The Bear’s Lair: The productivity death spiral

Fourth quarter U.S. labor productivity growth surprised markets last week by coming in at minus 1.8%. Over the past four years, annual productivity growth has averaged only 0.7% per annum. That’s far below the historical average of around 2% annually. The productivity growth shortfall has highly negative implications for U.S. living standards. Contrary to the theories of Northwestern professor Robert Gordon, however, the world is not running out of things to invent. Instead, this is an indication of just how far U.S. policies in several areas have gone wrong.

Gordon’s theory is somewhat akin to the 1899 Punch magazine joke (no, contrary to urban legend, it wasn’t the Head of the U.S. Patent office!) where a genius goes to the Patent Office in the (then future) 1999, to be told by the office boy that everything that can be invented has been invented. As I discussed in a previous column, this seems very unlikely to be true.

While some well capitalized recent innovations, such as social media and the Uberized economy, appear limited in their productivity potential, other potential advances, such as self-driving cars and genetic manipulation seem likely to provide the same kind of huge long-term productivity boosts as steam, electricity and the Internet. God knows, we are paying enough for education, more than at any other period in human history; it seems excessively pessimistic (although certainly possible) to believe that this massive investment is wholly unproductive.

We have of course been operating since 2008 in a period of exceptionally cheap capital, whose economic effects are subtle and pernicious. Since the productivity effects we are discussing relate to labor productivity, one would expect that increasing the amount of capital available per unit of labor would increase labor productivity, even as it possibly reduced multifactor productivity (since the increase is artificial, caused by eccentric monetary policy.)

In 2009-10, this seems to have happened. Labor productivity increased by over 3% in each year. This column even predicted this around that time, and pointed out that the fast rise in labor productivity was artificial, was probably causing employment gains to lag, and could be contrasted with the relatively slow rise in labor productivity and rapid employment gains in the early 1980s recovery, when real interest rates were exceptionally high. This column also postulated that multifactor productivity, which is published almost two years after the event, would show no equivalent gain.

In that I was correct, but I had not expected the trend since 2011, whereby labor productivity growth itself has been exceptionally sluggish, even though one would have expected it to be rapid. From one point of view, this has been beneficial; employment trends have been much healthier since about 2012 than they were before that date, so although long-term unemployment remains far above historic levels and labor force participation is close to an all-time low, millions of unemployed Americans have found jobs, even at lower wages than they would like.

Nevertheless, the sluggish productivity growth figures are evidence of a deep malaise. The rate of U.S. new business formation has halved since 1978, and since 2009 the number of new businesses formed has been lower than the number of businesses ceasing to trade, a situation that has never previously existed in the 50-year history of the statistical series concerned. That, perhaps, is the epicenter of the productivity malaise. Small businesses are typically the major creators of both jobs and innovation, yet even though “funny money” venture capital is available in unprecedented quantities, and every techie from Stanford and MIT is funded with lavish amounts of start-up money, business formation just isn’t happening.

It’s not quite clear why not, but the finger of suspicion must point to monetary policy and regulation. Banks are able to make good money by investing in Treasury bonds and funding themselves in short-term markets, so have little incentive to fund small businesses. More important, the suppression of interest rates has caused U.S. savings to languish permanently below 5% of GDP. This has depressed the pool of savings available to finance the vast majority of small businesses that are not in fashionable sectors able to attract fly-by-night venture capital money. Most worthwhile small businesses are initially financed by retained savings and aunts’ spare nest-eggs. Low interest rates have drained these, to the immense long-term detriment of the U.S. economy’s health. A similar but more extreme effect has been visible in Britain, where a similar monetary policy of negative real interest rates has caused labor productivity in the third quarter of 2014 to remain 2% lower than before the 2008 downturn.

Meanwhile U.S. regulations in a host of areas have been multiplied beyond belief, with environmental, employment, financial and land use regulations all being more onerous than at any previous period in U.S. history. The linkage between monetary policy, regulation and small business formation is thoroughly misty; however that between lagging small business formation and sluggish productivity growth appears clear as crystal. Poor policy is probably causing the lag in small business formation, and that lag is undoubtedly a central factor in the productivity malaise.

