For decades, the productivity of American workers seemed stuck. No matter how hard people worked, or how much was invested, productivity, except for a few years, never seemed to move much.
Recent data suggests that the American economy may be on the verge of a productivity renaissance.
That may be changing. Last year, American productivity improved by 2.7%, and gained steam in the second half with a 4% increase, according to the traditional measurement released by the Labor Department.
That is the type of productivity that the U.S. economy has not experienced since the period between 1995 and 2004, when it averaged 3%.
It is most welcome news for economists and policymakers given the implications regarding growth, employment, inflation and general living standards that weigh on fiscal and monetary policy decisions.
Economists, after all, are not given to doe-eyed optimism. But the productivity story that is emerging—especially in an alternative measurement called total factor productivity—suggests that the economy may indeed be on the verge of a productivity renaissance.
Total factor productivity captures capital investments as well as labor, and is seen by many as a better measure of productivity. A recent study by the San Francisco Federal Reserve found that total factor productivity grew by a robust 4.99% on the most recent quarter after adjusting for factors such as labor, capital, utilization and worked hours.
Absent those adjustments, TFP advanced by 2.62%, the study found. The change was much higher than the commonly used labor productivity measure that is released each quarter by the Bureau of Labor Statistics. Labor productivity growth, calculated as output per hour worked, was at 3.2% in the fourth quarter.
The San Francisco Fed uses total factor productivity, which is widely known as Solow’s Residual for the late Nobel Laureate Robert Solow. The Solow Residual is best understood as the portion of overall economic output that cannot adequately be explained by the factors of production or the accumulation of capital and labor.
The San Francisco Fed’s measure is our preferred metric of productivity as it strips away the changes in labor and capital input built into the labor productivity measure. It provides a better way to identify the impact of technology and the change in economic structure on underlying productivity.
The increase in total factor productivity, especially in back-to-back quarters, is an encouraging sign that suggests the significant investments that businesses have been making might have finally started to cause real changes.
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While it remains too early to claim that such changes are permanent, there are reasons to believe the economy is on the cusp of a boom in productivity in the next decade or so with the adoption of AI, automation, the shift in work model, and industrial policies.
If productivity continues to rise, it could be the economic tide that benefits everyone.
It is important to note that the recent innovation around artificial intelligence and quantum computing are still too early in their life cycles to have caused the recent improvement in productivity.
In addition, it is understood that some of the improvement in productivity may be a result of the rebound in the economy following the historic shocks caused by the pandemic.
But the pandemic raises another question: How much can rising productivity be attributed to people working from home?
Approximately 20% of the American labor force now works from home, according to the Bureau of Labor Statistics. One would anticipate that the recent improvement in total factor productivity would capture the impact of this recent trend.
While we have no definitive evidence of that, it is now going to be part of the economic narrative about the long-term structural changes caused by pandemic.
The policy implications are simply too important to ignore.
What is special about total factor productivity?
Total factor productivity is a measure of productivity that accounts for the changes in labor and capital. The measure is calculated based on how we model the economy using a production function that includes labor and capital as inputs.
The simple labor productivity measure, or output per hour, does not account for the changes in capital or other factors, which could be misleading.
Total factor productivity is a measure of productivity that accounts for the changes in labor and capital.
For example, when a company invests in new equipment, which would increase the total level of spending output, that investment would not necessarily increase how many products its employees could produce, yet the measure of labor productivity would increase.
By controlling for the increases in capital and labor, total factor productivity is what is left that cannot be explained by both labor and capital, hence the name Solow’s Residual. In general, total factor productivity represents the improvement in technology or shift in economic structures, which are rare yet significantly impactful when they happen.
The San Francisco Fed takes the metric one step further by introducing a utilization-adjusted version following research by Susanto Basu, John G. Fernald and Miles S. Kimball in 2006.
Their version “sought to adjust for a range of non-technological factors that affect measured total factor productivity, of which variations in the utilization margin—i.e., the intensity margin for the workweek of capital and labor effort—are only one.”
Once one starts to think about the Solow Residual and its impact on the economy, it’s difficult to think about little else.
