For the last year or two, it has been fashionable to ridicule the idea of a "New Economy," which underlay the stock market boom of the late 1990s. However, last week's productivity report shows that the New Economy is alive and kicking.
The original notion of a New Economy was that computers, the Internet, wireless phone technology and other innovations had radically altered the economy permanently. In particular, these innovations significantly raised the trend rate of productivity growth.
Productivity rises when people make more with less, especially less labor, but also less capital, lower inventories and other costs of production. Increasing productivity, measured as output per man-hour, is per se a good thing. The standard of living could not rise unless workers are able to use less and less labor to produce the same goods year after year.
During the 1970s and 1980s, we went through a productivity crisis. The trend rate of productivity growth fell from about 3 percent to about 1.5 percent per year. This may not sound like much, but the change was dramatic. At a 3 percent productivity rate, the real standard of living will double every 24 years. At a 1.5 percent rate, it would take 48 years.
There is still no consensus on why the productivity rate trend fell so dramatically. Some blame OPEC for raising the price of energy. Others blame the massive wave of government regulation that was imposed on the economy in the 1970s. There was also a role for demographics and other factors, as well.
The idea that productivity was going to grow at a permanently lower rate had important implications for government policy. For one thing, it encouraged the Federal Reserve to keep a tighter hold on the money supply. Since inflation results when the money supply rises faster than the production of goods and services, lower output per hour meant that the money supply needed to grow more slowly to prevent inflation.
Computers and the Internet changed all that. They made it possible for companies to economize in many ways. Individuals, too, found the new technology time-saving and, therefore, productivity-increasing. People like me order all manner of products over the Internet, saving me the need to drive to the store. And it saves money as well by allowing easy price comparisons. Perhaps the most dramatic impact of this is in the area of travel, where the Internet allows people to buy airline tickets and book hotel rooms at sometimes ridiculously low prices.
Eventually, government policymakers came to believe that the New Economy had reversed the productivity decline. In the 1990s, the trend rate of productivity rose to 2.5 percent. This allowed the Fed to run a looser monetary policy than it otherwise would have been able to. This fueled the stock market boom, which provided capital for myriad new technology companies, which in turn underpinned the New Economy and continued to raise productivity.
The problem we are facing now is that while rising productivity raises living standards, it can also mean that fewer workers are needed to maintain output at the same level. So in a time of slack demand, as we have now, there are fewer jobs available. Indeed, high productivity is at the base of the jobless recovery we are experiencing.
A review of recent recessions shows that there has been a change in the behavior of productivity. Historically, a sharp drop in productivity preceded recessions, as employers kept workers on even as output fell. Productivity rose after the recession mainly because employers were reluctant to hire as output increased. Thus, in the six quarters preceding the trough of the 1973-75 recession, there was zero increase in productivity during that whole period. In the six quarters before the 1981-82 recession, the total increase in productivity was just 0.8 percent. In the six quarters after the trough, productivity rose by 5.9 percent in both cases.
This started to change with the 1990-91 recession. Productivity rose by 1.2 percent going into the recession and 4.5 percent coming out. The higher productivity going in meant that fewer workers were needed coming out of the recession. Now, in the current recession, which ended in the fourth quarter of 2001, we have seen even higher productivity on either side. The latest data show an increase in productivity of 4 percent in the six quarters before and 6.5 percent in the six quarters after. That is why employment growth and hiring levels remain weak. Employers are raising output without adding much new labor.
It is important to remember that this is a short-run phenomenon. In the long run, higher productivity increases employment, a fact documented in two new studies from the Federal Reserve Bank of Richmond and the Federal Reserve Bank of San Francisco. But in the meantime, employment growth may still be slow for a couple more months.