Raising the Speed Limit

At Project Syndicate, Barry Eichengreen writes that one of the Great Depression's lessons is that slumps can be good for productivity growth:

Output expanded robustly after 1933. Between 1933 and 1937, the US economy grew by 8% a year. Between 1938 and 1941, growth averaged more than 10%.

Rapid output growth without equally rapid capital-stock or employment growth must have reflected rapid productivity growth. This is the paradox of the 1930’s. Despite being a period of chronic high unemployment, corporate bankruptcies, and continuing financial difficulties, the 1930’s recorded the fastest productivity growth of any decade in US history.

How could this be? As the economic historian Alexander Field has shown, many firms took the “down time” created by weak demand for their products to reorganize their operations. Factories that had previously used a single centralized power source installed more flexible small electric motors on the shop floor. Railways reorganized their operations to make more efficient use of both rolling stock and workers. More firms established modern personnel-management departments and in-house research labs.

There are hints of firms responding similarly now. General Motors, faced with an existential crisis, has sought to transform its business model. US airlines have used the lull in demand for their services to reorganize both their equipment and personnel, much like the railways in the 1930’s. Firms in both manufacturing and services are adopting new information technologies – today’s analog to small electric motors – to optimize supply chains and quality-management systems.

A similar argument has been made that extensive business restructuring around the time of the 2001 recession contributed to productivity growth in the following years.

Indeed, productivity growth recently has been quite strong:

(Business sector output per hour - Bureau of Labor Statistics)

Eichengreen goes on to argue that policy support is necessary:

But this positive productivity response is not guaranteed. Policymakers must encourage it. Small, innovative firms need enhanced access to credit. Firms need stronger tax incentives for R&D. Productivity growth can be boosted by public investment in infrastructure, as illustrated by the 1930’s examples of the Hoover Dam and the Tennessee Valley Authority.

Which sounds alot like the Obama administration's recent initiatives to increase small-business credit, build more infrastructure and make the R&D tax deduction permanent. While a case can be made for the first two as short-run stimulus, the benefits of the research and development tax credit are almost entirely of the long run variety.

In the long run, higher productivity is good news: it means more output per worker and, therefore, higher average wages. However, it also means less employment is needed for any given level of output, which means the increase in unemployment during the recession was than the decline in output would normally imply (see this previous post).

By increasing potential output, ceteris paribus, productivity growth increases the distance between actual economic activity and the economy's capacity sometimes known as the "output gap." This suggests that even stronger demand growth is necessary to close the gap.

The resurgence of productivity growth in the mid-1990's is one of the factors that allowed the Fed to keep interest rates low and allow unemployment to fall to 4% without igniting inflation (whatever else we say about Alan Greenspan now, he deserves credit for recognizing this early on). If Eichengreen is correct, the "productivity boom-in-waiting" will raise the economy's speed limit, and this is one more reason for the Fed to step on it.