Productivity. That’s an all-important yardstick for measuring the value of goods and services workers can produce in any given time period. And growth in productivity is key in raising income and living standards. But, in the US, productivity growth has flagged in recent years. And that has economists worried. A recent study by consulting group McKinsey gives reason not to worry — but only if the government supports policies that bolster consumer demand.
Secular stagnation
Here’s the big issue: growth in the US economy has been sluggish since the end of the Great Financial Crisis. There have been spikes of growth. But invariably, the economy downshifted again. And the level of growth has been lower than in previous expansions.
In fact, there hasn’t been a single calendar year in which the economy has grown 3% or more since 2005. The longest stretch previously was 4 years. And that was during the depths of the Great Depression between 1930 and 1933. So that means we have seen 12 straight years of decidedly sub-par growth. Some people are calling this secular stagnation.
Productivity to the rescue
Now, growth depends on both the labor force and worker productivity. The only way to get growth back up is to either get more workers or get existing workers to make more stuff or both. Many economists have focused on the labor force piece. But many economists have instead focused on the productivity piece.
Former US Federal Reserve Chairman Alan Greenspan is particularly worried about the productivity piece. For years, he has said that producitvity growth is the key to understanding inflation. And more importantly, he recently warned that low productivity growth is the key difference between the macro backdrop today and the 1990s.
In the mid- to late-1990s, Greenspan resisted the urge to raise interest rates as unemployment dropped, despite worries about consumer price inflation. He theorized at the time that productivity growth would keep inflation at bay. Here’s how the New York Times put it in 2004. That’s when Greenspan repeated his experiment with low rates despite a growing housing bubble:
“Mr. Greenspan’s last big idea came 10 years ago, when he correctly perceived that American productivity was growing much faster than official statistics suggested and that the country could grow much more rapidly without inflation than most experts believed at the time.”
More recently, Greenspan has worried that low productivity gave us less room to maneuver. With tax cuts increasing the deficit, he fears inflation. He told Bloomberg late last month that “we’re dealing with a fiscally unstable long-term outlook in which inflation will take hold…we’ve been through almost a decade now of stagnation and we’re working our way toward stagflation.”
McKinsey sees demand as more important
What if Greenspan is wrong? Perhaps it is the labor force side of the equation that is more important.
Recent work by McKinsey supports this notion. The McKinsey research shows that demand for goods in services can increase productivity. And that means the number of workers can alter growth by affecting both the number of workers and productivity at the same time. Higher wages would have similar impacts by increasing present or expected consumption.
Here’s how the researchers described their findings in the Harvard Business Review a few days ago:
A little over a century ago, Henry Ford doubled the minimum pay of his workers to $5 a day. When other employers followed suit, it became clear that Ford had sparked a chain reaction. Higher pay throughout the industry helped lead to more sales, creating a virtuous cycle of growth and prosperity. Could we be at another Henry Ford moment?
Some major companies have announced plans to boost employee pay. Target raised its minimum wage to $11 this past fall and committed to $15 by 2020. More recently, Walmart announced plans to match that increase to $11. In banking, Wells Fargo and Fifth Third Bancorp also announced pay increases for minimum wage employees.
[…]
After a year-long analysis of seven developed countries and six sectors, we have concluded that demand matters for productivity growth and that increasing demand is key to restarting growth across advanced economies.
The impact of demand on productivity growth is often underappreciated. Looking closer at the period following the financial crisis, 2010 to 2014, we find that weak demand played a key role in the recent productivity growth decline to historic lows. In fact, about half of the slowdown in productivity growth — from an average of 2.4% in the United States and Western Europe in 2000 to 2004 to 0.5% a decade later — was due to weak demand and uncertainty.
The data on demand
What the researchers say is that workers with higher wages buy more complex goods and services. These goods and services require greater investment because their production requires is more complex. And this mix of output and investment increases productivity.
The investment piece is key.
“We have found from our global surveys of businesses that almost half of companies that are increasing their investment budgets are doing so because of an increase in demand. Demand is the single most important factor driving corporate investment decisions. Investment, in turn, is critical for productivity growth, as it equips workers with more – and with more recent and innovative – equipment, software, and structures. But we have seen capital intensity growth fall to the lowest levels in post-WWII history. Weaker demand leads to weaker investment and creates a vicious cycle for productivity and income growth.”
In essence, the researchers are saying demand leads investment and productivity. Or at least, prospective demand leads investment and productivity because prospective demand drives corporate investment decisions.
Conclusions?
If we think about the recent tax cuts from this framing, they can be effective in increasing investment if they are effective in increasing demand. But since lower-wage workers have a higher marginal propsensity to consume, we really should’t expect a big lift in investment. After all, the tax cuts were tilted toward corporations and higher income workers. And indeed, so far, the empirical evidence for increased capital investment is weak.
The big takeaway is that companies are using funds to buy back shares that could be used for capital investment. Suggests pickup in capex will be disappointing https://t.co/BOduHfqDYB
— Edward Harrison (@edwardnh) February 21, 2018
I remain sceptical about an imminent durable surge in growth and inflation in the US. The longer-term macro trends don’t support it. The demographics, the bargaining power of labor, the technological disruption all support low inflation and low growth. Moreover, macro policies in the US do not directly support robust wage gains. Only through a derivative or trickle-down effect do wage earners benefit from largesse directed toward corporates and the wealthy.
This business cycle will have to go on for much longer before wage pressures ignite in earnest. Until then, any breakout in growth is likely to be fleeting. The question is whether the Fed sees it that way because the Fed makes rate policy. And after years of zero rates, the Fed’s policy of increasing interest rates is critical for asset markets and the economy.