Gap Analysis #4: The Productivity Shortfall

By SBE Council at 22 August, 2016, 9:30 pm

The Productivity Shortfall: Causes and Results

Gap Analysis # 4 

August 2016

by Raymond J. Keating

Chief Economist

Small Business & Entrepreneurship Council

Summary: U.S. labor productivity growth has been extremely poor in recent years, but why does it matter? Compensation is tied strongly to productivity. Meanwhile, it is private-sector investment that boosts labor productivity, and feeds economic and compensation growth, including, of course, income. Higher output per worker means higher earnings in a competitive market.

Productivity depends upon foundational issues in any economy, such incentive and institutional structures like establishing and protecting property rights. Built upon such a foundation, two broad areas of investment stand as the key sources of productivity growth. The first is private investment in technology, processes and physical capital, including innovations and improvements in computers, telecommunications, machinery, tools, facilities, and production methods. Second are investments in human capital, that is, in the forms of practice, experience, knowledge, and education.

The slowdown in productivity growth in recent years has been dramatic. Consider that from 1956 to 2016 (note: 2016 is the average rate for first two quarters), annual productivity growth averaged 2.0 percent. Before the recent recession and poor recovery, productivity averaged 2.2 percent annually from 1956 to 2006. Since the poor U.S. economy of the late 1970s and very early 1980s, productivity growth showed similar growth rates, that is, averaging 1.9 percent from 1983 to 2016, and 2.3 percent from 1983 to 2006.

These rates of growth make clear how poor productivity growth has been in recent years – averaging a mere 1.1 percent from 2007 to 2016, and a woeful 0.4 percent from 2011 to 2016.

Since 2011, productivity is running at only 20 percent of the average annual rate prevailing over the past 60 years. And compared to the 1983 to 2006 period, average annual productivity growth from 2011 to 2016 is running at only 17 percent of the average rate.

Three Takeaways:

FIRST, given the second SBE Council Gap Analysis showing a lost decade of private investment, poor productivity growth in recent years should come as no surprise.

SECOND, recent poor productivity growth, again, translates into sluggish economic and compensation growth. For example, over the last six years, from July 2010 to July 2016, real average weekly earnings of all employees grew by a woeful 4.4 percent.

THIRD, stepped up private sector investment clearly is needed to generate a long-term reacceleration in productivity growth.

Productivity Gap: Causes and Results

Over the past decade, the U.S. shifted from a few years of respectable economic growth to a long and deep recession, and then to one of the worst periods of economic recovery and expansion on record. As the nation looks to a new presidential administration and a new Congress taking power in January 2017, SBE Council is publishing a series of analyses that highlight key gaps or shortfalls in our economy. The first analysis focused on the GDP shortfall, the second on a lost decade of private investment and the third on the decline of entrepreneurship and millions of missing businesses.  These will be followed by analyses on productivity (this report), income, jobs, and trade, with a final report highlighting the basic policy changes needed to close these gaps.

This fourth SBE Council “Gap Analysis” looks at the issue of productivity growth. As explained by the BLS, “Labor productivity, or output per hour, is calculated by dividing an index of real output by an index of hours worked of all persons, including employees, proprietors, and unpaid family workers.”

Productivity Matters

Why does labor productivity matter? Quite simply, compensation is tied strongly to productivity. Private-sector investment boosts labor productivity, and feeds into economic growth and compensation growth, including, of course, income. Indeed, the link between productivity and earnings cannot be ignored. More productive workers are in demand, and in turns, they can demand higher compensation. To link it back to one’s own career, the more valuable, that is, the more productive, you make yourself in the marketplace, the greater your market compensation. Higher output per worker means higher earnings in a competitive market. This explains earnings differences between individuals, and between workers in different nations. U.S. workers rank among the highest earners in the world because they are among the most productive workers.

Investment Matters

Productivity certainly depends upon foundational issues in any economy, such incentive and institutional structures like establishing and protecting property rights. Built upon such a foundation, two broad areas of investment stand as the key sources of productivity growth.

The first is private investment in technology, processes and physical capital. These include innovations and improvements in computers, telecommunications, machinery, tools, facilities, and production methods. These and other developments make workers more productive. Consider, for example, that investments, innovation and improvements made in information technology are widely seen as a key sources of U.S. productivity growth over the period of 1996 to 2004. (See Dale W. Jorgenson, Mun S. Ho, and Kevin J. Stiroh, “Will the U.S. Productivity Resurgence Continue?” Current Issues in Economics and Finance 10, no. 13 (New York:Federal Reserve Bank of New York, 2004), p. 1, http://www.newyorkfed.org/research/current_issues/ci10-13.pdf.)

By the way, this economic reality makes clear how capital and labor actually work together. That is, entrepreneurs, shareholders and workers mutually benefit from productivity-enhancing investments. This stands in stark contrast to the archaic notion still pushed by class warriors and the labor union movement that capital, if you will, and labor are at odds.

Second are investments in human capital, that is, investments in the forms of practice, experience, knowledge, and education. Families and individuals implicitly understand this, as they often speak of the importance of education in getting ahead in life. Indeed, the link between education levels, and higher median earnings and lower levels of unemployment have long held, and still do. (See the clear links between higher education attainment levels, and higher median earnings and lower unemployment from the U.S. Bureau of Labor Statistics.) At the same time, fields of study matter considerably as well in terms of differences in compensation.

Dramatic Productivity Slowdown

As for lagging salary and wage growth recently in the U.S., there are various aspects to the story, including poor economic and employment growth, but a significant part of the story has been much slower productivity growth.

Chart 1 (below) shows the dramatic slowdown in productivity growth in recent years. That has been particularly the case since 2011. But one can also make the case that it’s been going on since 2006, with only 2009 and 2010 showing strong productivity growth as rather unique reflections of the recession and significant job losses, including reduced hours worked.

*2016: average rate for the first two quarters of the year.

Data Source: U.S. Bureau of Labor Statistics

Chart 2 (below) breaks out average annual productivity growth over various periods of time. Over the longest period, from 1956 to 2016 (note: 2016 is the average rate for first two quarters), annual productivity growth averaged 2.0 percent. Before the recent recession and poor recovery, productivity growth averaged 2.2 percent annually from 1956 to 2006. Since the poor U.S. economy of the late 1970s and very early 1980s, productivity growth showed similar rates, that is, 1.9 percent from 1983 to 2016, and 2.3 percent from 1983 to 2006.

These rates of growth make clear how poor productivity growth has been in recent years – averaging a mere 1.1 percent from 2007 to 2016, and a woeful 0.4 percent from 2011 to 2016.

So, since 2011, productivity is running at only 20 percent of the average annual rate prevailing over the past 60 years. And compared to the 1983 to 2006 period, average annual productivity growth from 2007 to 2016 has run at less than half, and from 2011 to 2016, at only 17 percent.

*2016: average rate for the first two quarters of the year.

Data Source: U.S. Bureau of Labor Statistics

Takeaways

First, given the second SBE Council Gap Analysis showing a lost decade of private investment, poor productivity growth in recent years should come as no surprise.

Second, recent poor productivity growth, again, translates into sluggish economic and compensation growth. (There will be more on income in the next SBE Council Gap Analysis.) For example, over the last six years, from July 2010 to July 2016, real average weekly earnings of all employees grew by a woeful 4.4 percent.

Third, stepped up private sector investment clearly is needed to generate a long-term reacceleration in productivity growth.