Starting the year out at a snail’s pace has become something of an annual ritual for the American economy. True to form, GDP shrank by 0.7 percent in the first quarter of this year on an annualized basis, a revision down from the initial report of a 0.2 percent gain. The U.S. will return to growth later this year, but the economy’s weakness over the past couple years suggests pathetic interludes like the first quarter will keep occurring. The likely culprit for this stagnation: slowing productivity growth.
“Productivity gains are the wellspring of higher living standards,” Princeton economist Alan Blinder wrote recently, “and the well has been running pretty dry lately.” Productivity actually contracted in the fourth quarter of last year and the first quarter of this year, a back-to-back decline that’s occurred only two other times in the past quarter century. This doesn’t just mean weak GDP numbers, it also means weak gains for American workers: Between 1991 and 2012, real wages grew on average by a paltry 1 percent a year.
What explains the productivity swoon? Economist Robert Gordon has suggested that the impact of technological innovation on economic growth is declining. Tyler Cowen believes we may have plucked all of the economy’s low-hanging fruit, while the gains from automation accrue to a select few. Or perhaps a loss of entrepreneurial dynamism is to blame, say John Haltiwanger and others.
But a new report by the International Monetary Fund (IMF) drills down into this question on a state-by-state level, and concludes that the experts are all wrong.
The real source of America’s productivity problem, the authors find, is with our lack of technical efficiency — that is, our ability to combine labor and capital to fuel output.
The IMF finds that growth in America’s total factor productivity (TFP), a measure of the economy’s output not explained by capital and labor inputs, has indeed dropped in half since 2005. This decline began well before the Great Recession, making the downtown an unlikely cause, and came on the heels of steady productivity growth from 1996 to 2004.
The real source of America’s productivity problem, the authors find, is with our lack of technical efficiency — that is, our ability to combine labor and capital to fuel output. Efficiency is a product of America’s institutional, regulatory, and legal environments.
The slowdown in productivity growth from the mid 2000s, the report says, has been due to declining educational performance and reduced spending on research and development (R&D) rather than slowing technological progress. In fact, technological innovation appears to be as robust as ever.
The productivity drop-off is happening across American states, but clearly in some more than others. New Mexico and South Dakota saw their rates of TFP growth decline by over 3 percentage points in 2005 to 2010 compared with what they were in 1996 to 2004, while Washington State saw growth drop by just a third of a percentage point.
The variation in the efficiency of investments between states is surprisingly large. In New Mexico, investing $100 in capital and labor would yield a $5 return over five years. That same hundred dollars invested in Oregon would yield a $25 return. The latter state, in other words, is far better at combining innovation with its labor and capital. It is for this reason alone that Oregon has dramatically better performance in productivity than New Mexico.
What does Oregon have that New Mexico doesn’t? Their differences in productivity cannot be explained by their tech communities, both of which are vibrant. New Mexico’s Los Alamos and Oregon’s Silicon Forest are the envy of other states. Whether or not a state is using or producing lots of information technology appears to have little effect on the variation in TFP.
Instead, the most inefficient states in America were found to have lower rates of educational attainment; less spending on R&D, particularly by the private sector; and a smaller financial sector (though the IMF doesn’t dwell much on this conclusion).
#related#Incredibly, if all the below-average states had simply became average in 2010, America would today be enjoying an extra $400 billion in additional consumption, investments, and exports. That’s over $1,000 for every man, woman, and child.
Greater human capital, which the authors measure by the number of years spent in school, has a sizeable effect on boosting efficiency in states. Spending more on R&D also raises efficiency while aiding technological progress. Michigan, for instance, has the highest share of business investment in R&D in the country (4.2 percent of GDP), perhaps thanks to its auto industry. Washington, D.C., and Massachusetts are at the top of the national league in education, while Mississippi and West Virginia fall far behind.
The IMF is not alone in concluding that education and investment are key. Economist Andrew Smithers has warned of a long-term decline in education improvements and investment as a share of GDP, while the Aspen Institute and the Manufacturers Alliance for Productivity and Innovation recently pointed to a sizeable lag in capital investment in recent years.
The solution to America’s productivity slowdown should be obvious to policymakers: improve education and build a business environment that encourages more investment in innovation and knowledge creation. Neither approach should be the job of the state alone, particularly when it comes to R&D. These investments will become more valuable thanks to the private sector’s technology-induced growth, not less.
Why does all this matter? Total factor productivity is the secret to boosting living standards. Jumpstarting it will go a long way toward mending the stagnant wages that have afflicted the middle class in recent decades, complementing a tremendous rise in technology-fueled lifestyles. Greater productivity growth becomes even more important as rich countries face the challenge of maintaining growth with an aging population.
The ingredients of growth may not be quite as weak as the usual numbers suggest. After all, we happen to live in a time when the digital technologies are dramatically improving our well-being, even as they barely register as a blip on official statistics. That should be all the more reason to capitalize on the progress we’re making.
Investing in people and big ideas will actually become more helpful in boosting America’s productivity and living standards in a growing digital economy. Technology is not the source of our troubles — it’s the solution.
— Michael Hendrix is director of emerging issues and research at the U.S. Chamber of Commerce Foundation. The views expressed here are his own.