Will The Miracle Last?

For the past three years, through recession, corporate scandals, terrorist attacks, and massive federal budget deficits, the U.S. has turned in one of the best productivity performances of all time. As companies used new technology and improved business practices to squeeze more output from fewer workers, nonfarm business productivity soared at a 4.5% annual rate. That unexpectedly strong showing -- double the 50-year average of 2.2% -- propelled robust profits as the economy came roaring back.

But that's all history now. Companies have begun hiring again, and the reported growth in productivity is inevitably going to slow. The current pace of hiring suggests companies will create 2.5 million to 3 million jobs over the next year. That could cause productivity growth to dip to 2% or even lower.

Such year-to-year fluctuations in productivity are normal. However, Federal Reserve Chairman Alan Greenspan and other policymakers face a tricky task: Amid all the noise, they must try to discern the economy's underlying rate of long-term productivity growth -- what economists call the "sustainable" rate. Obviously, 4.5% per year is not sustainable, but is a long-term rate of 3.5%, 2.5%, or perhaps an even slower pace?

The answer has huge implications for the economy and Fed policy. That's why BusinessWeek turned to the experts. We surveyed nine of the country's leading economists, from a Nobel laureate to one of the main skeptics of the 1990s' New Economy, looking for their best judgment about how fast the productive capabilities of the economy are growing.

The results are surprisingly upbeat. On average, the nine economists estimate the productivity growth trend to be 2.75% annually over the next few years. The outlook exceeds what most optimists thought possible just a few years ago. "The forces that have driven productivity growth since 1996 still seem to be operating," says Martin N. Baily, an economist at the Institute for International Economics and head of the Council of Economic Advisers under President Bill Clinton.


This high level of sustainable productivity growth, if true, carries major consequences for future Fed policy that go far beyond the quarter-point hike in interest rates on June 30. Higher underlying growth in productivity will help Greenspan keep to his strategy of slow and measured interest-rate hikes, since the economy can grow more quickly without igniting inflation.

What's more, sustainable productivity growth is a key indicator of the long-term health of the economy. Over the past 10 years, productivity has risen at a 2.7% rate, translating into higher incomes for most Americans and higher stock prices. If productivity continues to rise at the same rate -- as the economists expect -- the same should hold true for the future. Moreover, strong productivity growth makes it easier for society to pay for defense, Social Security, and Medicare as well as manage the federal budget deficit.

Still, productivity growth is tough to forecast, and it's no sure bet it will stay at a robust 2.5% or higher. Because productivity is driven by intangible factors such as technology and changes in work practices, the underlying trend can shift sharply, as it did upward in the mid-1990s and downward in the mid-1970s. So some economists are wary of being too confident about big gains. "I would bet on 2.5% productivity growth for the next few years," says George A. Akerlof, the 2001 winner of the Nobel prize in economics. But Akerlof warns that "the number is very uncertain since we have not had this very high productivity growth for so very long."

That's why several of the economists surveyed gave a wide range for their best and worst cases. For example, Alan B. Krueger, a Princeton University economist who was chief Labor Dept. economist under Clinton, estimated sustainable productivity growth at 2.9%, but noted that it could be as low as 1.5% or as high as 4%.

With its cyclical nature, productivity growth may slow considerably for a year or more as companies catch up on hiring. "Anyone who looks at the profits explosion should be predicting big job growth and below-trend productivity growth from now on for at least the next two years," says Northwestern University economist Robert J. Gordon. A string of bad numbers may unnerve Wall Street and pressure Greenspan to raise rates faster.

Yet Gordon, a skeptic about the New Economy in the '90s, now sees trend productivity growth at about 3.1%. Even if productivity slows to 2% over the next two years, the four-year average from 2002-2006 could be 3% a year, which is "entirely possible and pretty impressive by historical standards," says Robert Hall, a Stanford University economist who heads the National Bureau of Economic Research committee responsible for calling the beginning and end of recessions.

Among the economists surveyed, the high estimate was sustainable productivity growth of 3.3% per year from Hal R. Varian, an economist and former dean of the School of Information Management & Systems at the University of California at Berkeley. But even the lowest estimates of 2.25% to 2.3% -- from Kevin A. Hassett of the American Enterprise Institute and Dale W. Jorgenson, a renowned productivity expert at Harvard University -- show very healthy gains. By comparison, in the two decades from 1975 to 1995, productivity growth averaged only 1.5%.

Not only has technology fueled those big productivity gains in the last decade, there's every indication that info-tech advances are proceeding apace. Wal-Mart Stores Inc. (WMT), already is starting to require its big suppliers to attach miniature radio-frequency ID transmitters (RFID) to shipments. Tracking inventories by radio will boost productivity by enabling Wal-Mart to run its mammoth distribution and warehouse network with even fewer people and to trim costs by lowering inventories. Eventually, much of the retail industry is likely to follow Wal-Mart's lead, meaning such gains will spread.

Even in traditional manufacturing, similar gains continue. Parker Hannifin Corp. (PH), a $7 billion maker of hydraulic, pneumatic, and fuel equipment, has lifted productivity by reorganizing its factory floor and using technology effectively. Plant managers used to send orders for raw materials to a central purchasing department. Now, factory workers place orders directly with suppliers via touchscreen computers at their work stations.

Gains are spreading from the biggest, most advanced companies to smaller operations. "The dramatic reduction in IT prices means that small companies now have access to technology that only big companies could afford a decade ago," argues Varian. "That will lead to big productivity gains at small and medium-size enterprises in the years ahead."

No one can offer any guarantees of future productivity growth. But right now it looks like the economy can grow for the next few years with plenty of new jobs, even as inflation stays tame. Now that's a productivity miracle.

By Michael J. Mandel, with Heather Green in New York and Michael Arndt in Chicago

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