June’s unemployment figures showing growth of 372,000 jobs were hailed as unambiguously good news by the media and the markets. However, there is a problem: advance estimates of second quarter GDP, to be announced at the end of this month, suggest a decline of 1.5% at an annual rate, similar to that in first quarter GDP. If that figure pans out, it can only do so by a catastrophic fall in productivity, already down at a 7.3% annual rate in the first quarter. That says something very ominous indeed about current monetary and regulatory policy, and about Americans’ living standards going forward.
Productivity growth, while difficult to measure accurately, is the key to improving living standards. Before industrialization, productivity grew very little, although if you measure output figures over a long enough period you can detect changes. In general, the productivity of labor increased in periods when labor was scarce, such as in the centuries after the Black Death of 1348, which reduced European population by about a third.
Conversely, the productivity of capital increased when capital was scarce, as even a modest increase in capital per worker would produce a disproportionate increase in output. Thus, in Pitt’s famous Budget speech of February 1792 he attributed the increased prosperity observed in Britain to the increase in capital allocated to industry – for him, more water wheels powering textile production meant more output. Only later did it become clear that the embryonic Industrial Revolution was increasing output per person – and therefore living standards – not merely by building more water wheels but by technological innovation, increasing the output resulting from each unit of input.
From around Pitt’s time the world has been blessed by continuous productivity increases resulting from technological innovation. Productivity growth was at its highest following World War II, with U.S. productivity growth averaging 2.8% annually in the quarter-century 1948-73. Part of that growth was due to capital deepening, the factor Pitt saw in 1792. If McDonalds fast-food restaurants are more productive than old-fashioned mom-and-pop restaurants, then the spread of McDonalds over the entire U.S. landscape during those years inevitably increased productivity.
Since 1973, productivity growth has declined, and living standards have grown more slowly, especially for the working class, who have generally not benefited much from the massive boom in asset prices since 1980. Productivity growth in 1973-2007 averaged 1.8% per annum, with the slowing after 1973 almost certainly the result of the mass of environmental, health and other regulations introduced in the 1970s, and multiplied beyond belief thereafter. There appeared to be no technological reason for the decline in productivity growth; computers were still fairly primitive in 1973, so the revolution in computing and information transmission technology since then should be expected to have kept productivity increasing at a rapid clip.
Then after 2007 there was a further downward shift in productivity growth, to below 1% per annum. Professor Robert J. Gordon, in his “The Rise and Fall of American Growth” published in 2016 postulated that all the major productivity-enhancing advances of the various Industrial Revolutions were now completed, so that productivity growth would now slow to a halt, making the key economic problem distribution rather than production. I disagreed strongly with this thesis at the time, especially as Gordon’s solutions were a dreadful socialist mix of environmental regulation and redistributive taxation. However, the passage of another six years, with the temporary recovery in productivity growth under President Trump now worse than nullified under the Biden administration, have made me think that he may have something – though his solutions would make the problem still worse.
My argument against Gordon in 2016, which I hold with even more conviction now, was that the wildly off-market interest rate policies of the Federal Reserve since 1995 and more particularly since 2008, have caused a progressively worse misallocation of resources in the U.S. and global economies, which has produced an ever-worsening adverse effect on productivity growth. This effect was mitigated during the Trump years by aggressive de-regulation, which reversed some of the productivity-sapping effect of the post-1973 slowdown; in addition there was a brief period in 2017-18, before Trump opened his big mouth, when interest rates were being moved painfully slowly towards a market level, further mitigating the adverse productivity effect of “funny money.”
The truly appalling productivity growth figures we are now experiencing, reducing productivity by 7% per annum, would send us back up the trees within two decades, thus achieving the wokies’ “net zero” fantasies in the most painful way possible, through zero output, which by definition would presumably produce zero carbon emissions. The catastrophic recent figures appear to result from a resurgence in dozy regulation by the ever more extreme officials of the Biden administration, and the outbreak of inflation, as I shall explain.
Inflation affects productivity in two ways, one direct and one indirect. Directly, inflation makes the asset allocation process less efficient, because consumers are less able to assess relative prices, and the long-term costs and benefits of particular purchases – they engage in hoarding and other unproductive behaviors. Indirectly, inflation makes real interest rates even more negative than they previously were, thus exacerbating the pull towards unproductive asset purchases and away from productive creation of marketable goods and services.
Current inflation of around a 9% annual rate, when combined with nominal interest rates still only at 2-3%, creates a real interest rate of minus 6-7%, steering the economy away from optimal resource allocation. We saw this from time to time in the 1970s, when inflation got ahead of interest rates, bubbles occurred, which then had to be liquidated. Indeed, real interest rates are more sharply negative now than they were through either the 1970s or the 2010s, at least temporarily worsening the productivity-destroying effect. However, the move away from negative nominal rates does at least mitigate the further pathologies and loss of freedom produced by the attempts to abolish cash by the World Economic Forum and its totalitarian acolytes.
An increasingly puzzling mystery of the 2010s, that will (or at least should) be debated by economists for the next century or two, is why given interest rates forced to zero by central banks throughout the world, inflation did not take off. In 2009-10, of course, the global economy was in deep recession, which would prevent inflation from appearing, but after 2011, when interest rates would normally have risen to normal levels of about 2-3% above inflation, they were kept artificially low, yet the normal corollary of such a policy, sharply resurgent inflation, failed to appear. The extra decade without inflation had a pathologically bad effect on policymakers, since it convinced them that they could continue getting something for nothing forever. Debt levels and budget deficits spiraled worldwide, while leftist economists came up with ever more lunatic ideas of how economies worked – Modern Monetary Theory has surely now been exploded by the return of reality since 2020.
In an ideal world, the Fed and other central banks will remain staunch, will ignore the anguished bleating of politicians, and will restore interest rates to normal levels significantly above inflation. If this was done quickly, rates of 7-8% would probably be sufficient, not 10%, as inflationary psychology has not yet taken full hold. In that case negative productivity growth would disappear over time, and Professor Gordon’s thesis would be properly tested and, I believe, found wanting. The world would suffer a sharp recession as the budget deficits of the last decade were eliminated, together with the idiotic investments brought on by funny money, but it would be a short recession and well worth it. Within at most 18-24 months, productivity would resume growing and we would all resume getting richer.
In the more likely case, the appearance of recession, probably with a negative GDP figure at the end of this month, causing an official recession of two down quarters (though every trick will be made to undefine it and prevent such a declaration) will cause intolerable political pressure to be put on the weak sisters of the Fed by the Biden administration. After no more than a few months of feeble resistance, the Fed will cave, and lower rates again, from a peak below 4% that is far too low to affect an inflation rate of 9%. Inflation may decline temporarily to around 5-6%, simply through the effect of recessionary downward pressure on commodity prices; this will encourage the Fed in its wimping out.
In this latter case, inflation will trend upwards from 6%, quickly heading into double digits, while the Fed is once again left trailing feebly in its wake. Most important, in this case, productivity growth will continue negative, because only the most useless investments will be made, and true innovation will be quelled through the recession and the accompanying credit contraction. By 2030, we can all expect to be around 25% poorer. That will of course have a beneficial effect on our carbon emissions, but so what? The Industrial Revolution, the greatest economic benefit mankind has ever seen, will have gone into reverse.
(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.)