Invest and growth will come.

Photographer: Troy Harvey/Bloomberg

Let's Be Optimistic About Productivity

Narayana Kocherlakota is a Bloomberg View columnist. He is a professor of economics at the University of Rochester and was president of the Federal Reserve Bank of Minneapolis from 2009 to 2015.
Read More.
a | A

The U.S. economy is suffering from a malaise that undermines its ability to boost living standards: Labor productivity, or the amount of goods and services people produce for each hour worked, isn't growing like it has in the past.

What it needs is a dose of optimism.

Eight years after the beginning of the last recession, the economy is in much worse shape than was expected -- at least judging from the forecasts that the Congressional Budget Office published back in August 2007. As of 2015, nonfarm business output was 15 percent lower than forecast. About a third of this shortfall is attributable to people working fewer hours than expected.  The rest is attributable to businesses having a lot less physical capital (such as machines and software) than was anticipated, and having unexpectedly low total factor productivity (the productivity of labor and capital).

What to do? When faced with a decline in productivity, economists typically offer so-called supply-side solutions, such as lowering taxes or eliminating regulations. It's important to recognize, though, that policies aimed at stimulating demand might be able to help a lot.

Suppose, for example, that macroeconomic policy choices convinced businesses to expect faster growth in the demand for their goods and services than they currently do. Companies would react by investing in more physical capital, and in the innovation needed to make that capital (and the people who work with it) more productive.

Of course, the extra investment would also require companies to hire, putting upward pressure on wages and prices.  The question is whether this would lead to undesirable inflation. That is, would expectations of outsized demand growth -- of, say, 4 percent per year over the next four years in inflation-adjusted terms -- generate undue inflationary pressures that would require the Federal Reserve to respond by raising interest rates, essentially killing off any actual growth that those expectations could generate?

A pessimist would see such an outcome as inevitable. In this view, Americans have turned out to be a lot less innovative and inclined to work than was anticipated in 2007, and businesses have responded rationally by investing less. Hence, the added hiring and investment would boost wages without spurring the productivity needed to justify the pay increase, leaving companies with no option but to raise prices. The Fed would then have to raise rates, or else inflation would get out of control.

An optimist, by contrast, could offer three reasons to believe that fostering faster growth would not lead to undue inflationary pressures. First, prime-age employment remains low compared with 2007, suggesting that relatively small wage increases would be enough to draw people back into work. Second, corporate profits are still high by historical standards, so businesses still have a lot of room to absorb wage increases before they would have to raise prices. Third, given more and better capital, workers could produce more for each hour of labor -- a force that would allow companies to pay more without raising prices.

I’m an optimist. I think there's room for improvement.  The government has the power to raise expectations of demand growth -- for example, by announcing plans to invest trillions of dollars in infrastructure. Those expectations can, in turn, lead businesses to undertake investments that will make American workers more productive.

Granted, the optimists could be wrong. But inaction entails big risks as well: As the divisive presidential election campaign has eloquently demonstrated, inadequate growth is imposing big social costs on the U.S. Shouldn’t we give optimism a try?

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

To contact the author of this story:
Narayana Kocherlakota at nkocherlako1@bloomberg.net

To contact the editor responsible for this story:
Mark Whitehouse at mwhitehouse1@bloomberg.net