The Economic Mega-Worry

The start of a new year is a good time to take stock, and there are few better indicators of our long-term economic prospects--and also our prospects for political and social peace--than productivity. As anyone who's taken basic college economics should know, productivity is simply jargon for efficiency. It's also what most people think of as economic progress. The good news is that productivity has been growing strongly; the bad news is that it may slow down.

To see why that matters, consult a fascinating government report, "100 Years of U.S. Consumer Spending." A century ago, Americans spent 43 percent of their incomes on food and another 14 percent on clothing. By 2002, those shares were 13 percent and 4 percent. Meanwhile, family incomes (after inflation) had tripled. Filling the spending gap are all the things we take for granted--cars, TVs, travel, telephones, the Internet. Home ownership has zipped from about 20 percent to almost 70 percent of households.

This triumph of mass consumption is usually credited to technological breakthroughs, from the assembly line to computer chips. But the whole process is also described as productivity improvement. In 1900, 41 percent of Americans worked on farms. If mechanization, new seeds and fertilizers hadn't meant that fewer people could produce more food, we'd still be paying two fifths of our income to eat. Labor productivity is measured as output per hour worked. Whatever enables people to produce more in a given time (machinery, skills, organization) boosts productivity.

That in turn raises our incomes--or gives us more leisure. It also promotes domestic tranquillity by muffling the competition between government and personal spending. Slow future productivity growth virtually ensures a collision between the heavy costs of retiring baby boomers--mostly for Social Security and Medicare--and younger workers' living standards. Higher taxes will bite deeply into sluggish incomes. The reason: what seem to be tiny productivity shifts have huge consequences.

Consider. In 2005, the U.S. economy produced $12.5 trillion of goods and services, or gross domestic product (GDP). Per capita income--the average for individuals--was $35,000. If productivity growth averages 2.5 percent a year, the economy reaches $34 trillion in 2035 (in constant "2005 dollars"), estimates Moody's Economy.com. Per capita income rises to $73,000. Now, suppose productivity growth averages 1 percent annually. Then GDP in 2035 is only $23 trillion, and per capita income is $48,000. That $13,000 gain ($48,000 minus $35,000) may look large, but it occurs over three decades, and for workers part of the gain would be taxed away to pay baby boomers' retirement costs. Typical take-home pay would rise less than 1 percent annually.

Unfortunately, productivity growth has recently decreased. In the past year, it's been only 1.4 percent. By contrast, it averaged about 3 percent from 2000 to 2005. The fall-off partly reflects a mature business cycle. As the economy slows, so do productivity gains. But some long-term forecasts project that the poor performance will continue. In Moody's Economy.com's outlook, productivity growth averages 1.4 percent a year from 2005 to 2035. The main reason: stunted business investment in new machinery, technologies and buildings, says chief economist Mark Zandi.

"We don't save much as a nation, and we've gotten away with it so far because overseas investors have been willing to finance our investment," he says. But he doubts that will continue. As global investors shift to other markets, big federal budget deficits will compete increasingly with private companies for credit. Higher interest rates will crowd out some business investment. Productivity will suffer.

Maybe. But Federal Reserve chairman Ben Bernanke has suggested that the post-1995 trend (2.5 percent or higher) might persist for years. In truth, economists have a dismal record in anticipating and explaining productivity shifts. A big slowdown in the early 1970s remains a mystery. Productivity gains averaged 1.5 percent for several decades, down from about 2.5 percent in the 1950s and 1960s. The post-1995 rebound was first attributed to computers and the Internet. But its continuation after 2000--when high-tech investment peaked --suggests other forces contributed. It's unclear what they were.

The great frustration is that something so critical is also so elusive. Productivity ultimately encompasses a society's entire economic culture: its technologies; management; workers' skills and motivation; schools; entrepreneurial spirit; work ethic; ambition and risk-taking; the competitive pressure on companies; government policies; financial markets. Everything counts--and connects with everything else.

Therein lies a caution to the Democratic Congress and the Bush administration. Although government can't easily dictate higher productivity, its policies may perversely favor lower productivity. What's politically expedient today--a dubious tax break, a lazy budget deficit, an expensive regulation--may be economically corrosive tomorrow. Don't ditch the future.