Productivity is still the missing ingredient

This is a re-posting, with updated data and commentary, of a similar post three months ago.

We've know for years that this recovery is the weakest post-war recovery on record, and the chart above makes the case. If this had been a typical recovery, national income (GDP) would be about $2.8 trillion higher than it is today. That's like saying that average wages and salaries would be 17% higher. For a family earning $60,000, that's over $10,000 more income per year that has failed to materialize despite all their hard efforts.

What's been lacking is productivity (the additional output that each unit of labor produces), because productivity is the key to rising prosperity. We can only earn more if we work and/or produce more. We've had about the same rate of jobs growth (~2%) during this recovery as we had in the latter portion of the 2001-2007 recovery, but GDP growth has been much weaker. The reason? Very low productivity growth, as seen in the chart above. I use a 2-yr rolling annualized growth rate to measure productivity, since it is quite volatile on a quarter-to-quarter basis. Over a 2-year period I think the quarterly volatility tends to wash out and a truer picture is revealed. Note that the productivity readings we've had in the past several years have always been associated in the past with recessions. It's no wonder that everyone keeps complaining about the economy. It's as if we've been living in recessionary conditions even though things have been slowly improving. Put another way, we've had to work unusually hard just to enjoy very modest improvements in our standard of living.

The chart above uses the same data, but instead of a two-year rolling period, it uses a 5-yr rolling period. This, I believe, captures the effect of policies put in place by different presidential administrations. It can take years for policies to be put into effect and then have an impact on the economy, and good policies can have effects that last even after they have been reversed.

The colored bars correspond to different presidential terms, with the red bars reflecting a sustained period of declining productivity growth and the green bars a sustained period of very strong and/or rising productivity growth. I would be quick to note that Republican administrations have yielded three periods of declining productivity (Eisenhower, Nixon, and Bush II), while Democratic administrations have only yielded two periods of declining productivity (Carter and Obama). No political party can lay a claim to implementing policies that consistently lead to sustained rises in prosperity.

One thing that stands out is that the Obama years have seen productivity growth that rivals the malaise that characterized the Carter administration. For the five- and six-year periods ending last March, non-farm productivity rose at a miserably slow 0.5% annualized rate. In all of post-war history, only the five-year period ending in mid-1982 was worse. (Small footnote: Reagan's announced tax cuts did not take effect for almost two years, so his faulty implementation of tax cuts—which encouraged people to delay investments—only served to prolong the declining productivity of the Carter years).

There are many factors that contribute to the slow growth of productivity, such as rising regulatory burdens that increase the cost of economic activity, high marginal tax rates that reduce the incentive to work and invest and take risk, and transfer payments that create a culture of dependency and a reluctance to seek out work. John Cochrane has an excellent op-ed in the WSJ which expands on the reasons why this has been such a weak recovery: "Ending America's Slow-Growth Tailspin."

The charts above show that a significant increase in transfer payments (money the government gives to people for a variety of reasons) beginning in late 2008 corresponded to the beginnings of a significant decline in the labor force participation rate. Many millions of workers have left the workforce, and it could be due at least in part to the fact that the benefits that accrue to those not working (e.g., food stamps, disability payments, welfare, earned income credits, assistance to single-parent families) are greater than the net benefits of working, especially on an after-tax basis. Transfer payments now equal 20% of disposable income, and that is a big number that currently totals $2.74 trillion and consumes fully 73% of all federal government spending. Maybe it's simply the case that our government has grown to the point where it is now suffocating the private sector. Too few people are working and too many are on the receiving end of federal largesse. And for those who are still working, the burden of complying with regulations and the burden of taxes is inhibiting their ability and willingness to work and invest more.

We are not going to see significant improvement in productivity and living standards unless and until we adopt policies that are more conducive to work, investment, and risk-taking. It's that simple. Unfortunately, the proposals being discussed on the left (e.g., higher taxes on income and capital, plus higher minimum wages which price many young workers out of the market and inhibit new business formation) are only going to exacerbate the current situation. Trump sensibly advocates for lower and simpler income and business tax regimes, but his calls for trade protection are misguided and could weaken the economy.

Yesterday the level of uncertainty surrounding this year's presidential election was reduced as Trump became the presumptive Republican nominee. But uncertainty remains inordinately high since future policies could take either a positive or a negative direction, and by a lot, regardless of who wins. We know one of the eventual two candidates, but Hillary's candidacy remains deeply clouded by the ongoing FBI investigations. Such a level of uncertainty is not conducive to new investment and is not likely to be inflating equity prices—small comfort.

UPDATE: There is school of thought that holds that the productivity slowdown is the result of mismeasurement; that many valuable products (e.g., GPS, VoIP) are being given away for free. Here is a paper that considers whether this argument is supported by the facts. It concludes: " the reasonable prima facie case for the mismeasurement hypothesis faces real hurdles when confronted with the data." In other words, mismeasurement problems can't come close to explaining the magnitude of the decline in productivity. (HT: John Cochrane)