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1996 Annual Report Essay

Breaking Down the Barriers to Technological Growth

Labor productivity is the key to economic growth

The wealth of a nation, as Adam Smith recognized two centuries ago, lies not in the amount of gold or silver amassed within its borders, but in the goods and services it can produce to meet the needs and wants of its people. For people to experience an increase in their standard of living—for them to be able to meet more of their needs and wants—more goods and services must be produced.

There are two ways such an increase in production can come about. One way is to use existing resources more intensively, for example, to use more labor. Another way is to use such resources more productively, that is, to produce larger quantities of useful goods or services from each worker.

In real economies, increased output comes from combinations of these two approaches. But the greatest part of the increase in output comes from the fact that we use labor more productively, more efficiently, than at midcentury. In other words, economic growth, by which we mean growth in per capita output, has been driven primarily by labor productivity growth. This is likely to be true in the future as well. The less than optimistic view about growth, then, is a view that labor productivity growth will be slow.

A simple equation, in words, can help us understand the determinants of growth in per capita output. Per capita output can be divided into two parts:
       

It follows, then, that economic growth is about equal to the sum of the growth of its two parts; that is, the growth in per capita output is about equal to the growth of labor productivity plus the growth of labor intensity. (The growth in per capita output is not identically equal to the growth in labor intensity plus the growth in labor productivity because the growth identity holds only for small changes.)

Labor intensity is a measure of how hard a population is working. It is determined by three factors. The first is the labor force participation rate, which is the percentage of people of working age who are in the labor force. The second is the employment rate, the percent of all participants in the labor force who are employed. The third is average hours worked, or the number of hours the average employed person works in a week.

Since 1964, labor intensity has contributed little to growth: In spite of the fact that a higher proportion of women work out of the home, the overall labor participation rate rose only at an annual rate of 0.4 percent for the period since 1964. This modest increase was partially offset by a drop in average hours worked, which declined at an annual rate of -0.4 percent. Finally, the employment rate did not change at all. In the future, these three components of labor intensity, taken individually or collectively, are unlikely to contribute much to economic growth.

Though increases in labor intensity did little to increase output in the last three decades, and are not likely to do so in the foreseeable future, labor productivity growth is another story. It accounts for the bulk of the growth in per capita output since 1964: Real per capita output increased at a 1.9 percent annual rate, while labor productivity increased at a 1.4 percent annual rate. Given the muted outlook for labor intensity, it is likely that labor productivity growth will also account for the bulk of future economic growth.

What is the likely future course of labor productivity growth? In the accompanying chart we see that labor productivity growth averaged 2.8 percent over 1964 to 1973; since then it has grown much more modestly—1.1 percent per year. The slowing in the trend growth of labor productivity during the '70s remains, to a large extent, a puzzle. Since this is the case, a conservative prediction is that labor productivity's recent performance will continue in the future. This, then, is how the less than optimistic view of future labor productivity growth, and economic growth, are derived.

Productivity growth may well have begun to pick up

Some observers argue that the recent labor productivity figures are misleading. They argue that in recent years there has been a sizable opening of international trade, important industries have been deregulated, corporations have been restructured and there has been an explosion of new technologies related to computers, telecommunications and medicine. All of these have strengthened the economy and made it more productive. These critics argue that reported U.S. statistics for labor productivity have not accelerated for a number of reasons:

1. There may be serious mismeasurement.
   a. Productivity measures are derived from measures of the value of output, adjusted for changes in the general price level. If the Boskin Commission's conclusion is correct that the Consumer Price Index is biased upwards by more than 1 percent per year, then estimates of labor productivity are biased downward by close to that amount. Actual increases may have been greater than reported due to imperfect measurement of price levels.
   b. Two economists, Slifman and Corrado 1996, analyzed official U.S. data and found that these data imply that productivity has declined in the service sector. Such a decline is counterintuitive; it does not jibe with readily apparent increases in service sector productivity. Hence, there may be measurement problems in the published data.

2. Acceleration may take time to occur.
   a. Historically, it has taken time for major, earth-shaking innovations to have an impact on aggregate productivity. It takes time for firms and workers to learn and adapt to such fundamental change. Some argue that the computer revolution fits into this story. (David 1990 has described the slow response to development of electricity at the turn of the century.) Consistent with this explanation that large productivity gains from computers are on the horizon is the rise in stock market values. Market expectations of future productivity gains may be what is driving up corporate earnings predictions and thus driving up equity values.

We do not know with certainty why labor productivity growth since 1973 has been so slow. A conservative prediction is to assume its current growth trend will continue at a rate of a bit more than 1 percent a year. This implies that growth in real per capita income also will be at a rate of slightly more than 1 percent a year. However, if the arguments of the critics of official data are correct, future labor productivity growth could well exceed the conservative prediction. In any case, given labor productivity's poor recent performance, it is prudent to consider policy changes that might increase labor productivity growth.

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