Over the last five years, much was heard about the "new economy." This was the idea that trend productivity growth had risen to a permanently higher level as the result of technological innovation, especially the Internet. Now, some economists are questioning whether there ever was a "new economy." The answer is important because the speed at which productivity returns to trend after the recent slowdown will determine how fast the economy will recover.
From 1972 to 1995, average productivity growth was 1.5 percent. By productivity, we mean output per man hour in the economy. The more a worker can produce in an hour, the higher his productivity. Higher productivity lowers costs and increases both profits and wages.
In the 1960s, productivity had risen at an average annual rate of 3.2 percent. Thus, the decline that began in the 1970s was very significant, although it took a while for economists to recognize that it was more than a temporary phenomenon.
Then, just about the time that many economists began to believe that we were stuck with a permanently low productivity growth rate, the rate suddenly jumped up. Between 1995 and 2000, productivity grew at an average annual rate of 2.6 percent. Since, during this period, businesses were investing heavily in information technology, as the Internet grew and spread, economists assumed that this was the cause of the productivity rise.
For some years, there was deep skepticism among many economists about whether productivity growth had risen permanently and whether it resulted from investments in information technology or something else, such as demographics. Then, just about the time when most economists were finally won over to the "new economy" idea, economic growth and the stock market collapsed.
Until Sept. 11, the thinking was that the "new economy" idea was still sound and had only been temporarily sidetracked by a tight monetary policy from the Federal Reserve. Since that date, however, there has been a reassessment going on, with some economists saying that permanently higher business costs may offset the gains from information technology, putting us back where we started. These increased costs include those for added security, insurance, backup systems, inventories and travel.
This brings us back to the central question, which is whether the economy will return to a trend productivity growth rate of 1.5 percent per year or 2.6 percent once the slowdown has ended. A new report from the McKinsey Global Institute tries to shed some light on the issue by looking at increased productivity industry by industry over the last five years. It found that almost all of the aggregate increase in productivity in the U.S. economy resulted from higher productivity in only six industries, representing just 30 percent of the economy: retail trade, wholesale trade, securities, telecommunications, semiconductors and computer manufacturing.
While some of the productivity increases in these six key sectors resulted from technology, much did not. It came about because of basic market forces, such as economies of scale, competition, shifting consumer demand and managerial innovation. Although technology may have enhanced the increase in productivity from such factors, it was not the primary source. Thus, the McKinsey report concludes that information technology "was not the most important cause of the post-1995 productivity acceleration."
Just because technology was not the most important factor behind the "new economy" phenomenon, however, does not negate the idea that productivity growth has risen to a permanently higher trend. It may simply have a broader base than previously thought. Nor is there any reason to think that the events of Sept. 11 will result in more than a temporary fall in productivity levels, with the previous trend continuing afterwards.
Federal Reserve Chairman Alan Greenspan is one who is taking a more optimistic view. Testifying before Congress' Joint Economic Committee on Oct. 17, he said, "The level of productivity will presumably undergo a one-time downward adjustment as our economy responds to higher levels of perceived risk. But once the adjustment is completed, productivity growth should resume at rates in excess of those that prevailed in the quarter-century preceding 1995."
Chairman Greenspan went on to say, "For the longer term, prospects for ongoing rapid technological advance and associated faster productivity growth are scarcely diminished. Those prospects, born of the ingenuity of our people and the strength of our system, fortify a promising future for our free nation."
Let us hope he is right.