Former Treasury Secretary Larry Summers recently lamented that “poor prospects for sustained rapid growth are not surprising given the economy’s weak foundation. Despite record-low capital costs and abundant corporate cash as inducements to investment, productivity growth has been slow.”
He has a point. Nonfarm productivity over the last five years has expanded at an annual rate of just 0.8%, a pace almost without precedent. Yet, weak productivity growth isn't guaranteed to continue to be feeble and recent evidence presents reasons for optimism.
Recent productivity growth has probably been understated because gross domestic product has a tendency to be revised up much more than hours worked. Trying to square strong growth in hours worked with weak output growth has been common since 2009.
At times, it seemed as if companies were adding to their employment ranks and boosting total hours worked only to produce less. Business economists tend to focus on employment and hours because those are a much more stable measure of activity than GDP. So, we might just see GDP growth revised up in coming years, making productivity growth somewhat stronger.
There a few reasons to be optimistic.
Much of the recent weakness in productivity growth coincided with weak growth in capital-intensive industries in the goods-producing sector. That has reversed. In 2017, the economy has enjoyed a rotation of workers into productive industries in the goods-producing sector.
Manufacturing payrolls are on track for their best year since 2014. Mining industries are poised for the strongest annual employment growth since 2011. These sectors tend to be more capital intensive and more productive in comparison to service industries.
The recovery in manufacturing and mining is a reason to be a cyclical optimist about productivity. There are more fundamental reasons as well. Labor productivity can be broken down to a few factors:
Labor quality, or the education level and skills of the workforce. Total factor productivity, which incorporates many of the intangibles that propel long-run growth. Capital deepening, defined as the growth in the capital stock per labor hour.
Labor quality and capital deepening are believed to be observable, measurable factors while total factor productivity is not.
Data from the Federal Reserve Bank of San Francisco shows that productivity has advanced less than 1% annually since 2011, less than half the pace of the last two decades. Second, a lack of capital deepening is the primary reason productivity has been weak in recent years.
Normally, capital deepening is a positive driver for labor productivity. Today, it has been negative. While it has been popular to argue that the gains from new technologies have been exhausted, this appears to be a small factor behind the sluggish performance of productivity. This phenomenon is mostly explained by weak investment. Thus, the recent pickup in business investment spending is good news for the productivity outlook.
The drop in investment during recessions causes a slowdown in the capital stock with a lag. The housing and credit boom of the last cycle likely caused a significant misallocation of resources across industries, which may imply a prolonged mismatch between jobs and workers. That can’t be good for labor productivity, but an economy operating at full employment long enough probably helps resolve at least some of this problem. Moreover, tight labor markets tend to be associated with stronger rates of business fixed investment than slack labor markets. So, there are good reasons to think that a strong jobs market will encourage productivity growth.
A recovery in productivity will help take on several key issues facing the economy and capital markets heading into 2018. The flattening yield curve is an example. Stronger productivity should help lift the level of rates. It also tends to keep inflationary pressures at bay while raising potential growth.
As a result, the Fed can move slowly to the exit door, anchoring the short end as stronger potential growth lifts the long end. Wage growth also remains a conundrum in the face of low unemployment. We suspect weak productivity is a reason behind this sluggishness. If productivity is picking up, it will create space for companies to increase pay without lifting selling prices.
By Neil Dutta