In an earlier posting I mentioned that the economic task of the next Administration will be to deal with the weakness in the economy (going beyond the credit market seizure and financial market meltdown). The new IMF World Economic Outlook notes that:
The major advanced economies are already in or close to recession, and, although a recovery is projected to take hold progressively in 2009, the pickup is likely to be unusually gradual, held back by continued financial market deleveraging.
That is the standard macroeconomic world view: the economy will rebound but financial constraints will limit growth. In this view, we are working off a credit bubble that inflated the economy faster than it should have grown. As the IMF puts it:
lax macroeconomic and regulatory policies may have allowed the global economy to exceed its “speed limit” and may have contributed to a buildup in imbalances across financial, housing, and commodity markets.
While it is undoubtedly true that we are facing the hangover from an easy credit boom, the question of whether the economy exceeded its speed limit is at the core of the discussion as to future remedies. Is the economy doomed to a period of slow growth or are there actions that can be taken to effectively raise the speed limit?
Key to raising the economy’s speed limit involves continued productivity gains via innovation and re-establishing the link between productivity gains and wages. This will require a look at structure issues. A consumer-oriented stimulus package would be fine. But ultimately the economy will grow to the extent that we increase productivity – not by how much we increase consumer spending. As Larry Summers said in a recent piece in the Financial Times, “there is a need to ensure that the pressure to increase spending is directed at areas where it will have the most transformational impact. We need to identify those investments that stimulate demand in the short run and have a positive impact on productivity.”
This is not necessarily the standard view. As Rob Atkinson has pointed out, there are a set of standard views that look at the macroeconomic level without every considering innovation and that “transformation impact” mentioned by Summers. See Rob’s paper “Economic Doctrines and Policy Differences: Why Washington Can’t Agree on Economic Policies” – and his earlier book Supply-side Follies. William Baumol, Robert E. Litan, and Carl Schramm have a slightly different take on the argument. In there book, Good Capitalism, Bad Capitalism and the Economics of Growth and Prosperity, they focus on entrepreneurship as engine of growth.
The ability of the economy to transform itself is key to the discussion of the economic “speed limit” and the debate over “the new economy” in the late 1990’s. The term “new economy” has fallen into disrupt after the collapse of the dot-com bubble. At its best, the term helped describe the economic changes due to technological advances and other factors. At its worse, the term was used to justify an overly rosy outlook that the old economic rules no longer applied. When some of those fundamentals re-applied themselves (like the idea that companies actually needed to have revenues to sustain their stock prices), many were quick to discard the entire concept.
But the underlying question remains valid: to what extent have changes in technology and economic structure increased the productivity level and to what extent can those gains be sustained.
Some fundamentals. The economy’s “speed limit” refers to the potential non-inflationary growth rate of the economy. Conventional economic wisdom holds that economic growth can not exceed a certain rate without increasing inflation. That rate is determined by the rate of growth in the labor force (the number of workers and their hours worked) and the rate of growth of the productivity of those workers.
Proponents of “the new economy” talked about a number of factors that either 1) lowering the possibility of inflation or 2) raising the non-inflationary potential growth rate:
• globalization has increased competition and made it harder for companies to raise prices, therefore keeping down inflation;
• globalization has opened up new sources of supply, thereby reducing any domestic bottlenecks in the production process that could result in inflation due to a lack of capacity to meet demand;
• deregulation has forced companies to become more productive; and,
• new technologies have dramatically increased productivity;
• restructuring has allowed companies to become more productive through increased economies of scale and specialization.
