Commentary: The Real Threat Isn't Housing

If productivity growth keeps sliding, a widespread crisis could be next

The quickest way to get run over is to look the wrong way when you cross the street. Right now everyone is worrying--or obsessing--about a potential housing bust. And why not? You can hear the screams issuing from California to Florida as subprime borrowers and lenders take it on the chin.

But the biggest danger is not the housing decline, however painful it might be. Instead, an 18-wheeler that threatens to flatten the economy and the financial markets is barreling at us from another direction altogether: weak productivity growth.

On Mar. 6, the Bureau of Labor Statistics announced that nonfarm business productivity rose by only 1.6% in 2006, its smallest gain since 1997. And more bad news was buried deep in the report: Productivity gains for 2005 and 2004 were revised down as well.

Investors shrugged off those numbers, sending the stock market up 1.5% that day for the biggest gain since July, responding to a rise in Asian markets and reassuring words from Treasury Secretary Henry Paulson. But if productivity growth continues its three-year slide, the U.S. will be vulnerable to a widespread recession or financial crisis that dwarfs any damage from the housing slump. Like a family living large that has to cut back, Americans will find that all of the bills put off for years will come due.

Consider the facts. Since 1995, when the New Economy and the information revolution really took hold, gains in productivity (output per hour) have averaged about 2.7% per year. That's a full percentage point higher than the preceding two decades.

Faster productivity growth means that the annual output of the economy today is about 10%, or $1.2 trillion, bigger than it would have been at the previous anemic pace. That additional output is more than enough to pay for the war in Iraq, which is costing $100 billion to $150 billion per year, and for the entire $767 billion annual cost of home construction and renovation in 2006. And you'd still have some spare billions left over.

In short, the productivity acceleration of the past 10 years has created a total of $6.4 trillion in extra output since 1995, measured in 2006 dollars. That helps explain why American households, taken together, are so much richer than they were: Household nonhousing net worth, adjusted for inflation and federal debt, has soared by almost $14 trillion over the same period, despite the dot-com debacle that crashed the market.

The massive amount of additional production is a key reason why the U.S. has not faced upward pressure on prices. And good productivity gains gave the economy enough momentum to fight off the disasters of 2001--the terrorist attacks, the stock market crash, the collapse of Enron--with only a minimal recession.

But the bonanza starts to disappear if productivity growth drops much further below its current level. Such a decline is a lot more possible than most economists realize or are willing to accept. History shows that shifts in the long-term trends of productivity are essentially unpredictable. No economic forecaster, as far as I know, foretold the productivity acceleration of the mid-1990s. And nobody, but nobody, predicted the productivity slowdown of the 1970s, which ignited years of high inflation.

What are the warning signs that the productivity revolution might be flagging? One is the decline in business investment in the fourth quarter of 2006, combined with the drop in new orders for nondefense, non-aircraft capital goods in January. This could be due to the housing slump, or it could be that companies are seeing fewer good investment opportunities, at least in the U.S.

Another disturbing indicator would be an unexpectedly high increase in jobs over the next few months. If companies run into productivity problems, their first response will be to hire more workers to meet demand. Finally, the biggest red flag would be a shortfall in corporate profits that lasts more than one quarter, just as a precursor to the New Economy was a sharp rise in profits.

I have no crystal ball when it comes to productivity; no one does. But when you hear that tractor-trailer blow its air horn, it's a good idea to pay attention.

By Michael Mandel

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