- The Washington Times - Wednesday, March 28, 2007

Labor productivity, certainly one of the most important concepts in economics, is also one of the dismal science’s least understood notions. Essentially defined as output per hour of labor, productivity is so important because “productivity growth is the fundamental source of long-term improvement in the standard of living,” a recent analysis by the Congressional Budget Office (CBO) authoritatively asserts. Note well: CBO did not characterize productivity growth as “an important source” or “an indispensable source” (though it is surely both); in fact, it is “the fundamental source” of long-term gains in society’s general standard of living. That is a powerful declaration, and few, if any, economists would dispute it.

Productivity growth is also a key determinant of potential gross domestic product (GDP). Potential GDP is the level of output that corresponds with high rates of resource utilization (e.g., labor and industrial capacity) in the absence of significant inflationary pressures. A basic goal of any economy is to constantly raise its potential GDP, while operating as close to it for as long as possible. As the growth of the U.S. labor force (another key determinant of potential GDP) diminishes over time, productivity growth will assume a relatively more important role in raising the economy’s potential GDP and future standard of living. The faster productivity grows, the less severe will be the problems confronting the U.S. economy as the Baby Boom generation retires and begins placing eventually gargantuan demands on Social Security, Medicare and Medicaid.

As the CBO study, “Labor Productivity: Developments Since 1995,” notes at its beginning, the vigorous growth in labor productivity represents a “striking aspect of recent U.S. economic history.” Indeed, in the mid-1990s, as economists continued their decades-old effort to explain the dramatic slowdown in productivity growth since 1973, the rate of productivity began to take off. So poorly understood was the concept of productivity growth that virtually no economist predicted its eye-popping acceleration. But accelerate it did.

The growth rate of productivity averaged 2.6 percent per year from 1947 to 1973. It declined to 1.4 percent per year during the 1974-1995 period. Then, contrary to all expectations (and projections), over the next eight years (1996-2003) the rate of productivity growth more than doubled, averaging 3 percent a year and significantly exceeding the growth rate achieved during the postwar golden era (1947-1973) of productivity growth. In terms of the long-term impact on living standards, the difference between productivity growth rates of 3 percent (1996-2003) and 1.4 percent (1974-1995) is stark. Specifically, growing at 3 percent per year, labor productivity (output per hour) doubles in less than 24 years; at 1.4 percent per year, it takes 50 years for productivity to double. Keep in mind that productivity is a good gauge of a society’s standard of living.

During the last three years (2004-2006), the average annual growth rate of productivity sharply decelerated to 1.8 percent. During the past 10 quarters, dating to the middle of 2004, productivity has grown at an annual rate of only 1.5 percent. And during the second half of last year, productivity increased at an annual rate of 0.5 percent. To be sure, short-term productivity data are highly volatile, and the numbers are frequently subject to large revisions. However, given the declining growth rate of the labor force (and the simultaneous rise in the retiree-to-worker ratio) and given the subsequently increasing relative importance of productivity in the determination of potential GDP, a long-term return to the disappointing productivity growth rates of 1974-1995 would significantly worsen the already potentially catastrophic fiscal challenges confronting America in the decades ahead.

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