Multifactor productivity data, announced to little fanfare last week, showed a sharp downward revision for 2008-09, with a net fall over the two years. The quinquennium 2005-09 had the lowest average multifactor productivity growth of any quinquennium since 1978-82, at a beggarly 0.2% per annum.. Lovers of the current economic order like to trumpet the recent high labor productivity figures, but when multifactor productivity is considered, it becomes clear that the U.S. economic engine has become seriously distorted. As so often in U.S. economic questions, the distortion’s cause traces back to the same root: the increasingly misguided “sloppy money” policies of Alan Greenspan and Ben Bernanke.

When commentators refer to “productivity” they usually mean labor productivity, the amount of output produced by one unit of labor. U.S. labor productivity has risen at a decent clip in recent years, mostly because of layoffs by companies outsourcing production to emerging markets. Indeed, that rise in labor productivity has been a hidden cause of the sluggish employment growth since the bottom of the recession. However if you really want to look at the productive efficiency of the U.S. economic engine, you need to look at multifactor productivity, which measures the change in output per unit of combined capital and labor.

Here the picture is much less favorable. Multifactor productivity rose only 0.1% in 2009 and on revised data fell by 1% in the previous year. The very low 0.2% annual rise in the 2005-09 quinquennium had a real effect on output. With the average annual multifactor productivity growth since 1948 having been 1.17%, we can legitimately say that if multifactor productivity in 2005-09 had risen at its long-term annual rate, output in 2009 would have been 4.9% higher. Shortfalls in multifactor productivity thus have to be taken very seriously indeed; in the long term they can have a major and very unpleasant effect on living standards.

The difference between labor productivity and multifactor productivity does not appear to be well understood by policymakers. In the late 1990s, for example, Fed Chairman Alan Greenspan proclaimed a “productivity miracle” because labor productivity was increasing somewhat faster than the 1980s-90s average (although still below the rates of increase of the halcyon postwar period of 1948-73.) However when you look at multifactor productivity, you discover that during the 1995-2000 period it increased at 1.12% annually, slightly below the 1.17% postwar average. Thus the “productivity miracle,” and the over-expansionary monetary policy that resulted from Greenspan’s perception of it, was simply a mirage – the only real change in those years was that an ever-increasing supply of capital was being stuffed into investment in the tech sector and telecoms.

There have been two multi-year dips in multifactor productivity growth since the series started in 1948; the other was in 1979-82, when it declined for four successive years. The reasons for the dips become very clear when you look at interest rate trends and the business cycle. Recessions tend to make growth dip, with a sharp recovery in the years following the recession. The negative figures in 1969-70 were thus followed by a recovery in 1972-73; that in 1974 was followed by a sharp recovery in 1975-76. However 2005-2008 were not years of recession; hence the slower growth in those years must have been due to some other factor.

When you look at the sharp decline in 1979-82 and the sluggishness in recent years, the true culprit becomes clear: the level of interest rates. In 1979-82, following Paul Volcker’s 1979 “October surprise” real interest rates were very high. That not only reduced the level of capital applied to the economy, it also made obsolete a high proportion of the existing capital stock. For example, not only did the steel mills of Youngstown, Ohio go bankrupt, but the entire capital stock of the Monongahela Valley region was devalued, housing, shopping centers, offices, the lot, as former steelworkers were compelled to move and the assets that served them no longer had sufficient uses to give them value. Demand for labor, on the other hand, remained high in the areas of the country that were not suffering from bankruptcy of their capital stock, in particular on the East and West Coasts. Once the recession lifted, therefore, job creation was exceptionally buoyant.

This time around, the redundancy effect has damaged the labor rather than the capital factor in the economic equation. Job loss levels in the winter of 2008-09 were far above those of any recession since the Great Depression, and the level of long-term unemployment is far above that of the early 1980s, especially when you take into account the legions of “discouraged” workers who have exhausted their benefits and dropped out of the statistics. Even before the latest recession, demand for labor was sluggish and workforce participation rates were below those of the late 1990s, although the surge in employment in construction, mortgage banking and real estate sales disguised this effect.

Extreme levels of interest rates thus adversely affect multifactor productivity, and the rate at which technological advance translates into living standards. If rates are too high, capital stock that would otherwise remain in use is made redundant, new investment is choked off and productivity growth slackens as the economy operates sub-optimally. Similarly if as at present interest rates are too low workers who would otherwise have remained productive are forced into long-term unemployment and the economy again fails to produce the increases in living standards that it should – with 4.9% of GDP going missing in the 2005-09 period. If you examine the detailed productivity breakdown, you discover that capital factors formed a record high percentage of total factor inputs in 2009, again suggesting that the economy was out of equilibrium.

Once interest rates return to normal levels – a real return of 2-4%, rather than a negative real return, as at present, or real rates in the 5-10% range, as in the early 1980s – multifactor productivity will presumably return to its long term trend growth level. It should be noted however that from the 1983-84 experience there is only a modest level of “catch-up” following a productivity dearth, so that a certain amount of living standards improvement will have been irretrievably lost.

This therefore is the cost of Bernankeism. Just as sloppy monetary policy in the 1970s and the squeeze that proved necessary thereafter lowered sharply the robust 1.9% annual multifactor productivity growth of 1948-73, so Bernankeism and the likely squeeze that will be necessary to remove the inflation it is causing, will cause permanent multifactor productivity shortfalls, and very possibly a reduction in its long-term growth potential even after interest rates have been restored to their proper level.

This also has implications for asset returns. If multifactor productivity has entered a lengthy period of sluggishness, with the Bernanke years and the years of squeeze that must follow, then traditional ideas about investment returns must be sharply scaled back. We have already seen the beginnings of this in a decade in which stock returns were below zero in real terms, although the buoyancy of bond returns and the rise in commodity prices has helped to disguise this effect. Going forward, the sluggish growth in multifactor productivity must inevitably reduce the intrinsic value of common stocks, prolonging the period of negative real returns for a second and even possibly part of a third decade. We have seen this before, in the stubborn refusal of stock prices to exceed their 1929 highs until as late as 1954. This time, there has already been some nominal movement beyond the 2000 peak levels in the Dow Jones and Standard and Poor’s 500 stock indices, but the return of normal real interest rates will inevitably squeeze out this gain and collapse stock prices. It must be remembered that the stock market in February 1995, at the beginning of a lengthy boom, was at just 4,000 on the Dow index, equivalent to less than 8,000 today when inflated by nominal GDP.

Multifactor productivity data are an enormously useful analytical tool; they illustrate the fundamental growth in the economy due to advances in technology, when labor and capital changes are factored out. However, the information they give us on the current state of the U.S. economy and markets confirms and even darkens the pessimistic view.

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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.)