THE GREAT PRODUCTIVITY DEBATE.
No one knows where it comes from, everyone agrees that it's hard to measure, and its most important moves defy explanation. Yet, judging from its influence on the Federal Reserve Board chairman the stock market and the national budget, the productivity number may be the single most important item in the economist's analytical kit.
American productivity growth had lagged around 1 percent for over two decades when suddenly, in 1995, it more than doubled. Although an increase from 1.2 percent to 2.5 percent may not seem huge, the magic of compounding makes it very big potatoes. Moreover, the rise fit nicely with the Internet boom, sparking talk that higher productivity levels might be a permanent condition brought on by wider connectivity and lower technology costs.
Productivity tends to fall as economic growth slows, and that is happening. Still, as measured by the U.S. Labor Department, nonfarm productivity -- expressed as the amount of goods and services workers produce each hour -- roset 2.1 percent in the second quarter, down slightly from the 2.5 percent forecast but still relatively strong.
Of course, any number that Fed Chairman Alan Greenspan hangs his hat on has to matter. And Greenspan clearly believes in the productivity miracle. Fed economists attribute most of the improvement in productivity to the widespread adoption of new technologies throughout the economy. Greenspan clearly thinks the productivity improvement is here to stay -- in fact, he's gone so far as to say so unambiguously, more than once. And Fed Governor Laurence H. Meyer has been even more forceful and clear than Greenspan on the subject. These top Fed decision-makers clearly believe not only that the recent productivity slowdown is temporary, but that productivity is holding up reasonably well despite the slowdown in the economy.
If they're right, the implications for stocks, interest rates and even the national budget are enormous. But are they right? New figures released in the summer showed that productivity growth during the booming 1990s was less than people (including Greenspan) had thought. The revision blew a chill through an already uncomfortably cold summer stock market, but warmed the hearts of New Economy skeptics.
Jack Grayson, chairman and founder of the American Productivity and Quality Center in Houston, dismisses the productivity optimists' claims. "I think people got euphoria," he says. "When you're starving and see food, anything looks good. People called it the 'productivity miracle.' But this had happened before."
Grayson, who ran President Nixon's wage and price control program, remembers growth rates during the 1960s higher than anything the recent New Economy generated. And he remembers well that productivity growth fell from as high as 4.5 percent in the mid-60s to only about 1 percent during the late '70s, '80s and early '90s. "The technological revolution is over-hyped. To date, it has not produced the sustained growth rate people had hoped for," he concludes,
The productivity story is not about a single number -- it's about expectations that will determine stock prices, interest rates, Fed policy and more in the years ahead. The implications for corporate decision-makers are pervasive. So, in August, Financial Executive contacted three notable market and economic authorities for in-depth discussions of the productivity question: Ed Yardeni, chief investment strategist at Deutsche Banc Alex. Brown; Ethan Harris, co-chief U.S. economist at Lehman Brothers Holdings Inc.; and Susanto Basu, who has been studying productivity for over a decade as associate professor at the University of Michigan and research associate at the National Bureau of Economic Research.
Chief Investment Strategist
Deutsche Banc Alex. Brown
What is this productivity debate all about?
A. Productivity is what drives purchasing power, real incomes and our standard of living. If we look at real consumption per worker, real wages and salaries per worker, those numbers are at an all-time high. During the '90s, they had their best growth rates since the 1960s. So real income data corroborates that there was a rebound in productivity because there couldn't possibly have been a rebound in real incomes and salaries without underlying improvement in productivity growth.
In fact, if you really take a long historical perspective on productivity, it's fair to say the slowdown in the '70s and '80s was an aberration. I've been arguing since the early 1990s that there would be a secular rebound in productivity back to the historically normal pace of 2.5 percent. So, having numbers revised down didn't faze me because I was surprisingly and pleasantly shocked by how strong they were. Even after the revision, we're left with numbers that confirm there was most likely a secular rebound in the '90s.
Where do the people who disagree with this view of the long-term trends go wrong?
A. I think they're just inherently pessimists. They're not focusing on the key issue here, which is that our standard of living today is the highest it has ever been, and it improved dramatically in the '90s. And let's not forget that while the stock market is down, it did go up 10-fold from 1982 until the end of the '90s. To say that the downward revision in productivity growth and a soft stock market somehow disproves the New Economy - that's just nonsense.
What does this productivity debate mean for business leaders?
A. We shouldn't assume that this rebound in productivity implies only good things for corporate profits. In many ways, it's a reaction to the difficult pricing environment [that] companies find themselves in, in globally competitive markets. We could continue to have a secular rebound in productivity and yet see pricing under a lot of pressure, profits under a lot of pressure and stock prices perform poorly. The rebound in productivity is no recipe for profitability and good stock performance.
