In the summer of 1995, Alan Greenspan broke with longstanding economic dogma and lowered interest rates. This was a break with the widely held within the economics profession, because the unemployment rate was only 5.6 percent at the time. This was at or below the level that most economists believed was consistent with a stable rate of inflation. At the time, most economists felt that by lowering interest rates and possibly allowing the unemployment rate to sink further, Alan Greenspan was risking sending the economy into an inflationary spiral.
However, Greenspan argued that the economy could support lower rates of unemployment, first and foremost because he believed that the rate of productivity growth had accelerated. As it turned out, Greenspan was right, both about the potential for the unemployment rate to fall without triggering inflation (it eventually fell below 4.0 percent for a few months in 2000) and also about the uptick in productivity growth. Productivity growth averaged 2.8 percent annually from 1995 to 2005, compared to just 1.4 percent from 1973 to 1995.
But the good times may now be coming to an end. Since the second quarter of 2004, productivity growth has averaged less than 1.6 percent annually, just a shade better than the growth rate during the 1973-95 slowdown.
This is potentially a really big deal. Economists attach great importance to productivity growth because in the long-run it is the main long-run determinant of living standards. The more rapidly productivity grows, the greater the potential for improvements in living standards over time. And even small differences add up of time. In thirty years, a 1.5 percent growth rate allows for a 55 percent increase in living standards. By contrast, a 2.5 percent growth rate would allow living standards to more than double over the same period.
Such differences can be especially important in the context of the rising inequality that we have seen for the last quarter century. If productivity growth is fast enough, then it is possible to achieve gains up and down the income ladder even as inequality increases. But if productivity growth stays on the path of the last 11 quarters, then the continued growth of inequality will virtually guarantee stagnant living standards for the bulk of the U.S. population.
The social implications of this scenario over the long-run are not pretty. While a small segment of society may continue to grow richer, the bulk of the population will be excluded from the benefits of economic growth. To a large extent, this describes the situation of the last thirty years, with the boom years of the late nineties being the major exception.
It is still too early to pronounce the end of the mid-nineties productivity upturn, but 11 quarters of weak growth is enough to raise grounds for concern. In spite of its importance, economists really don’t understand the main factors that determine the rate of productivity growth. There is no generally accepted explanation for the slowdown that began in 1973 or the 1995 acceleration. Clearly computers and information technologies are an important part of the acceleration story, but computers, and even personal computers, were not new in 1995. Even the Internet was not new, although it did first start to take on economic importance at around that time.
In addition to its long-term impact on living standards, a productivity slowdown also has substantial implications for the near-term course of the economy. While the mid-nineties productivity boom helped to alleviate inflationary pressures, a slowdown would have the opposite effect. With the same rate of growth of wages and other costs, a one percentage point reduction in the rate of productivity growth would translate into a one percentage point increase in the rate of inflation.
Higher oil and food prices have already have pushed the overall rate of inflation to the highest rate since the early nineties. Non-oil import prices have also been rising more rapidly in recent months. If the dollar falls further as part of the process of correcting the trade deficit, there will be addition rises in import prices in the future. If productivity growth remains slow, then more of these price increases are likely to show up in core inflation measures.
While the Fed has arguably been overly concerned about inflation, if it continues to keep containing inflation as its primary target, then lower productivity growth will likely mean a future of higher interest rates, slower growth, and higher unemployment. In short, we may see the pleasant surprise of the mid-nineties, that gave us the late nineties boom, run in reverse. It will not be pretty.