Productivity's Second Wind

Why this growth engine still has a lot of oomph

Is the productivity miracle that powered the New Economy gasping its last breath? It may have seemed so on Feb. 6, when the government was expected to report that productivity growth ground to a virtual halt in last year's fourth quarter. And plenty of people on Wall Street and in Corporate America have all but given up on seeing the rapid gains of productivity that the U.S. witnessed in the late 1990s.

A word of advice to those gnashing their teeth over productivity: Relax. Predictions of its demise are greatly exaggerated. One bad number doesn't make a trend. Since productivity is tied to fluctuations in economic growth, it's no surprise that it flattened out in the final three months of 2002 as growth in gross domestic product abruptly slowed to an annual rate of just 0.7% from 4% in the third quarter.

By the same token, it should also come as no surprise that productivity will bounce back. The real question is to what level? And there's every reason to expect that it'll return to a healthy clip. The deep cost-cutting that helped propel gains last year will likely continue for at least a while. What's more, companies are continuing to make better use of the high-tech gear they purchased in the boom years. That should help keep productivity growth this year at a respectable 2% or more, says Chris Varvares, president of consultants Macroeconomic Advisers.

Over the long term, the outlook is equally upbeat. The main reason: Rapid improvements and falling prices for computer and communications technology--which have persisted through the tech-spending bust--will continue to help companies get more work done without adding to the payroll. Fueled by the revolution in microelectronics, the long-term trend for growth in nonfarm business productivity is probably between 2% and 2.5%, according to several productivity experts.

Sure, that's not as fast as the 2.6% pace during the New Economy boom from the end of 1995 through mid-2000--and nowhere near the 5.6% peak seen most of last year. But it's far better than the 1.4% average during the protracted productivity slump from 1973 through 1995.

These aren't just abstract numbers. Over 20 years, a one percentage point gain in annual productivity growth produces roughly a 30% increase in output per hour--and raises living standards by an equivalent amount.

A few economists are even more bullish. J. Bradford DeLong, of the University of California at Berkeley, contends that the long-term trend in productivity growth is 3%. That's why worrying about the recent volatile swings in productivity numbers is just so much wasted anxiety. Productivity normally slows in the second and third years of a recovery as companies become more confident about the economic outlook and take on more workers.

Moreover, that's also about the time the gains from cost-cutting rounds start to peter out. Or, as Chief Financial Officer Karen M. Hoguet of Federated Department Stores (FD ), the owner of Bloomingdale's and Macy's, told analysts on Jan. 16: "The low-hanging fruit is gone and, in fact, the medium fruit is gone."

Yet this time around, many companies haven't yet put away the pruning shears, meaning more productivity gains ahead. Most have little choice but to continue to do whatever cost-cutting it takes to maintain profit margins amid weak sales. "That will help keep everybody's feet to the fire," says Martin N. Baily, chairman of the Council of Economic Advisers under President Clinton and now an economist at the Institute for International Economics in Washington.

The good news is that there's more than old-fashioned penny-pinching at work. Much of the current gain is a delayed payback from heavy info tech investment during the late 1990s. Companies are learning to use the technology that they've already bought to enhance efficiency and improve productivity. "It's only when you change the processes that you get the productivity payback," says Cisco Systems Inc. CEO John T. Chambers. From Cisco's (CSCO ) experience, he says the greatest payoff doesn't come until seven to nine years after an investment is made. He thinks that if customers learn to make full use of technology, productivity could grow 3% to 5% annually.

The experience of many companies bears out Chambers' views. Industrial maintenance products distributor W.W. Grainger Inc., for instance, found that it took a while before new business management software bought during the boom produced any returns. "We're getting a lot smarter about the things we [bought] a few years ago," says Tim Ferrarell, senior vice-president of enterprise systems.

What's more, plenty of cutting-edge technology is already in existence, yet not widely used. A paper published last year by Jason G. Cummins of the Federal Reserve Board and Giovanni L. Violante of University College London found a wide gap between what they called "frontier technologies" and what was actually being utilized by many companies. If anything, that gap has gotten larger following the capital-spending bust, suggesting that corporations have plenty of room to boost productivity by purchasing equipment with the latest technology.

Of course, it won't happen unless companies step up and buy the gear. "We can't limp along with low investment indefinitely without paying the price on productivity," says former Federal Reserve Governor Lyle Gramley, now a senior economic adviser for Schwab Capital Markets.

Luckily, there are signs of an upturn in tech spending. The Commerce Dept. reported on Jan. 27 that business investment in inflation-adjusted terms rose for the first time in nine quarters in the final three months of 2002. Spending on information processing equipment and software, the lifeblood of the New Economy, climbed to its highest level in two years. "The tide is rising," says economist James K. Glassman of J.P. Morgan Securities.

And thanks to the continued steep fall in prices of microprocessors and other high-tech equipment, companies are getting more bang for their IT budgets. Microprocessor prices in December were 50% lower than they were a year before, after accounting for improvements in the quality of the product. Juri Matisoo, vice-president for technology of the Semiconductor Industry Assn. in San Jose, says that the world's top semiconductor engineers figure they have at least 10 and perhaps 15 years left in which they can continue doubling the circuit density of chips every 18 months. That relentless progress translates directly into benefits for computer buyers and the economy as a whole. "We are decreasing our budget," says Dave Kaercher, an information systems leader at retailer Best Buy Co. (BBY ) "But we're expanding our capabilities. Our money goes a lot further."

What's also important for long-range productivity is the pace of innovation. The biggest gains come from whole new ways of doing things, not just incremental improvements. On that score, the steep falloff in venture capital could be construed as worrisome. VC disbursements to U.S. companies fell from $29 billion in the first quarter of 2000 to just $4 billion in the last quarter of 2002, according to the MoneyTree Survey by PricewaterhouseCoopers, Venture Economics, and the National Venture Capital Assn.

But that drop reflects much more the crazed venture-capital boom of 2000 than any deep hole that startups have now fallen into. Disbursements of venture capital, in fact, are running as high as they were in 1997, which was considered pretty good at the time. Put another way: Plenty of money spent at the peak of the venture-capital boom went for pure fluff. In fact, Stewart Alsop, general partner with venture capitalist New Enterprise Associates, argues that today's sober atmosphere is better suited to building solid companies that will last.

Any way you cut it, productivity growth is likely to slow sharply this year from its lofty levels of most of last year. But that's hardly the end of the world--nor of the New Economy gains.

By Rich Miller in Washington and Peter Coy in New York, with Rob Hof and Peter Burrows in San Mateo, Robert Berner in Chicago, and bureau reports

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