A. You've got to step back and put the productivity debate in a bigger context of what's happened to markets around the world. Ever since the end of the Cold War, even a little before that, markets have become increasingly globalized and competitive, with an enormous amount of deregulation in many industries. The new paradigm that business managers have been confronting is really an old paradigm called "competition."
Markets have never been this competitive, and it's hard to be successful in a competitive market. Companies have to constantly search for ways to reinvent themselves, cut costs, increase productivity, make their products and services winners in the marketplace - but in a competitive market, the only sure winner is the consumer. Everybody else is in a kind of Darwinian struggle.
You constantly have to increase productivity, and yet in a competitive market, you find that all your efforts to increase productivity go to offset the deflationary pressures on pricing. I'm not surprised that the productivity rebound has not translated into sustainable, booming profits.
Let me ask you to put your investment strategist hat back on for a moment and tell us what this means for the stock market.
A. The Dow has gone from 1,000 to 10,000 since 1982. I wouldn't be surprised if we just drift sideways for a while longer. We've been stuck around 10,000 for two years now, and the market is telling us something: companies are profit-challenged and earnings-challenged. P/Es (price/earnings ratios) are high. We may have some contraction in multiples. We may be in for a protracted period where stocks move sideways or up by single digits. Earnings drive returns, and earnings are going to grow at the historical norm of 5 percent to 7 percent. There's not a lot of upside with P/Es where they are, and the market is coming to terms with a more subdued longer-term outlook.
Co-Chief U.S. Economist
Lehman Brothers Holdings Inc.
Why should we care about whether or not there was a productivity miracle?
A. The trend growth in productivity is central to a whole range of issues around financial markets. Labor productivity is the building block for profits. If you have high output per worker, you can pay workers more and gain high profits at the same time. So you can support continued high valuations in the stock market, and when the economy returns to high growth, the stock market should rebound.
And what if the productivity miracle didn't really happen?
A. If the productivity story is a mirage, then overall growth in the economy and in corporate earnings will be slow going forward, it's hard to justify the levels of the stock market and you don't get a rebound as the economy [grows again]. One of the big things that rove the stock market up in the early '90s was the expectation that long-run growth in the economy would be better. If that turns out to be a mirage, then we probably haven't seen the worst yet in the stock market.
So, is productivity growth likely to be strong, or was the run-up just a one-time event?
A. My answer is that a good chunk is a sustainable, long-run development reflecting improved business practices in the U.S., greater flexibility of the labor force and application of new technology. It's hard to talk in rosy terms right now because of retrenchment in the tech sector, but the reality is that if you take away the final year-and-a-half of explosive boom at the end of the last decade and take away the last year of collapse, you will still be left with a pretty strong trend to high investment in new technology. Communications equipment and computers are becoming pervasive and [are] adding to the productive capacity of business, and there has been a real acceleration of productivity due to this technological evolution.
What is the productivity track record in this country?
A. For most of the period since World War II, the U.S. has had high productivity growth. There was a bad period from the mid-'70s to the late '80s when you saw a big drop. So the recent stronger growth is a return to more normal productivity growth after really poor performance for 15 or 20 years. When people talk about a new paradigm economy of higher growth and productivity, I say it's not a new paradigm but rather a return to the old paradigm. Right now, we are in a near-recession condition and productivity has weakened.
What does the revision of the productivity numbers imply for the future?
A. The revised data don't show quite as big a boom in productivity in 2000. We expect 3 percent over the next several years. That's consistent with the improved performance of the U.S. economy relative to what it looked like in the '70s and '80s, though perhaps not as good as the great optimism that surrounded the economy a couple of years ago. There are boundaries to how fast the U.S. can grow, and we're discovering them.
What are the most immediate implications for financial executives?
A. Inflation has been low and will continue to be low, but because of high productivity growth there has been some upward pressure on interest rates. Relatively high (relative to inflation) interest rates should be around for a while. That affects decisions on borrowing, since it means borrowing costs will be a little higher.
And the stock market?
A. At this stage, the stock market has a much more sober view of the world than it had a while ago. If the economy recovers and we get some kind of growth, the market will recover with the economy. I don't think you can expect the booming days of the late '90s to return, when the market went up 20 to 30 percent per year, because the market has already factored in stronger growth over the long haul.
Lousy economic performance currently has depressed stocks, but the market has some optimism about the long-run outlook and hasn't given up on the idea that growth in productivity will return in the years ahead. When worries around current conditions go away, growth in the stock market should be more like the historical average, on the order of 10 percent per year, not the 20 to 30 percent. we saw in late '90s. It doesn't make sense to have above-normal returns every year, year after year.
