US productivity growth is good but it's credit growth that matters

Last week's market volatility to a large extent resulted from the realisation by investors of the increasing probability of a recession in the United States. For those thinking that the much-vaunted US productivity will save the economy, they should perhaps think again.

For some time, Michael Mandel, chief economist for BusinessWeek, has expressed the view that productivity growth would keep the United States economy healthy and growing. Productivity growth through innovation and research would offset the lack of savings and a persistent trade deficit (see, for example, the 2006 article "Why The Economy Is A Lot Stronger Than You Think".

More recently, though, he has been expressing doubts about this view. These doubts culminated in an article for BusinessWeek last week that is significant for the fact that it clearly deviates from his longer-standing view and instead asks the question: "How Real Was the Prosperity?"

After the market turmoil last week was halted by the Federal Reserve's emergency cut in the federal funds rate by 75 basis points, he wrote in the article: "But the underlying problems that ail the markets and the economy cannot be waved away by the Fed's magic wand. In truth, we're at the beginning of a long, arduous process of figuring out how much of the post-tech bubble prosperity was real and how much was the result of a credit-induced frenzy."

He highlighted the recent improvements in productivity growth. "Over the past 10 years, productivity, as measured by the Bureau of Labor Statistics, has grown at a 2.6% annual pace," he wrote. "That's up from a 1.6% annual rate over the previous decade."

However, he then added: "Yet despite the higher output, U.S. consumers have taken on an extra $3 trillion in debt."

That provides the clue. "Some of those apparent productivity gains also may be illusory," he goes on. "If the economy was artificially boosted by excess borrowing, that would show up as higher output and, presumably, higher productivity. The implication is that once borrowing recedes to the historical average, actual underlying productivity growth might be lower than we thought."

All quite valid, I think, except that his association of higher productivity with higher output may actually be overemphasising the positive.

The following charts use data from the Federal Reserve Bank of St Louis. All figures depict year-on-year percentage changes.

The first two charts show that the trend in productivity growth has indeed been rising since the late 1980s, and, as Mandel implied, this improving trend has mostly taken place at the same time as credit growth has accelerated, with the rise in household debt in particular far outstripping growth in gross domestic product, especially since 2000.

However, the growth rate in real output has, on the whole, been flat over the same period, despite the increasing productivity growth rate. Rather than a higher output growth rate, the rising productivity growth of recent years has essentially been driven by weaker employment growth in terms of both numbers of workers employed and hours worked. The impact of weaker employment growth on consumer spending was offset by strong credit growth, which helped to boost demand and kept output growth stable.

Businesses have long understood that it is easier to boost profits in the short term by downsizing the workforce rather than by increasing output. Apparently, the same applies to national productivity as well.

Note that I am not suggesting that higher productivity is necessarily bad for the economy or even for employment. In a healthy economy, higher productivity, when driven by innovation and technology, should eventually translate into stronger employment and economic growth.

However, if productivity growth was, as Mandel wrote, "artificially boosted by excessive borrowing", then it could be heading down and providing no support for the US economy in the near future. After the financial turbulence of the past few months, credit growth is now threatening to turn negative. If credit growth had helped boost productivity, it could now undermine it. And the economy along with it.