There are also some structural problems. In education, healthcare and government, productivity has tended to decline, as political correctness and regulation generally has imposed layer upon layer of administrators on the structure that actually teaches, cures patients or carries out useful functions. To some extent, GDP doesn’t care about the economic productivity of public sector employees or those employed in sectors like education and healthcare that function essentially on a cost-plus basis. In those sectors, the more bureaucrats there are, the higher the output is assumed to be, whether or not the increase has any actual value. (The output is recorded directly in the public sector, and reimbursed through non-market mechanisms in the case of hospitals and colleges.)

Finally, excessive immigration, especially of low-skill immigrants, has lowered productivity simply by adding workers who are less productive than average. According to the Center for Immigration Studies, even in the last six years of depression, not only has official immigration been running at record levels, but the USCIS has added 7.4 million work permits in the last five years, over and above the officially admitted immigrants. The thesis that these immigrants start more businesses than the native-born is belied by the dearth in new business formation.

If the productivity malaise continues, its effect on the U.S. economy will be thoroughly unpleasant. Living standards will continue to lag, as the output generated by the workforce will no longer justify decent wage increases. Minimum wage laws will become increasingly damaging to employment, as employers drive wages down to their mandated level. Unemployment won’t necessarily be very high, except in states with high minimum wages, but the quality of employment will deteriorate, as employees find fewer and fewer options for attractive jobs with good prospects.

More ominously, all the Social Security, Medicare and education programs run by the U.S., government and funded by the unfortunate taxpayers will be thrown hugely out of kilter. Social Security in particular depends crucially on productivity growth producing sufficient growth in wages that future generations can fund the retirement allowances that have always been actuarially somewhat too generous. Without decent productivity growth, the actuarial deficits in the Social Security and Medicare trust funds will spiral to infinity. The bankruptcy of Social Security, currently due in 2033, will not just be a technical point at which the trust fund runs out of money but a true bankruptcy, in which the payments to beneficiaries can no longer be supported by the system.

The solution to the productivity malaise is a long-term one, as has been the problem. Interest rates need to rise to a level at which savers receive a healthily positive return, enabling them to rebuild the balances depleted by two decades of monetary folly. This will be an immensely painful process, for it will cause the liquidation of the malinvestment accumulated in the U.S., economy in recent decades. The stock market will crash, as will bond markets, while bankruptcies will ripple through the U.S. economy, probably causing severe damage to the financial system.

This pain will of course be blamed on the higher interest rates, and there will be immense pressure to start printing money again. Of all the damage caused by Bernankeist monetary policies, the political damage is the most dangerous, for it prevents the misguided policies from ever being reversed. Just as in Greece, the limited attempts at necessary austerity tried by the Samaras government after thirty years of profligacy caused the electorate to choose a political group that was both economically illiterate and truly dangerous, so in the U.S. a Syriza-type response to essential corrective monetary policies cannot be ruled out.

Monetary sanity is however not enough to restore productivity growth. In addition, a bonfire of regulations must be undertaken and, even more important, a bonfire of government departments, removing Federal bureaucracies like the EPA, the Energy Department and the Education Department whose sole purpose is to enlarge their place in the economy and thereby damage its performance further. Only when both regulations and the entities producing them have been removed will the economy start to rebuild the productivity losses of the last decade and indeed those incurred since the great regulatory wave of the early 1970s.

Finally, the borders need to be brought under control and immigration cut back. The capacity of the U.S. economy to absorb new workers may be immense, but such absorption drags down living standards and productivity of those already in the country. Moderating immigration, to the extent that’s possible in a world of cheap airfares, is an essential part of an economic cure.

An earlier column calculated that, without the productivity drop-off around 1973, probably due to the advent of the great regulatory agencies, we would now be about 45% better off. That drop-off has worsened and time has gone by; today we’re missing a living standards improvement of over 50%. Curing the problem should be the #1 economic objective of the U.S. political system.


(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.)