Productivity is the latest economic buzzword. Solid productivity growth is a vital part of a healthy economy. Productivity supports economic growth, improved corporate earnings and standard of living gains that fuel aggregate demand – all elements that are crucial to financial markets. Low productivity contributes to the new normal landscape of low growth and low income.
Productivity is the economy’s foundation, like the crust on a pizza. Anybody who enjoys pizza knows it’s all about a good crust. Without crust, you just have cheese and tomato sauce. And when the crust tastes like cardboard, the entire pie just falls flat.
To help unpack this buzzword, let’s start by answering, on a basic level, what is productivity? Put simply, productivity is how much output we get from input. The graphic shows input as a person, but productivity actually reflects both labor productivity and the productivity we get from a machine.¹ Think of a person stamping out five widgets per minute: the input is both the person and the stamping machine.
Productivity growth, then, is how much more output we get from input. The person at the machine on the right is now stamping 10 widgets per minute. This productivity improvement could come from improved labor (i.e., specialized training) or a better stamping machine.
What is productivity?
The graphic reflects 100% productivity growth, but, in reality, productivity growth of 2% would be considered quite healthy. In fact, productivity growth in the U.S. averaged 2% from 1950–2000.² In the 2000s, productivity surged after businesses invested heavily following the technology revolution, and productivity growth crested at 3.5% in 2004.³
Productivity has been on a downtrend since 2004 – that is, even before the Great Recession. Since 2010, productivity growth has averaged only 1.0%, and was 0.0% year over year in Q3 2016.
Declining rate of productivity
Sources: Bureau of Labor Statistics Nonfarm Business Productivity (1985–2015), FS Investments.
But why is productivity so important? Because like the crust on the pizza, it touches and supports almost every part of our economy. It holds it all together and makes it work well as a system. Investors need to understand why it is important so they can better appreciate the impact of falling productivity growth on their investment portfolios.
There are three long-term patterns grounded in economic theory that connect productivity to economic trends. While actual data may vary quarter to quarter, over the long run these broad relationships hold up relatively well. Below we discuss the impact on the economy when productivity falls to zero – about where it is now.
1. Output is a function of hours worked and productivity.
It makes sense: The more hours worked, the more output we produce, plus whatever new output there is comes from productivity growth (thereby making our hours more productive). When productivity is zero, growing output becomes entirely dependent upon workers putting in more hours. When labor markets get tight – as they are right now – the simple laws of supply and demand take hold and can put upward pressure on wages.
2. Wage growth is a function of price inflation and productivity.
Real wages are wages adjusted for inflation, and, over the long run, productivity grows roughly in line with real wages. We adjust our paychecks for inflation, and only when our wages rise more than general price inflation do we consider that a real wage gain, or a standard of living increase. When productivity growth is zero, however, we can expect nominal wage increases to do no more than keep pace with inflation, with no real improvement in standard of living.
3. Potential GDP is a function of labor force growth and productivity.
Potential GDP is the “cruising altitude” of our economy – the growth rate at which it operates most efficiently, without overheating or stalling out. Over time, it relates to a simple combination of labor force growth and productivity growth. When productivity growth is zero, potential output is solely dependent on labor force growth. However, labor force growth has been trending down for decades as the working age population shrinks with baby boomer retirement. Going forward, without stronger productivity, our economy will tend to grow at a lower level. The San Francisco Fed estimates U.S. trend growth could now be as low as 1.50–1.75%.⁴
Explaining the slowdown
Much time and attention has been spent speculating why productivity growth has slowed. Some of the more common reasons attributed to its decline include:
- Measurement error: As computing advances have moved toward consumer uses (think smartphones, social media and web searches), there is concern that their benefits to productivity are not being fully captured in the data.
- Demographic changes: As older workers retire, they are being replaced by younger, less-experienced workers.
- Regulation: Many point to the significant increase of regulation as a share of economic activity.
One of the most compelling explanations for the downtrend is the decline in investment spending,⁵ particularly research and development, which has been weak since 2004⁶ and has a solid statistical relationship with productivity. The debate as to why productivity is weak will likely continue for some time. It is also a trend that we are watching closely.