Recent data suggest the labor market remains quite strong. The unemployment rate is the lowest it’s been in decades, people are being drawn back into the labor force, and wages are growing at a more respectable pace. Perhaps most encouraging to me is the better pace of wage growth on the lower end of the income spectrum. Rising economic inequality has been a sizeable drag on economic growth for many years. Fortunately, it would appear that US workers can expect the good times to continue for a while. Continued low inflation should keep the Fed from applying the brakes through interest-rate hikes, and a shortage of available labor will likely mean that US companies will increasingly have to pay up to attract qualified workers. All good news for US workers.
But the news isn’t all rosy. There is one important element missing from the largely positive labor-market story. The Bureau of Labor Statistics reported last week that labor productivity fell 0.3% from the second quarter to the third quarter – the first decline since the fourth quarter of 2015. On a year-over-year basis, productivity increased just 1.4%. Although the weakness in the quarter was partially due to growth in self-employed workers, like Uber drivers, that factor only accounts for a portion of the weakness. Even after adjusting for the effects of the “gig economy”, this most recent report on productivity continues a trend that’s been in place since the end of the Great Recession. In the years leading up to the recession (2000-2007), growth in labor productivity averaged 2.7% annually. In the years following the recession the pace has averaged just 1.2%. This may not seem like a big difference, but it is. The pace of productivity growth can and does influence the pace of wage growth, and that can be seen in the chart below.
The dramatic deceleration in productivity growth is largely the result of a relative lack of investment. Business investment has been held back, in part, due to low labor costs. A massive amount of slack in the labor market following the Great Recession meant that businesses were not required to pay up to attract workers. So rather than make major investments in equipment and new technologies, for example, many companies have found it more cost-effective to hire additional cheap workers instead. Choosing workers over expensive equipment also provides more flexibility to adapt to lower-than-expected demand (layoffs). Which brings me to my next point. Businesses have also been reluctant to make major investment expenditures because demand for their products and services has been relatively subdued and highly unpredictable. Contributing to the uncertainty in recent years has been weak economic growth outside the US and the effects of the trade war with China. Until those issues are resolved, it’s hard to see business investment picking up in earnest.
Productivity growth has also been negatively affected by a relative lack of investment by governments. We have long argued that the huge deficits created by the 2017 tax cuts would have been much more impactful if the money had been spent on things that have the potential to drive sustainable economic growth. Economists generally agree that factors like educational achievement and infrastructure modernization can be highly effective in boosting labor productivity and therefore economic growth. But these deficiencies were not addressed in the Tax Cuts and Jobs Act (TCJA). Instead, policymakers chose to double-down on “supply-side” initiatives, including major tax cuts, which have thus far been unsuccessful in generating more than a short-term boost to economic growth.
The reason that tax cuts and ultra-low interest rates have been impotent is that access to cheap capital has not been the factor inhibiting investment spending. In fact, ready access to very cheap capital has been a defining characteristic of the post-recession years. Therefore, increasing the supply of cheap capital at this point has mostly been an exercise in futility (see Europe). Instead, we need to properly identify the cause of the problem, which is relatively low and unpredictable demand. Ours is a demand-side problem that will require a demand-side solution. In my estimation, the solution has to include a wider distribution of income/wealth so that money gets into the hands of those most inclined to spend it! And no, I’m not advocating for a large-scale redistribution of wealth in this country. But one highly effective way to lift up the middle class is by making investments in the things that have been proven to drive productivity growth, like education and infrastructure.