April 23, 2021
I know it was the last guy who promised hope and change, not Joe Biden, but I couldn’t resist stealing Sarah Palin’s best line ever. Besides, even if Biden didn’t promise hope and change, it looks like he might deliver.
We are going to get the GDP growth data for the first quarter next week, and it is almost certain to be very strong, quite likely over 7.0 percent. This is great news in terms of recovering from the pandemic recession and getting people back to work, but we know that all the inflation hawks will be yelling that we will soon be back in the 1970s, with inflation spiraling ever higher. For this reason, it’s worth trying to dissect the data to see if it can give evidence that bears on this question.
Productivity Growth
One of the key factors that will determine whether inflation ends up being a problem is the economy’s rate of productivity growth. The story here is straightforward. If productivity grows more rapidly, then wages can grow more rapidly without causing inflation to increase or profit margins to be squeezed.
To take a simple example, if productivity growth is 1.0 percent annually, and wage growth is 3.0 percent, we would expect inflation to be roughly 2.0 percent. By contrast, if productivity grows 2.0 percent annually and wage growth were still 3.0 percent, then we would expect 1.0 percent inflation. Alternatively, if we want to see 2.0 percent inflation and we have 2.0 percent annual growth in productivity, then we would want wages to be rising 4.0 percent annually.
There is some evidence that we are actually seeing an uptick in productivity growth. Productivity grew at just a 1.0 percent annual rate from the fourth quarter of 2009 to the fourth quarter of 2019. However, it grew 2.5 from the fourth quarter of 2019 to the fourth quarter of 2020. Hours worked increased at roughly a 2.5 percent annual rate in the first quarter. If GDP growth comes in around 7.0 percent, it would imply productivity growth of around 4.5 percent.
Quarterly productivity data are enormously erratic, so we should be cautious about making much out of the extraordinary growth we are likely to see in the first quarter, but it is consistent with the continuation of the more rapid growth from 2019. If we can stay on track with something close to 2.5 percent annual productivity growth, or even 2.0 percent, it will go very far towards alleviating any inflationary pressure that might be caused by Biden’s recovery package.
Any discussion of productivity growth has to come with a huge caveat: our ability to predict it is close to zero. The figure below shows annual productivity growth in the post war era.
While the data are highly erratic, the average for the years 1947 to 1973 was 2.8 percent. Growth slowed sharply in the 1970s, averaging just 1.5 percent in the years from 1973 to 1995. Productivity growth then increased to 3.0 percent annually from 1995 to 2005, when it slowed again to just over 1.0 percent.
These sharp shifts in trends caught nearly everyone by surprise. Virtually no one saw the 1973 slowdown coming and it was not recognized for many years after the fact. Even today there is no widespread agreement as to its cause. Most economists feel reasonably comfortable attributing the 1990s upturn to computers and other information technologies, even if few saw it coming. The slowdown in 2006 again caught economists by surprise, and here also there is no generally accepted view as to its cause.
So, when we see an uptick in growth in 2020, that seems to be continuing at least into the first quarter of this year, we can be encouraged by it, but we should not have much confidence it will persist for any substantial period of time. Clearly the pandemic forced businesses to adjust their way of doing things, and it was undoubtedly a big factor in the rapid productivity growth we saw last year, but whether we will continue to see large gains is really little more than a guess at this point.
Investment
In the sloppy Econ 101 textbook, investment is the key to productivity growth. The idea is that we get more and better capital, and thereby make workers more productive. Think of one person driving a bulldozer instead of 20 workers with a shovel.
As a practical matter, most of the differences we see in rates of productivity growth over the post-World War II era are not due to differences in the rate of investment, or the rate of improvement in the education of the labor force, the other major input for productivity. Most of the differences between the periods of rapid productivity growth and the slowdown years are due to differences in the rate of multi-factor productivity growth.
This is the growth in productivity which cannot be attributed to either more capital or more educated workers. In other words, it is the growth in productivity that we can’t explain.
But if we do turn to the productivity growth that we can explain, investment is clearly a plus, In general, more investment means more productivity. And on this score, we have been seeing good news.
Investment held up remarkably well through the pandemic. The fourth quarter level was only 1.4 percent lower than the year-ago level. And, this falloff was entirely due to weaker investment in structures. Businesses were cutting back spending on office buildings and retail space for obvious reasons.
By contrast, investment in both equipment and intellectual products was already slightly higher in the fourth quarter of 2020 than in the fourth quarter of 2019. We will see further increases in the first quarter, indicating that investment is pretty much in line or possibly even above its path from before the pandemic.
With most business surveys showing considerable business optimism, much of it spurred by Biden’s recovery package and now his infrastructure plan, we should see investment continuing at a healthy pace for the immediate future. Again, this is not the biggest factor in productivity growth, but it certainly is a positive one. If investment remains strong, the resulting increases in productivity growth will help alleviate inflation risks.
The Trade Deficit
In other times, we may view the rise in the trade deficit as a bad signal about US competitiveness, however that is not the case at present. With the economy getting a solid boost from the recovery package, the trade deficit provides a useful relief valve. Insofar as domestic producers are unable to meet demand, foreign producers will be stepping in to fill the gap. The trade deficit will also provide a welcome boost to growth for our allies in Europe, Japan, and elsewhere.
In the past, the loss of manufacturing jobs also meant the loss of relatively high-paying jobs for people without college degrees. This was a good reason to be worried about the trade deficit.
This is no longer the case as the devastation the sector suffered due to import competition in prior decades has largely eliminated the wage premium in manufacturing. In 1990, the average hourly wage for production and non-supervisory workers in manufacturing was close to 6.0 percent higher than for the private sector as a whole. Now it is more than 6.0 percent lower. Manufacturing workers are still more likely to get health care insurance and other benefits than non-manufacturing workers, so there is still some compensation premium, but it is clearly much less than in prior decades.
The reduction in the wage premium has gone along with a plunge in unionization rates in the sector. Historically, manufacturing has been a relatively heavily unionized sector. This is no longer true. Its 8.5 percent unionization rate is still somewhat higher than the 6.3 percent rate for the private sector as a whole, but it’s hardly a qualitatively different story.
Furthermore, when we added back jobs in manufacturing, they have not been union jobs. Since 2010, we have added more than 1.6 million jobs in manufacturing, however the number of union members in manufacturing has fallen by 180,000.
As a result of the deterioration in the quality of manufacturing jobs, there is little reason to be concerned about the impact of the trade deficit on the composition of employment. Instead, we can mostly be relieved that trade provides an outlet for excess demand in the U.S. economy.
That is what we have seen to date. Measured as a share of GDP, it had risen by 1.2 percentage points from the fourth quarter of 2019 to the fourth quarter of 2020. The share of the trade deficit in the first quarter is likely to be the largest since the start of the Great Recession.
This is a story where the US economy is growing far more rapidly than the economies of our trading partners. As a result, our imports in the fourth quarter were almost back to their pre-pandemic level, while our exports were still down by almost 11.0 percent.
The Future is Bright
Okay, we have a long way to go, and there should be no celebrations when we still have 6.0 percent unemployment and millions of people who have dropped out of the labor market and given up looking for work altogether. But for the moment, the economy is moving in the right direction and at a very rapid pace. If this continues for another year or so, we will have some serious cause for celebrating.
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