Something Wonderful Might Be Happening in the American Economy

Source: Capital Economics.

Are we seeing a productivity break out or fake out? Fingers crossed that it’s the former, and that we’ll see a lot more quarters like Q1. Productivity increased at a rapid 3.6% annualized during the first three months of this year. On a year-ago basis, this put productivity growth at 2.4%, the fastest pace since early 2010 and far better than the 1% pace that has typified the post-financial crisis expansion.

Faster productivity growth is key to sustained faster economic growth of anywhere close to 3% — not to mention the long-run growth in living standards. As economist Paul Krugman famously put it, “Productivity isn’t everything, but, in the long run, it is almost everything. A country’s ability to improve its standard of living over time depends almost entirely on its ability to raise its output per worker.”

So is this the start of something good? Obviously that would be awesome and a correct bullish call would be a huge reputation maker for the forecaster. In the 1990s, Federal Reserve Chair Alan Greenspan was one of the first experts to notice something was up with productivity, much to the skepticism of many of his colleagues and staffers. “In the end, the chairman turned out to be right,” writes economist and former Fed Governor Laurence Meyer in his book, “A Term at the Fed.” “His call on the productivity acceleration was a truly great one.”

What are experts saying today? Barclays: “One quarter does not make a trend, and we do not expect productivity growth to be sustained at the current level, but a gradual shift towards 1.5-2.0% seems plausible to us.” And JPMorgan: “Further ahead, any lasting acceleration in productivity growth will likely need to be accompanied by solid growth in business spending on labor-saving investments. Here the data is thus far inconclusive.” Finally, this in The Wall Street Journal from Chad Syverson, a University of Chicago economist who studies productivity: “We may be seeing the first glimmers of coming out of the doldrums experienced during the past eight years. I’m not ready to throw a party yet.”

If it is sustained, who gets the credit? Is it Trumponomics? Economist Brian Wesbury argues that a productivity bump this long into the economic cycle “suggests tax cuts and deregulation are the key drivers.” Or maybe recent technological developments, such as AI, are finally working their way seeping into the economy with measurable effect. Or maybe all of the above. Here is a good overview from Capital Economics (bold by me):

The acceleration in productivity growth suggests the economy’s supply side is responding to the tightness of labour markets and the tax cuts introduced early last year. With investment growth slowing more recently, there’s a good chance productivity growth will drop back again. But we wouldn’t rule out a more sustained acceleration in productivity growth in the long run, as new internet and AI technologies diffuse through the economy. … The most likely explanation is that we’re seeing a cyclical pick-up, reflecting the tightness of labour markets. The latter has contributed to some capital deepening over recent years but, more recently, investment growth has begun to slow again, and the recent opening of spare capacity implies less need for firms to invest. That in turn suggests productivity growth may soon slow again.

It’s possible we are wrong and that we’re witnessing some broader transformation to the economy’s supply side. The tax cuts may not have provided a big boost to equipment investment, but investment in intellectual property has surged.  We are open-minded about the potential for a more sustained recovery in productivity growth, driven by the adoption of a new wave of technologies that increase efficiency across swathes of the economy. There are no shortage of potential technologies, including cloud computing, mobile technologies, AI and machine learning. If any of these transform productivity growth, we think there’s a good chance that will show up in the US first. That is why our long-term forecasts for the US are more upbeat than most.

If 2% plus productivity growth is the new normal, that would mean GDP growth of around 3% is sustainable over the longer-run. That potential would only be achieved, however, if the Fed recognized the economy could run hotter without generating excess inflation, as Greenspan did in the 1990s. The Jerome Powell-led Fed doesn’t sound convinced, but it may yet change its mind as faster productivity growth weighs on unit labour costs, pushing core inflation even lower this year.

Of course, this all could be more a blip than a boom. And we can do more than hope it is. Policymakers should think harder about pro-productivity policies in areas such as immigration, public investment, education, infrastructure, as well as taxes and regulation.