On the discombobulating productivity growth slowdown

 In her  Jackson Hole lecture Ms. Yellen has stated:

Finally, and most ambitiously, as a society we should explore ways to raise productivity growth. Stronger productivity growth would tend to raise the average level of interest rates and therefore would provide the Federal Reserve with greater scope to ease monetary policy in the event of a recession. But more importantly, stronger productivity growth would enhance Americans' living standards.

As the following chart shows  labour productivity has been growing at a slower pace in recent years. Moreover,  according to the revised estimates by the US Labor Department nonfarm business productivity measured as the goods and services produced by American workers per hour, decreased at a 0.6 per cent seasonally adjusted annual rate in the second quarter. This was the sharpest year-on-year decline over the past three years.

US labor productivity in the nonfarm business sector

This  was also the third consecutive quarter of decline the longest slide in worker productivity since the late 1979. In terms of year-over-year change  labour productivity was down 0.4  per cent in the second quarter, the first annual decline in three years.

It is worth to remind ourselves that productivity is the denominator in the unit labour cost ratio, with the numerator being the real wage, meaning  higher productivity would increase the country's competitiveness by reducing the unit labour cost. When  prodctivity grows at the same pace as the real wage it offset the adverse impact of the latter on  a country's competitiveness in the export markets. Unit labor costs rose at a 4.3 per cent annual rate, a 2.6 per cent rise from a year ago, reflecting  in part a 1.1 per cent rise in real  hourly wage per hour in the second quarter.

The strong productivity growth exhibited in the chart in the late 1990s has been attributed to the investment surge in the information technology that resulted in a marked reduction of the unit labour cost, which  boosted the GDP growth.

The productivity slowdown of recent years, as we have persistently argued in this forum, emanates from the effects of the global financial imbalances and high levels of global indebtedness  that have caused high level of uncertainty, whereby  businesses  postpone their irreversible capital expenditures and shift to an intensive margin mode of production. As a result of weak investment the economy's production frontier has not expanded and thus productivity growth has shrunk. This is a global phenomenon , which has been affecting international trade, encouraging currency wars and  spreading  poverty. Lower production frontier and rising unit labour costs have also diminished corporate profits and has aggravated  the financial imbalances.

As we have argued in the past  a lower productivity arising from a prolonged shift towards intensive margin mode of production would lower the economy’s potential growth. Many central banks around the world have already lowered their expectations for future growth and interest rates, without acknowledging the high level of debts and a fragile financial system as the main culprit. The consequential  uncertainty acting as a barrier to capital formation has created a vicious circle towards a rapidly approaching stagflation.

We believe the  alternative hypothesis put forward to explain the  productivity slowdown cannot be maintained with a sufficient confidence. For instance, it is hard to believe that in spite of  the recent advances in high tech communication, smart materials,  Internet of Things, large scale sensor network applications,  Big Data, cloud computing, supply chains  so on and so forth a  secular trend  toward a more modest efficiency gains, as compared to past advances, has been emerged.

It is also difficult to maintain the hypothesis of errors in measurement of productivity when the global economy is clearly slowing down, and businesses are delaying their capital expenditure plans. In the US fixed nonresidential investment, which is comprises about twenty per cent the economy --  has declined for the past three quarters  and new orders for nondefense capital goods excluding aircraf has declined on a year-over-year basis almost continuously for the past year and a half.

The situation is not materially different in Europe and Asia. In fact, investments have exhibited the same pattern of decline as aggregate demand since the 2015. The situation has deteriorated fast since the early 2016. During the second quarter, total investments declined 3.4 percent from the year earlier, and subtracted 1.68 percentage points from the GDP growth.

As the following chart shows the total factor productivity, TFP, that captures the efficiency with which labor and capital are combined to generate output ,  over the past four quarters ending in the second quarter of 2016, has fell at a rate of minus 0.7 per cent while Utilization-adjusted Total Factor Productivity has fell at rate of minus 0.32 per cent. This is another  clear indication of a shift towards intensive margin mode of production. We have in the past examined other evidence in favour of uncertainty hypothesis deriving from financial imbalances and will not repeat the argument here again. Suffice to remind readers that a greater use of contingent labour in the current capacity planning by businesses has resulted in wages falling behind productivity growth.

Total Factor Productivity Rate (Four quarter per cent change in natural log) Source: FRBSF

Another evidence for greater use of contingent labor is the fact that in  addition to the officially reported 7.8 million people currently out of work, there are 8 million individuals in involuntary part-time jobs. Furthermore, there are the 2 million of long-term unemployed and another 2 million of virtually unemployable persons that their only hope for finding a job is through demand for contingent labour.

Getting some of these 16 million people back on the payrolls will require a major capital formation so as  generate a favourable shift in the aggregate labor demand which has been lacking. As well, the slowing international trade need to be boosted. It is of note that in the first six months of this year, the U.S. trade deficit was running at an annual rate of $712 billion. That negative trade balance accounts for 4 percent of the economy, and it is currently taking half a percentage point off the growth of the domestic demand. For aggregate demand to grow at a healthy pace the global financial markets need to return to equilibrium, excessive global debts have to be restructured, and currency wars must be ended.