http://news.ft.com/home/us/ Miracle or mirage The decline in US productivity growth is renewing doubts about the new economy, says Gerard Baker Published: June 7 2001 18:36GMT | Last Updated: June 7 2001 18:43GMT New-economy icons have been falling for months in the US, like revolutionary statues after a coup. The rubble from billion-dollar dotcoms, million-dollar apartments and thousand-dollar suits continues to pile up in the streets as the business cycle reasserts its tyranny over those who thought they had liberated themselves from the laws of economics. But while the iconography of excess is steadily dismantled, so far at least, Americans' faith in the fundamentals of the revolution itself remains oddly robust. Equity prices still assume that high-technology-driven improvements in productivity will keep up the accelerated pace of profits growth for years to come. Bond and stock markets reflect a resilient confidence that new-economy processes and systems mean inflation has been conquered. And Alan Greenspan, chairman of the Federal Reserve, continues to espouse the cheerful view that changes in the economy mean that the rapid increases in income and output of the last few years will soon resume. "There is still, in my judgment, ample evidence that we are experiencing only a pause in the investment in a broad set of innovations that has elevated the underlying growth rate in productivity," he told the Economic Club of New York two weeks ago. The abiding optimism of Mr Greenspan and the markets rests on a distinction between two conceptions of the new economy not always understood by its sceptics: internet mania, which in fairness the Fed chairman at least (if not the markets) always argued was unlikely to be sustained; and real, lasting economy-wide improvements in productivity driven by the surge in investment in high-technology equipment over the last decade. On the optimistic view, the sharp slowdown in growth over the last year - from a year-on-year rate of nearly 5 per cent in 1999-2000 to the current rate of a little over 1 per cent - is not the beginning of a reversion to the average growth rate of about 2.5 per cent the US managed for the 25 years until 1996. It is, rather, a cyclical downshift from a brief period of excess that will end relatively quickly. This is now clearly the view of even some of those who were once most sceptical about the new economy. The Fed's own staff economists, never an especially exuberant bunch, are forecasting growth next year back in the range of 3.5 to 4 per cent that they consider the long-term sustainable pace. In a speech on Wednesday, Laurence Meyer, a governor of the Fed and one of its most persistent new-economy doubters, described the information technology changes of the last decade as on a par with the invention of the radio, the jet engine and other innovations that fundamentally altered long-term economic performance. "I believe we are still in the new economy . . . The shape of the slowdown has the new economy written all over it, just as the shape of the earlier expansion did," he told an audience at Harvard University. But even as Mr Meyer was speaking, troubling data were pouring in. This week, the Labour department reported that labour productivity - measured output per hour worked - at non-agricultural businesses dropped in the first three months of the year at an annual rate of 1.2 per cent. It was the worst quarterly figure for eight years and followed a sharp deceleration in the fourth quarter of last year, when productivity growth slowed to 2 per cent. Year on year, output per hour growth is now trailing back towards the rate of about 2 per cent that was the norm before the surge towards 4 per cent began five years ago. The worrying possibility from the latest data is that the productivity growth surge was what the sceptics had said it was all along - simply a response to an unsustainable growth in demand met by companies using their labour more efficiently. Further ammunition for the sceptics is provided in capital investment data. Spending on business equipment is wilting. Non-residential fixed investment was flat over the past six months after growing at double-digit percentage rates for five years. According to company data, it is set to fall in the next six months. If capital spending is reverting to a level more in line with the historical trend before the mid-1990s, productivity increases may also be slowing permanently. But it is far too soon to say that the productivity "miracle" of the past few years was in fact a mirage. For one thing, the decline so far is clearly in large part a cyclical phenomenon, a familiar feature of the early stages of a slowdown, as output growth falls faster than employment growth. There has been so far only a muted response in the labour market to the steep decline in demand growth in the past year. The unemployment rate has risen by only 0.5 percentage points since last autumn, meaning that companies have been holding on to workers with more tenacity than expected. After several years of coping with the tightest labour market in a generation, where even pizza delivery companies were forced to pay signing-on bonuses to lure staff, it would be no surprise if companies were a little leery about laying off workers at the first sign of a downturn in demand. This factor has almost certainly contributed to the productivity weakness of the last six months and, if demand remains soft, will presumably disappear over the coming months. In truth, given that productivity fluctuates sharply over the cycle, the truth or falsehood of new economy arguments cannot be properly tested until the current business cycle is complete. The longer-term picture still looks encouraging but only when demand recovers will it be possible to say with any certainty what has happened to the underlying efficiency of US business. Of more pressing concern is whether the weakness in productivity growth over the past six months will impair that recovery itself. The sharp turnround in output per hour is having two heavily negative effects: on companies and on monetary policy. The flip side of productivity weakness is an acceleration in unit labour costs. Wages are still rising strongly in the US - another hangover from a tight labour market. In the first quarter of the year, unit labour costs were up at an annual rate of 6.3 per cent. With productivity stalling, unit labour costs rising and demand weak, corporate margins are under intense pressure. That will undermine demand in two ways: delaying the investment recovery and damping investors' optimism about future profits growth. Mr Greenspan noted a year ago that the surge in productivity was raising demand faster than supply. The effect on companies' expected profitability and stock prices was immediately feeding through to consumers in the form of the wealth effect. The deceleration can presumably be expected to damp demand through a negative wealth effect from the equity market, which has been in negative territory for more than a year and may not yet have adjusted fully to the weakness in corporate profits expected over the next year. Furthermore, the spurt in unit labour costs presents a challenge to the Fed's strategy this year of aggressive interest rate cuts to stimulate the economy. Inflation remains relatively well contained and the widespread view at the Fed is that pressures - from higher energy costs and from rising labour costs - are merely a delayed reflection of economic conditions a year ago. There is no avoiding the fact that it was the productivity surge of the late 1990s that produced the virtuous circle around which the US economy revolved for five years. This circle of rising output per hour growth, stable prices, rising profitability, accelerating investment and faster output-per-hour growth - has been broken. Whatever happens to productivity in the long term, if it continues to weaken in the short term the cycle could quickly turn the other way.
