In an April 28 column, “The productivity puzzle,” I examined the evidence for the much-touted “productivity miracle” since 1995 and found that the apparent (albeit limited) gains in labor productivity were misleading. This week, I return to the subject, and discuss what the implications of this non-miracle might be for business, government, the U.S. economy and the markets.
In the April 28 article, I examined recent Bureau of Labor Statistics figures on multi-factor productivity, which take account not only of productivity in the use of labor, but also how productively the economy deploys capital investment. Like the BLS’s labor productivity figures, these statistics go back to the 1940s, but they are produced only with considerable delay — the figures for 2001 appeared in April 2003. The conclusion which appeared very clearly from these statistics was that not only was there no miracle in multi-factor productivity after 1995, but productivity in the use of capital dropped sharply after 1998, and by 2001 was far below the level of the 1960s.
The economic effect of proclaiming a non-existent productivity miracle is now apparent. Far too much capital was devoted to supposedly productivity-enhancing investments, with the result that capital productivity has dropped sharply. On the other hand, government spending plans and stock prices took the supposed productivity miracle into account, resulting in both being far higher than they would be in an equilibrium economy.
Meanwhile, because the supposed productivity miracle and the high stock market increased the apparent attractiveness of capital investment, foreigners (to the tune, now of $500 billion per annum in the U.S. current account deficit), “private equity” investors ($100 billion in 2000) and investors in general increased excessively the supply of capital to the U.S. economy. Since the multi-factor productivity of the economy has not increased above the long-term trend, returns on all that capital, in the form of bond interest rates and stock yields and potential appreciation, are now exceptionally low, lower than at any time since the Great Depression of the 1930s.
For business, this means that capital will become increasingly expensive over the next few years, while attractive investment opportunities are few and far between. Progress will come by trimming labor forces, and by making existing capital stock work more efficiently, reducing the amount of unused capital in the system. Price competition in domestic sectors will be intense, with a high level of bankruptcies removing excess capital stock, and many companies making money only because of the profits they are able to wring from the suddenly expanded international market as the dollar drops.
Business’s production capacity utilization rate, currently at a low, unseen since 1983, of 74.4 percent will descend further as the “double dip” of the economy takes hold, then begin a long slow climb back to efficient levels above 80 percent, with new investment being much scarcer than redeployment of existing investment.
For government, the expected surge in revenues from a continuation of the late 1990s’ boom conditions and productivity surge will never occur. Instead, revenues will continue well below forecasts (in this context, the government revenue and expenditure figures for April 2003, due to be announced Tuesday, will be an interesting indicator — April is the most volatile month in the 12 month Treasury cycle, because it contains corporate and individual income and capital gains tax payments). Deficits will thus be enormous, whatever policy is pursued.
Tax cuts, the Bush administration’s preferred solution to economic sluggishness, is not the answer. Instead, national, state and local governments must look to their own labor productivity, which has for so long lagged that of private industry, and make every effort to ensure that their share of the relatively scarce labor resources in the economy, and the currently cheap but in future increasingly expensive capital resources in the economy, is kept to the lowest possible level. Unproductive government activities, such as housing finance guarantees (which will cause an S&L-crisis type situation in around 2006) and the inadequately managed lending programs of the World Bank and the International Monetary Fund must be sharply cut back.
Economically speaking, the ideal president for the 1980s boom was Ronald Reagan, because he cut taxes and provided optimism after a decade of economic sluggishness. The ideal president for this recession would be Calvin Coolidge, stern cutter of government expenditure and encourager of private savings, which alone can balance the oncoming chasm in the U.S. social security system. Regrettably, while George W. Bush’s acolytes like to claim he is another Reagan, even his warmest admirers would not suggest that he could be another Coolidge — the virtues of Texas are almost the diametric opposite of those of Vermont!
For the economy as a whole, the next few years will be ones of very slow growth or more likely shrinkage in gross domestic product, with the non-miracle’s over-investment in equities of 1996-2000 and the Federal Reserve-induced over-investment in housing in 2001-03 taking a long time to be absorbed. Labor productivity figures will be continually disappointing, as the amount of capital applied to the economy fails to increase significantly, or even declines through bankruptcies. Capital productivity, after a sharp drop in 2002 to perhaps 2004, continuing its sharp drop of 1998-2001 to levels not seen since before statistics began in 1947, will slowly stabilize and begin to turn up. Multi-factor productivity will fall back for a few years, as the inefficiencies of unutilized resources affect the overall economy, then rebound fairly strongly, hopefully resuming after 2005 or so its long-term growth rate of around 0.7 percent per annum.
Unemployment will rise fairly rapidly, in spite of a flat or modestly expanding economy, for as long as the present elevated level of stock prices continues. Then the big forthcoming drop in the stock market, which will adversely affect the overall economy, will reverse the relationship between labor and capital. This will allow the economy to bottom out and begin a slow recovery while unemployment peaks well below the levels of the 1930s, since labor will for several years be a more valuable resource to the economy than capital.
Probably the most unattractive of all businesses in the U.S. will be commercial and investment banking, with high bankruptcies and moribund capital markets taking a savage toll (the Resona Bank collapse in Japan, the latest in a long series of disasters, is the result not of uniquely incompetent bankers but of a uniquely unpleasant environment for banks).
The most attractive businesses will be the large exporters and the makers of “inferior” goods (for example, baked goods) which thrive in a recession as consumers substitute them for more expensive pleasures. Profitability overall will be severely depressed.
For the markets, the next few years will be grim ones. The dollar will continue its slide until the balance of payments deficit has been corrected, since the low returns available to capital, either debt or equity, in the United States will render U.S. investment thoroughly unattractive to foreign investors. The stock market will decline beyond its long-term equilibrium of around 5,000 on the Dow Jones Index to a level that gives investors an adequate return on the poor profit levels reported by U.S. companies — maybe Dow 3,000 by about 2008.
Real interest rates, currently at historic lows when inflation is factored in, will begin to rise back to their normal levels, and possibly somewhat above them for a few years, as government absorbs resources needed by the private sector. Depending on the policy pursued by the Fed, this may produce significant price deflation, with interest rates remaining at around or a little above present levels. Alternatively, if the Fed eases really aggressively to prevent deflation, long-term interest rates will rise sharply in nominal terms, and be accompanied by a resurgence in inflation, as a somewhat milder (I hope and currently believe) version of the 1930s becomes a considerably nastier version of the 1970s.
For investors, U.S. stocks, bonds and real estate should all be avoided. EU stocks are also unattractive as the United States is exporting its deflationary tendencies to that region, where government sectors will inevitably expand as a percentage of their economies, driven by their generous and now unaffordable social programs.
Gold is attractive overall as a hedge against economic hard times, but most attractive if the Federal Reserve panics in the face of deflation and produces inflation instead.
Most attractive are common stocks in those economies where cost structure is far below that of the United States, which will be able to take advantage of outsourcing by U.S. companies and the somewhat slower adoption of new technologies in the world as a whole to catch up rapidly in terms of living standards. India, Russia and China are the most obvious examples of such polities, with all three having substantial political risks and structural rigidities to mar the attractiveness of their economic prospects.
Not a pretty picture, overall. But that’s what you get when policymakers spend almost a decade in pursuit of a delusion.
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(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)
This article originally appeared on United Press International.