will continue, though perhaps not at rates that prevailed in the late 1990s. Some top officials and economists at the central bank say in private that annual productivity growth from here on out will be roughly 2%. Greenspan, for his part, seems certain that there are plenty of efficiencies to be gained from the further application of information technology. But like some of his central bank colleagues, he seems unsure whether the resulting productivity growth will be up to the supercharged standards set in the late '90s.

Even Robert J. Gordon of Northwestern University, the leading skeptic of the New Economy, has acknowledged some productivity improvements. In an April, 2001, paper, he found that underlying "structural" labor productivity growth had jumped by 0.9 percentage points in the second half of the 1990s. Subsequent revisions of the data knocked that gain down to about 0.5 percentage points, in line with the consensus view. But Gordon cautions strongly that all of the productivity improvements came from the rising use and production of computers. Thus, in his view, if the tech slump continues, much of the productivity growth gains would evaporate.

The debate over where exactly productivity stands is of far more than theoretical importance. Suppose output per worker does grow at 2% a year rather than the 1.4% that prevailed from 1975 to 1995. If the labor force grows at about 1% annually, the shift up in productivity implies that gross domestic product can be expected to grow at about 3% rather than 2.4%. That extra half-percentage point or so of growth has tremendous advantages for the economy. It would provide an extra $3 trillion in output over the next 10 years, in current dollars. That's enough to pay for both guns and butter.

THE COST OF TERROR. Of course, there's no denying that the terrorist attacks and their aftermath are taking a toll on the economy and will continue to do so for some time. Inventory costs are up, and supply chains are slowing as companies that reaped such benefits of the information revolution as just-in-time inventory controls now must stockpile parts to prevent supply disruption. Others are spending on redundant and expensive computer backup systems. All are getting hit with higher insurance premiums.

And there's always the possibility that additional terror attacks or an expansion of the war will further erode the foundations of the productivity gains. If investors become permanently wary of taking risks, business investment could sink much further than anyone expects now. Terrorism and war could impose an even bigger cost on foreign commerce than is now expected and force a retreat from globalization. That is clearly weighing on Greenspan. "If we allow terrorism to undermine our freedom of action, we could reverse at least part of the palpable gains achieved by postwar globalization," he said in a speech at the Institute for International Economics, a think tank in Washington, D.C. Moreover, a bigger, longer war could mean a big jump in government spending--which would mean either higher taxes or bigger budget deficits and higher interest rates. Neither would be good for private-sector growth.

Still, Greenspan, for one, appears optimistic that Terrible Tuesday won't have a lasting effect on long-run productivity growth. There will be a sharp one-time hit to productivity in response to the attacks. But once companies and investors adjust to the reality of a riskier world--a process Greenspan concedes could take six months or more--productivity growth should pick up again. To Greenspan's way of thinking, the extra efficiencies yet to be reaped from information technology haven't gone away--they've just been set back.

Indeed, even after an 18-month tech slump, business investment in tech equipment and software is still substantially higher, as a share of GDP, than it was at the beginning of the 1990s, and companies are still using information technology to cut costs and revamp operations. Over the past 12 months, Office Depot Inc. (ODP ) has installed error-reducing scanners at 25 North American warehouses that serve online and catalog customers. That has helped cut operating costs at its business-services group by 1%, and the retailer hopes to triple those gains over the next three years.

TECH BOOST. In coming months, companies are sure to find new ways to better deploy their existing IT assets. The McKinsey report found that roughly half of the efficiency gains of the late 1990s were made in retailing and wholesaling. In these industries, higher productivity came from combining information-technology investment with basics such as building bigger stores and warehouses to take advantage of economies of scale and shifting to more efficient ways of organizing distribution. There's no reason why such improvements can't continue even if the tech-investment slump persists.

Indeed, productivity has surprised economists many times before, and there's at least a chance that productivity gains will exceed 2%. For one, the recession will put pressure on companies that grew fat in the boom years to get leaner. "When the economy was growing, there were revenue opportunities that covered a lot of sins," says Robert A. Eckert, chairman and CEO of Mattel Inc. (MAT ), the world's largest toymaker. "Now, it becomes even more important to focus on productivity." By cutting its workforce, closing a factory, and taking steps to reduce product-development times, Mattel was recently able to report a 19% increase in earnings, before special charges, despite a sales increase of only 2%.

Moreover, the combination of deregulation and the merger wave of recent years has produced large competitors that can take advantage of economies of scale. The banking industry went through massive mergers in the 1990s as regulatory barriers to interstate banking fell. That didn't immediately show up as increased productivity, according to McKinsey's analysis, since the big banks had to digest their purchases.

That's changing now as banks trim down and jettison unprofitable businesses. "Banks in general, as an industry, will get increased productivity," argues James Dimon, CEO of Bank One Corp. (ONE ) "In financial services, including banking, the massive project is to consolidate back-office software systems and eliminate the duplications." Bank One has lopped some 8,000 jobs since Dimon came on board in March, 2000. The resulting cost reduction means the bank now has just 46.9 cents in noninterest expenses for every dollar of income, a 14% decline since 2000.

And productivity gains may well spread to new areas of the economy. The McKinsey study argues that innovation and economies of scale could bring productivity gains in industries such as health care, media, movie-making, and software. Meanwhile, deregulation will force productivity gains in industries such as utilities, long a laggard. The coming years will not be easy ones. But the boom of the 1990s established the foundation for more productivity growth in the years ahead.

Corrections and Clarifications Because of an editing error, the display language introducing the lead story of News: Analysis & Commentary (Nov. 5) misstated the thrust of the article. It should have read: "Productivity: The real story. Its growth is slowing, but many of the New Economy gains will survive."

By Michael J. Mandel in New York and Rich Miller in Washington, with Joseph Weber in Chicago, Christopher Palmeri in Los Angeles, and Aixa M. Pascual in Atlanta

Before it's here, it's on the Bloomberg Terminal.