The ECONOMIST on U.S. productivity growth.

["Devine, James" <jdevine@xxxxxxx>]

[Interestingly, the ECONOMIST doesn't mention the role of the over 4%
average annual increase in the nominal major-currencies trade-weighted value
of the dollar -- or over 5% in real terms -- during the period 1996 to 2001.
This is a key factor that would hurt profits despite rising productivity.]

May 11, 2002

FINANCE & ECONOMICS
To these, the spoils

NOT only has America's productivity wonder survived its first recession; it
has positively thrived. Output per man-hour in the non-farm business sector
rose at an annual rate of 8.6% in the first quarter of this year, its
fastest growth in 19 years. Quarterly figures are volatile, yet the
year-on-year growth in productivity was also impressive, at 4.2%. This bodes
well for America's future economic growth--but not necessarily for company
profits, or for share prices.

Commentators cheered the latest evidence of rapid productivity gains, hoping
that it might promise fatter profits ahead. That America's productivity
continued to rise last year, in contrast to previous recessions, seems to
confirm that an increase has taken place in trend productivity growth.
Still, the latest numbers overstate the underlying trend.

First, the growth in output, and hence productivity, was inflated in the
first quarter by a big swing in inventories. Productivity often surges in
the first year of a recovery after recession, as firms produce more without
needing to hire extra workers. Productivity rose by 4-5% in the first year
following both the 1981-82 and the 1990-91 recessions. Firms have actually
continued to cut jobs this year, lifting the unemployment rate in April to
an eight-year high of 6%. Today's best guess is that trend productivity
growth is around 2-2.5%. That is less than the 3-4% claimed at the height of
the new-economy bubble; but still well above the 1.4% average over the two
decades to 1995.

A second, more fundamental quibble is that, although profits will certainly
rebound this year, as firms continue to trim their costs and revenues rise,
in the longer term faster productivity growth does not automatically mean
faster profits growth. A new study by Stephen King, chief economist at the
HSBC bank, concludes that workers and consumers have received the lion's
share of the productivity gains of therevolution in information technology
(IT). Companies have received relatively little reward for their
risk-taking.

In the late 1990s it was widely assumed that faster productivity growth
would mean higher profits (so justifying higher share prices). Over the
previous half-century a strong positive relationship had indeed held between
productivity and profits. In the 1990s that relationship broke down. Despite
a surge in productivity, national-accounts profits (as opposed to profits
reported by companies, a less accurate measure) fell between 1997 and 2000,
even before the economy dipped into recession (see chart). At the end of
2000 the profits of America's non-financial firms were no higher in real
terms than in 1994, implying a big fall in their share of GDP.

Mr King argues that workers (who are, naturally, also consumers) were
virtually the sole beneficiaries of the new economy, in the shape of faster
real wage growth. This was partly thanks to a fall in the prices of IT goods
that they bought. More important, the same IT that spurred productivity also
increased competition more widely across industries, from airlines and
banking to insurance and cars, squeezing prices and profits. Information
technologyreduces barriers to entry, and makes it easier for consumers to
compare prices.

What is more, globalisation, itself spurred by information technology, has
further trimmed the pricing power of firms. HSBC finds that, in most
economies, the correlation between domestic inflation and domestic
unit-labour costs has declined over the past 40 years; the correlation
between domestic inflation and average OECD inflation has risen. In most
countries in the 1990s domestic inflation was more closely correlated with
OECD inflation than it was with domestic costs.

The dismal performance of profits should not surprise. As the IMF's World
Economic Outlook last October pointed out, productivity gains from previous
technological revolutions, from railways and textiles to electricity and the
car, have gone largely to consumers. Each time, a decline in the prices of
goods and services has given a big boost to real incomes. Consumers gained
from cheaper travel or clothes, but profits disappointed. The difference
this time is that new technology has increased competition and squeezed
profit margins across the whole economy.

None of this lessens the overall benefit of faster productivity growth. But
it does lead to some interesting conclusions:

* The profit expectations built into share prices are unrealistic. Even if
productivity growth remains robust, long-term profits growth is likely to be
weaker than expected, making shares overvalued.

* A lower return on equities means that consumers will need to save more. In
the late 1990s consumers spent more and saved less, in the expectation that
capital gains would finance their future pensions. If future returns are
lower, consumers will need to tighten their belts.

* The dollar might well fall. The expectation of higher returns on capital
in America has attracted foreign money and made it easy to finance America's
big current-account deficit in recent years. If actual returns are
disappointing, foreign investors will dump the dollar.

* A lower than expected return on capital could also lead to a more
prolonged slump in IT investment. That firms have not benefited from their
massive investments in the late 1990s raises questions about their capital
spending over the coming years--and, in turn, over the sustainability of
faster productivity growth.

Perhaps two-fifths of the acceleration in productivity growth between the
first and second halves of the 1990s is explained by companies' increased
spending on IT equipment rather than by higher total factor productivity
(the efficiency with which both capital and labour are used). Spending on IT
has since fallen sharply from a peak in 2000. If it fails to return to its
earlier, clipping pace--because firms can see no pay-off--this could dampen
future productivity growth.
The good news is that companies still have plenty of scope to boost
productivity by reorganising their businesses to use information technology
more efficiently, which could yet boost growth in total factor productivity.
That theory might soon be put to the test.

Copyright © 2002 The Economist

Jim Devine jdevine@xxxxxxx &  http://bellarmine.lmu.edu/~jdevine