Susanto Basu Associate Professor Department of Economics University of Michigan
Why care about productivity?
A. Growth in productivity has to be at the heart of long-run growth in living standards. Unfortunately, where most improvements in productivity come from is still a black box. In a famous quote, productivity was called "the measure of our ignorance." It's the growth in output we attribute to those things we can't measure.
But from the standpoint of finance, more specifically, one of the things we know is that valuation of equity depends on the rate of growth we expect for firms' dividends. The most simple price-to-dividend ratio depends on the real interest rate and the growth rate of dividends. And the growth rate of dividends in the long run will match the growth rate of the economy. Therefore, if productivity grows faster, we should expect a higher price/dividend ratio for equity. Deciding what valuation is fair means taking a stand on the growth rate of the economy.
What's behind the recent revision of the productivity numbers?
A. Mostly that was a case of revising the output numbers, the numerator. We have a pretty good sense of the number of people employed in the economy and a somewhat good sense of how many hours each is working, but as information about output comes in over time, the statistical agencies may say that prices grew faster and output grew less. Preliminary estimates of output have to be revised downward, and this revision translates into a downward revision in productivity.
Productivity growth was estimated to be very high in 1999 and 2000. What made those figures surprising is that [they came] toward the end of a very long expansion that had started in 1991. Usually, it's toward the beginning of an expansion that productivity tends to rise. Most people thought that towards the end of this long expansion, it couldn't be cyclical.
A. I should point out that in a paper of mine with john B.] Fernald and [Matthew D.] Shapiro, we looked only at the 1995-98 period -- already deep into an expansion -- using unrevised data, and found that productivity growth was extraordinarily high - in fact, higher than at any time since the 1960s. Those data have not been revised, so this indicates that it isn't a mirage. There was something real and important going on.
But the numbers were revised downward.
Was that 'something' the so-called New Economy?
A. From the period 1990-95, productivity grew at about 1.2 percent per year. This is a slightly different concept of productivity. It's not output per person or hour, but rather output after subtracting both hours worked and capital and education. This is what economists call "total factor productivity." In the early 1990s, this productivity grew at 1.2 percent per year. But during the period 1995-99, it grew at 3.1 percent per year.
Now, that doesn't sound necessarily all that impressive, but with productivity growing at 1.2 percent per year, it would take 60 years for income per person to double. At 3.1 percent productivity growth, it would take only 23 years. Now, a bedrock of thinking in the U.S. has been that each generation would be far better off materially than the generation that preceded it. If you think of a generation as 25 years, then the slowdown in productivity growth that happened in early '70s through '90s meant that wasn't true, It would take more than 25 years for people to do twice as well off as their forefathers. Each person can expect doubling of living standards -- but only if new higher growth rate is maintained through 25 years. That's what we don't know yet.
So, was there a productivity miracle?
A. Yes. In terms of what happened roughly over those four years, there appears to have been a real resurgence of productivity, back to the good old days of the 1960s.
Will it last?
A. One of the biggest puzzles in the study of productivity is why we had a productivity slowdown starting at the end of the 1960s or, some say, at the time of the first oil price shock in 1973. Having those heady days disappear for reasons that are pretty much a mystery, we're reluctant to say that the improvement in the '90s implies some long-lasting change in the economy.
What's your personal opinion?
A. Even though we tried our best to control for the effect of more and better capital, my guess is that part of the higher productivity we saw came from the extraordinarily high rate of investment in computer and telecom equipment, and those rates of investment are not sustainable for the long run.
So my guess -- and this is truly a guess -- is that with more modest and reasonable rates of investment, we'll see a somewhat slower rate of productivity growth. But I don't see it going back down to where it was before 1995. If I were betting money, I'd put money on something in the middle.
Suppose you were in the CFO's chair at a major corporation. What would you be thinking about this issue?
A. I think I would really want to know, or at least form an educated guess, whether this increase in productivity growth rates might be around for a good many years, or not. In 1987, when [Nobel Economics laureate] Bob Solow made his famous quip that 'we see computers everywhere except in the productivity statistics,' the IBM personal computer was already six years old, and corporations had been investing heavily in computers and telecommunications for a number of years.
Why did it take another eight years for computers to begin showing up in the productivity statistics? Is it because we were connecting computers together more, or had more mobile or portable computers? One needs answers to those questions to make an educated guess about how long the productivity boom will last. And that should inform decisions about how much investment we want to make and, in terms of financial asset allocation, what we think of as fair prices.
Gregory J. Millman is a freelance writer in New Jersey and a frequent contributor to Financial Executive.
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|Author:||Millman, Gregory J.|
|Article Type:||Panel Discussion|
|Date:||Oct 1, 2001|
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