Commentary: More Productivity, More Profits?
By Michael J. Mandel
Trying to predict how fast productivity will rise is one of the more difficult tasks that economists and investors can undertake. The U.S. economy has shown itself prone to sudden and unanticipated shifts in productivity growth, with big effects on the economy and the stock market. The rate of productivity growth fell without warning in the 1970s, ushering in a bear market and a long period of stagnation. Then the equally unexpected jump in productivity growth in the mid-1990s was followed by soaring stock prices and wages.
All of which means that when it comes to productivity, uncertainty is the norm. Still, there are plenty of reasons to be optimistic that productivity growth will remain strong based on the information we have today. Indeed, some tentative signs are already emerging that productivity growth could be on the upswing in coming years and may be closer to 2.5% a year, rather than the 2% long-term annual rate that most economists expected just a few months ago.
One piece of evidence: Despite the recession, average productivity growth over the last five years was around 2.9%, the best five-year period since 1968. In addition, companies have been able to sustain their gains during the recession. Since early 2001, productivity has risen at around a 3.5%-to-4% rate despite the economic slowdown and the terrorist attack. Contrast that to the productivity gains of only 1.2% annually during the recession years of 1990 and 1991. Even with the tech bust, moreover, corporate spending on technology equipment and software is 75% higher today than it was in 1995. That means tech investment by companies is still strong enough to push productivity higher.
Of course, just because productivity did well in the past few years doesn't mean it will continue to do so. It is still quite possible that those good productivity numbers could be revised down sharply. In the years ahead, moreover, the high cost of military and anti-terrorist spending could siphon away resources that otherwise would go to productivity-enhancing investment. That could hold down gains.
However, another argument that productivity will remain strong is emerging from the improving corporate profits picture. How so? The ability of companies to boost profits depends on three things: how high they can lift their prices, how much they can increase output per worker, and how fast wages are rising.
When it comes to increasing prices and holding the line on wages, companies have been fighting an uphill battle since the downturn started. Pricing power has been virtually nil, with business able to boost prices by only 0.5%. At the same time, wages have been soaring, with the employment cost index, adjusted for inflation, up by about 3%.
As a result, reported profit numbers have been tepid at best. BusinessWeek's profit scoreboard for 900 large companies (May 20) calculated that reported profits fell by 2% in the first quarter of 2002 from a year earlier. On May 24, the Bureau of Economic Analysis reported several different estimates of corporate profit growth, ranging from up by 4.6% versus a year ago to down by 17.3%, depending on how the government adjusted for depreciation and taxes.
But while the overall numbers remain weak, BusinessWeek's first-quarter scoreboard shows that companies have been able to boost their profit margins. For example, outside the volatile oil and gas sector, profits as a percentage of sales rose from 4.7% to 5.3%. By the government's figures, profits per unit of output--another measure of profit margins--have been rising as well. While these margins are still nowhere near the peak levels of the 1990s, the magnitude of the increase is an encouraging sign that the productivity growth is real.
Indeed, a rise in profit margins in the mid-1990s was one of the main signs that Fed Chairman Alan Greenspan used as evidence that productivity growth had increased even though the rise had not yet shown up in the official government statistics. "Profit margins remain high," Greenspan told Congress in July, 1997, "suggesting that businesses continue to find new ways to enhance their efficiency."
The emerging consensus on productivity is summed up nicely by a recent paper from Stephen D. Oliner and Daniel E. Sichel, two leading economists at the Federal Reserve Board. They argue that the economy can maintain productivity increases of somewhere between 2% and 2.75% per year. That "puts us squarely in the camp of those who believe that a significant portion--and possibly all--of the mid-1990s productivity resurgence is sustainable," Oliner and Sichel write. Martin N. Baily, a productivity expert at the Institute for International Economics who formerly served as chairman of the Council of Economic Advisors in the Clinton Administration, now estimates the trend growth rate of productivity to be 2.5% annually.
Of course, there are some big differences between the mid-1990s' productivity surge and today's. Back then, companies had more ability to raise prices. Moreover, real wages were barely rising. During the years 1995 and 1996, real compensation per hour in nonfinancial companies actually fell. As a result, productivity improvements in the mid-1990s dropped directly to the bottom line.
This time, rising real wages are absorbing much of the productivity gains. BusinessWeek estimates that if real wages had been flat over the last two years, corporate profits would have been boosted by about $145 billion, or 20%. The implication? Even if productivity does rise at a 2.5% rate in the coming years, wage gains will keep profits from exploding.
Still, higher productivity should translate into enough profits to fuel capital investment and another wave of growth. Moreover, such a half-point increase in productivity growth, if it holds for the next five years, would mean that gross domestic product in 2007 would be roughly $300 billion higher than with 2% productivity growth. With federal taxes taking about 20% of GDP, tax revenues would be about $60 billion higher, and any budget deficit would be less of a problem.
Higher productivity growth, of course, is no sure thing. As the saying goes, past results are no guarantee of future performance. Increasingly, however, the prospects for more solid gains to come are looking better.
Chief Economist Mandel has written extensively on productivity.