By Lili Bayer

Economist Paul Krugman wrote in 1994 that “productivity isn’t everything, but in the long run it is almost everything.” We have previously outlined that labor productivity is a critical measure of economic health and an important long-term indicator of the U.S. economy’s future trajectory. In “The Wealth of Nations,” Adam Smith wrote, “the annual produce of the land and labor of any nation can be increased in its value by no other means, but by increasing either the number of its productive laborers, or the productive powers of those laborers who had before been employed.” Productivity, therefore, has long been seen as a primary driver of economic growth, and innovation and technological advances have come to be closely associated with productivity growth.

Nevertheless, America’s labor productivity growth has been slowing down over the last few years, and over the past two quarters, productivity actually declined. This decline is due to a slowdown in capital intensity and technological innovation, and the emergence of new challenges in the workplace. In the long run, these shifts will present a significant challenge for the U.S., with implications for the global economy.

Measuring Productivity

Productivity measures the relationship between output and hours worked. The more efficient economic activity becomes, the more goods and services the economy can produce. Training, technological innovation and changes in the labor force – the ratio of labor input to hours – are all factors that can boost output per hour. Increased U.S. labor productivity has played a major role in driving economic growth over the past century. Since 1947, when the U.S. government began issuing statistics on labor productivity, output growth has generally outpaced the increase in hours worked. During recessions, however, both output and hours initially fall.

productivity-change-nonfarm-business-sector

Beginning in the early 2000s, however, productivity growth started slowing down. Since 2007, productivity in the nonfarm business sector has grown by only an annual average of 1.2 percent – comparable to the sluggish productivity growth of the mid-1970s, when the U.S. experienced a recession and energy crisis. Five of the past nine quarters have seen labor productivity fall compared to the previous quarter in annual terms. Most important, these declines are the result of the growth in number of hours worked outpacing growth in output. This is a critical distinction because it means that output is still growing, but productivity is declining because workers now require more time to reach these output levels.

us-contributions-labor-productivity-growth

Why Is Productivity Declining?

There are two key reasons U.S. labor productivity is declining. The first cause is a slowdown in technological innovation and sluggish growth of capital intensity. Capital intensity is a ratio of capital services – a business’ physical assets and intellectual property assets – to hours worked. During times of heavy innovation, like the 1990s, capital intensity contributed significantly to overall labor productivity. In the 1990s, the availability of semiconductors and ability of businesses to increasingly use computers contributed to increased productivity levels.

For example, according to a study by the Organization for Economic Co-operation and Development, between 1980 and 1995, sectors producing and using information and communication technology contributed about half of the labor productivity growth in the U.S. economy. Between 1995 and 2009, these sectors contributed over two-thirds of productivity growth. Beginning in the early 2000s, however, innovation slowed down: investment in research and development and other kinds of knowledge-based capital began declining, while start-ups, as a proportion of all businesses, decreased. As a result, capital intensity’s contribution to productivity growth fell, from 1.2 percentage points (of the total 2.9 percent growth) from 1995 to 2000 to merely 0.5 percentage points from 2007 to 2015.

us-contributions-labor-productivity

The second explanation for declining productivity rates is that employees are increasingly distracted in the workplace. Email and the internet have become a basic part of work for the majority of Americans. According to a Pew Research Center poll published in 2014, 61 percent of working internet users say email is “very important” for doing their jobs, while 54 percent say the internet is very important. While email and the internet have boosted communications and access to information, over time they have also created new types of inefficiencies in the workplace.

One study, by Salary.com, found that while 64 percent of respondents in 2012 reported wasting some time at work every day, two years later 89 percent of respondents said they wasted at least half an hour every workday. Google and social media were cited as the chief distractors during the day. At the same time, these new technologies are also becoming a more integral part of employees’ workload. A study by McKinsey & Company found that, in 2012, so-called interaction workers – high-skill knowledge workers, including managers and professionals – spent 28 percent of the average workweek merely reading and answering emails.

number-hours-wasted-daily-2014

respondents-who-waste-time-every-day

Economic Impact

Declines in productivity have a direct impact on the U.S. economy, especially in the long term. An economy’s real potential GDP growth in the long run is the economy’s maximum sustainable output. Potential GDP growth depends on two variables: labor productivity and workforce size. Therefore, higher labor productivity means greater potential for economic growth in the future. In its January 2016 report, the Congressional Budget Office (CBO) projected that potential average annual GDP growth between 2016 and 2026 is 2 percent, while potential labor productivity growth is 1.4 percent per year.

For the CBO and other government agencies, these estimates are important not only because labor productivity affects GDP growth, but also because it affects tax revenues and deficits, and thus budget planning. At the same time, sluggish labor productivity and the resulting slower economic growth could also lead to stagnant or declining demand. Sluggish U.S. demand, in turn, will negatively affect American businesses and economies ranging from China to Mexico, Japan and Germany, which export large volumes of goods to the U.S. A long-term slowdown in the U.S. would also ultimately affect global financial markets.

Conclusion

Productivity can be a volatile measure of the health of an economy. It can shift with economic cycles, but there are indications that U.S. labor productivity growth is slowing down. The implications of this slowdown may not be apparent in the immediate term, but in the long run, they will be significant for both the U.S. and global economy. A revolutionary new technology or spike in innovation could reverse this trend, but evidence suggests innovation is now advancing at a more modest pace – and having a smaller impact on productivity and growth – than in previous generations. At the same time, shifts in the workplace are also posing a challenge for future productivity growth. Therefore, we will continue to track productivity, as we assess the trajectory of the U.S. economy.