Weekly Economic Commentary by Scott J. Brown, Ph.D.

The importance of productivity growth

November 13, 2017

Economists view the growth in labor productivity, or output per worker, as the single most important variable in an economy. It’s what lifts the standard of living, helps keep prices low, reduces government budget strains, and drives corporate profits. Over the next few decades, achieving faster productivity growth will be key as labor force growth slows. The outlook is encouraging, but uncertain.

Productivity growth has slowed significantly over the last decade. Some may be quick to blame polices out of Washington. However, the slowdown in productivity growth has been observed worldwide (that is, it can’t be due to U.S. policies alone). Most economists believe that the slowdown reflects weaker capital spending following the Great Recession. In the U.S. capital spending had begun to pick up in the middle of 2016 and has been further fueled by improvement in business optimism in 2017. A stronger global economy has helped. Most long-term economic models include stronger productivity growth assumptions over the next ten years.

One of the long-standing strengths of the U.S. economy has been its ability to re-invent itself. New industries arrive over time while others fade away. Through this process, low-productivity jobs are shed, replaced by higher-productivity jobs. However, as the population ages, we can expect to see less turnover in the economy. There is less job-hopping and less migration to other areas of the country. In turn, productivity growth will be less than it would be otherwise.

This has been especially true in manufacturing, where growth in output per worker has long outpaced overall productivity growth by a wide margin, reflecting advances in technology and the impact of increased global trade. The share of employment in manufacturing had been trending lower for decades, well before the rise of trade with China.

Over the last four years, productivity growth in manufacturing has stalled. At the same time, the pace of job turnover in the factory sector is half of what it was in the 1990s.

Technology changes (robotics and artificial intelligence) are expected to have significant effects on the U.S. economy. The transitions for displaced workers can be difficult. Over the next couple of decades, technologies will almost certainly alter the economy in ways that we cannot even imagine.

As the job market tightens, wage pressures should pick up. To gauge the inflationary impact, one has to factor in productivity growth. If wages rise by 3% and output per worker rises 3%, then the labor cost per unit of output is unchanged. This is a key argument in the Fed’s gradual approach to raising rates.

Output growth is the growth in labor plus the growth in output per worker. Labor force growth will slow in the U.S. (and worldwide) as populations age. It is unclear how demographic and technology forces will interact, but the pace of productivity growth should pick up relative to the last decade.


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