August 12, 2016

Productivity and the Welfare State

Recently the problem of declining productivity in the U.S. economy has made front pages. On June 1 U.S. News reported:
The U.S. economy is sick, and analysts aren't entirely sure where the ailment came from or how they should go about treating it. What is certain, though, is that domestic productivity gains have ground to a halt, and even the most senior Federal Reserve official is now worried about where the economy can reasonably go from here. "We have a lot of jobs being created in the face of not much output growth. Unfortunately, that means that productivity growth, which is the growth in output per worker [per hour worked], is very slow," Fed Chair Janet Yellen said recently during a speech at Harvard University. "Since productivity growth ultimately determines the pace of improvement in living standards for society as a whole, that's a serious and negative development."

There has been a lot of discussion about what exactly is behind this decline in productivity. One example is the Federal Reserve's Beige Book from June, pointing to low unemployment and a tighter job market as the main cause of a flattening in productivity gains. At the top of a business cycle employers "crowd" their facilities with workers, seeing a decline in the addition of output per worker (a slowdown in the increase of production.) This increases the cost of production on the margin, until employers have exhausted the profits from adding one more worker.

The flattening of productivity gains as the economy approaches full employment, is a real but short-term phenomenon. Either the economy shifts from growth to recession, or businesses start investing to expand their production facilities and again raise productivity. 

In today's macroeconomic situation the capital expansion alternative seems increasingly unlikely. As I explained recently, the investment pattern of American businesses over at least the past year has shown that they have been sitting on idle capacity. The slow drift upward in employment since last summer has gradually filled that idle capacity with workers - according to some reports of predominantly lower skills. 

In a paper from the NBER, Harvard economist Dale Jorgensen et al suggest that increased workforce participation of low-skilled workers actually helps drive productivity in the U.S. economy. If this were true we should be facing a productivity spike over the next year.

The problem is that the evidence Jorgensen cites, and based on which we can draw the conclusion on rising productivity, is from the latter half of the 1990s. That was a period of major technological innovation and expansion of the use of computer-based technology. The rise in low-skilled labor participation in the workforce was not the driving force of productivity gains - but a result of it. Rapid growth in productivity, business profits and workforce earnings expanded the lower end of the labor market. 

When we today see a rise in workforce participation by low-skilled workers we should therefore not expect a spike in productivity. On the contrary, the more prolific employment of low-skilled labor contributes to the explanation of productivity stagnation. 

So why will not businesses invest to capitalize on larger ranks of employees? There are two reasons: short-term uncertainty and the long-term cost of doing business. Over the short term businesses are not confident enough to expand facilities, buy new equipment and make significant software upgrades because of the state of the global economy. Add to that the major uncertainties associated with the presidential election and what course fiscal and regulatory policies will take, as well as the slow growth in the economy. The last variable is important because it signals weak consumer and investor confidence. It also means, simply, that markets are tight and the expansion in purchasing power, needed to motivate investments, is not there. 

Over the longer term, though, businesses are reluctant to expand for reasons I have discussed at length in my book Industrial Poverty. As government expands, businesses have to spend more and more of their resources to adapt to higher taxes and more onerous regulations. For some time the adaptation is no big deal; later on the burden of government policies shifts more of business focus from actual operations and investments to tax and regulatory compliance. 

Then there comes a point where businesses simply cannot adapt anymore. I have suggested that this point lies where taxes as a share of GDP, reach 40 percent. This does not include the cost of regulations, which effectively is a tax as well. A country with lower taxes, such as the United States, can "compensate" by expanding the regulatory burden on the private sector. 

Regardless of which combination of taxes and regulations a government chooses, when the weight of the combination reaches a certain share of business turnover it simply becomes unprofitable to expand and grow. Businesses concentrate instead on securing profits from the operations they have, expanding instead in other jurisdictions where the cost of doing business is considerably lower.

This industrial stagnation is a clear sign that we have left the era of high growth and strong productivity gains. Europe in general went through this process in the last quarter of the 20th century; now it seems to be our turn. 

If our businesses have indeed reached the point where expansion and government compliance are incompatible, then our productivity problem is much more complex than traditional economics has been telling us. It is time to start looking comprehensively at what can be done to structurally reduce the size of government. And that means not just in terms of regulations but, primarily, taxes and government spending.

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