Originally published in The Boston Globe
Tuesday, August 14, 2001

A Most Important Number
By Martin and Kathleen Feldstein

The Commerce Department just released the most significant economic fact that we have seen in a long time. Their most widely used estimate of economic productivity for the second quarter of this year rose at a seasonally adjusted annual rate of 2.5 percent. This figure and the Department's upward revision of productivity in the first quarter mean that the economy's potential for strong growth is alive and well.

Productivity is a broad, shorthand measure that economists and government statisticians use to describe the output that an hour of labor produces. It is calculated simply by dividing the government's estimate of total output by the number of hours worked by all employees and the self employed. If output per hour worked rises, productivity is said to increase. With a growing labor force, such increases in productivity generally result from better tools and technology.

An increase in productivity is the key to a rising standard of living. When productivity rises faster, employers can afford to increase wages more rapidly without passing that expense on to consumers by increasing prices. And output per employee can continue to rise even with a gradually declining number of hours worked per week.

As the results of the 2000 census are confirming, the standard of living in the United States has increased greatly in the last decade. A major reason for that is the rise in productivity. Although the immediate impact of higher productivity is higher profits, over time the profit rate returns to its normal level and the higher productivity translates into higher wages as competition among firms for the newly more productive workers leads to higher wage offers.

Rising wages over the last three years demonstrate this process in action. Real (after adjusting for inflation) compensation per hour, including fringe benefits, has increased at a rate of more than 2.5 percent a year for the last three years. That is a dramatic improvement over the average increase of less than one percent in the first seven years of the 1990's.

And despite that increase in real wages, inflation hasn't picked up. The increased productivity of workers has meant that firms could pay higher wages without raising prices at a faster rate and without driving profitability below its historic norms.

We are optimistic that the recent productivity gains will be sustained. Important changes in the way we do business in this country are just beginning to show results. There are good reasons that productivity shifted upward sharply at the end of the 90's from its trend growth, with output per employee hour rising at twice the rate of the previous 25 years.

Information technology is the engine of today's economy. Personal computers have been in use for twenty years, but it takes time for any new technology to be widely adopted and to spread its impact on workforce effectiveness throughout the economy. Better use of PC's and improvements in communication, especially through the internet and corporate internal networks, have been the driver for the productivity miracle. Productivity has also benefitted from an overall increase in business investment that has provided more equipment and better factories and offices that enhance employee output. Innovations like ergonomically designed workspaces have made the working environment more pleasant as well as more efficient.

No one can be sure whether the productivity gains of the late 90's can continue. Productivity came to a standstill in the first quarter of this year as the economy's overall pace of economic activity slowed. Such a cyclical downturn of productivity growth is to be expected since output declines before firms reduce their number of employees. This was particularly true in the first quarter of 2001 since most firms thought that the cyclical slowdown would be quickly reversed and preferred to hold onto their existing employees rather than being forced to seek new ones a few months later in a tight labor market.

But the most recent quarterly figures support our belief that the productivity gains are real and will be sustained. The 2.5 percent estimated rise in productivity in the second quarter is the same as the average for the past five years.

Without a doubt, there will be more variation in productivity in the quarters ahead. But businesses still have a long way to go before they will have realized all the benefits of recent technological innovations. The best may be yet to come.