The last two points – technology and structure – go directly to the argument on raising the economy’s non-inflationary growth potential centers through productivity. A decade ago, economist worried about the so-called so-called “productivity paradox.” Data on the overall productivity of the economy did not seem to show any impact from new information technologies. As Noble-laureate Robert Solow once quipped, “You can see the computer age everywhere but in the productivity statistics.” However, over time those productivity numbers final changed. Productivity has grown at an annual rate of 2.6% between 1995 and 2007, compared with a rate of only 1.4% between 1973 and 1995 (data from the Council of Economic Advisors: 2008 Economic Report of the President)
Brynjolfsson and Hitt have argued that the “productivity paradox” was over in large firms by 1991. Their 1996 research shows that “computers contribute significantly to firm-level output, even after accounting for depreciation, measurement error, and some data limitations.” Part of the reason for the delayed impact has to do with complementarities between technologies. Economic historians and theorists have pointed out that new technologies often require a host of other changes — technological, institutional/organizational, and in worker skills and knowledge — before they can be fully utilized. As Brynjolfsson and Hitt noted in a 2003 paper “Computing Productivity: Firm-Level Evidence”:
the observed contribution of computerization is accompanied by relatively large and time-consuming investments in complementary inputs, such as organizational capital, that may be omitted in conventional calculations of productivity.
One example often used is the case of electric motors replacing steam engines in the factory system. It took 40 years before full impact of this change was felt, because of the need for complimentary changes in power transmission technologies, plant design and organizational procedures. (See Nathan Rosenberg, “Uncertainty and Technological Change”.)
Every once and a while, this emphasis on information technology raises an alarm – such as this comment a few years ago in the Financial Times Federal Reserve may have hit speed limit
Importantly, most of that investment drop has come in computer equipment. So, to the extent that information technology is responsible for the productivity miracle of the 1990s, there is reason for added concern.
The Conference Board released a report earlier this month that U.S. Labor Productivity Growth in 2006 was the Lowest in More than a Decade. Much of the concern was about a slowdown in the impact of information technology:
According to Dr. Bart van Ark, Director of International Economic Research at The Conference Board: “Over the past decade, information and communication technology has been a key driver of global productivity growth, but with these latest numbers one begins to wonder whether ICT’s [Information and Communications Technology] contribution has peaked. The significant fall in U.S. productivity growth is unlikely to be purely cyclical, and the modest European revival of productivity also points to the limited impact of technological change and patchy liberalization of product and labor markets in many countries.”
However, according to the report, the “lull” in productivity could also be due to a transition phase to a second wave of ICT-driven productivity growth still to come.
Gail Fosler, Executive Vice President and Chief Economist of The Conference Board, said: “Today’s business models have reached a certain level of technology saturation, and incentives for creating a second wave of applications are weak. But there are many industries, in particular in services, in which the potential for more productive technology use seems large. Future productivity gains may be waiting for a new generation of business applications.”
But, it is unclear whether we have come to the end of information technology driven productivity increases. A new IT wave may be just beginning, in the form of cloud computing and Virtual Worlds. (Note: Athena Alliance has an on going project on IT and business collaboration – with the first paper to be released in a month or two.)
There are at least three ways in which information technology can increase areas: IT creating industries (such as software); intensive IT using industries (such as banking); and latent IT using industries (such as health care). Each has their own productivity rates. As the consulting firm McKinsey pointed out is a study “Where US productivity is growing”:
After 2000, some of the sectors with the fastest-growing productivity—notably computer equipment—saw their growth slow substantially. Yet productivity growth rates in both retail and wholesale trade have continued their strong growth trajectory. Interestingly, productivity in a much broader set of service industries, including administrative support, scientific and technical services, construction, and restaurants, has also increased. As a result, five of the largest contributors to productivity growth after 2000 were service industries. Over the past decade, the service sector, which today represents 70 percent of US employment, has been a major source of growth in productivity and employment alike.
Services may in fact be the area of biggest productivity increases in the future. (For a more detailed discussion of productivity in the services, see my earlier posting.)
Besides, IT doesn’t work as a productivity enhancer by itself. Organizational change is needed to take advantage of the new technology. Sometime the organizational change itself is enough to cause major productivity increases – think of Adam Smith’s example of the pin factory. As I’ve argued earlier in The Case for Technology in the Knowledge Economy), the issues is not just technology but knowledge.
Finally, there is the whole issue of innovation. Innovation does more than raise the productivity of the existing production process. It creates whole new products and processes.
But that is the subject of another posting.
Suffice it to say that the concept of an economic speed limit is useful. But when economic forecasts start raising the issue of hitting the limit, you need to ask questions about what that limit is, who enforces it and how to change it in order to continue economic growth.