Don't Be Misled By The Productivity Data

by: Martin Lowy

Summary

Productivity growth has been anemic. Why?

One reason is that less productive people are being hired as the economy improves.

That is natural. Productivity improves in recessions and is held back in recoveries.

We want the employment, but we should understand the consequences for how the data look.

Productivity - or, more to the point, a lack of productivity increases - has been very much in the economic news in recent times. A number of recent articles on Seeking Alpha have dealt with this problem. See, for e.g., here and here.

One of the less noticed aspects of the lack of productivity growth is the impact of low-level workers coming back into employment as the economy improves. I will try to explain with an example. Suppose there were 100 workers in the country, all working 100 hours per measurement period - 20 of them were highly productive, accounting for $1,000 each of GDP, and 80 of them were less productive, accounting for $100 each of GDP. GDP equals $28,000, or $28 per worked hour. Now, let's add 10 workers - all of them in the lower level of productivity, and all working the same number of hours as the already employed. We have added $1,000 to GDP, which now is $29,000, but we have added 10 workers, so the total is now 110 workers. GDP per worked hour has now declined to $26.36 without anything bad having happened. Technology hasn't changed, investment hasn't changed, and education levels in general haven't changed. This is what happens when economies recover from recessions. The workers who were out of work or out of the workforce were, in general, the least productive workers. As they come back, productivity declines.

This little example tells us that the concept of productivity is not what people think it is, or should, be. It is a slippery beast that is as likely to fool us as it is to inform us.

To carry out the example in the opposite direction, recessions are usually accompanied by measured increases in productivity. Why? The least productive employees are the ones laid off first.

Beginning with MIT's Robert Solow, economists have tried to make the concept more precise by separating the education/skill of the workforce component from the "capital deepening" component. They have found that after measuring skill levels and capital levels, those concepts do not fully account for changes in productivity. There is a "residual" that Solow dubbed "total factor productivity" (TFP). What accounts for that residual? The literature contains many surmises. The most compelling to me is what we might call "know-how" - that is, changes in methods and procedures that gradually enhance productivity. Changes in useful infrastructure, for example, also may influence TFP.

I have introduced TPF at this point only to suggest that although the concept of dividing GDP by the number of worker hours is simple, the issues of causation are complex and resist simple responses.

Why might we not have enough capital going to productive uses?

The markets should allocate capital to productive uses, in the sense of creating profit. That uses that create profit are productive, in the sense of enhancing the way people live, depends in turn on the effectiveness of the price mechanism. Prices are what people use to decide what is worth most to them. We know, therefore, that from a public policy perspective, if we believe in the efficacy of markets, we have to assure that they work. That means we must prevent monopolies or monopoly pricing, prevent regulatory capture or legislative capture, redress information asymmetries that allow sellers to pull the wool over the eyes of buyers, and should enact other market-enhancing regulations. At the present time, those market-enhancing regulations are not high on the lists of most pundits seeking higher productivity. Indeed, commentators are more likely to seek reductions in the level of regulation. They are not wrong to want to reduce regulations that interfere with competition, but both less and better targeted are needed.

Agency issues also may interfere with the efficient working of capital markets. An example might be (though I am making no judgment here) corporate chiefs choosing to buy back stock or make acquisitions rather than reinvesting in the business.

If one does not believe in the markets, then the range of potential ways to enhance productivity is, in theory, wider. Central planners can decide whatever they want. We market people would proclaim that the non-market solutions are always less productive over the long term, because politics captures the decision-making process more completely than it can when markets are allowed to function.

Education is more straightforward

Better education also is manifestly favorable to greater productivity. See my book, The Education Solution, for an exegesis.

Monetary policy cannot help

But please don't look to monetary policy to help productivity. Accommodative monetary policy tends to reduce productivity, not enhance it. See my article here. That doesn't mean that we don't want more employment - it just means that more employment may reduce measured productivity.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.