Looming Challenges Make US Productivity Growth an Imperative

“Labor productivity growth has been the engine of US economic power and prosperity since World War II, adding 2.2 percent annually to economic growth and contributing mightily to a 1.7 percent annual gain in real incomes,” said a recent report by the Mckinsey Global Institute, “Rekindling US productivity for a new era.” But since 2005, “US labor productivity has grown at a lackluster 1.4 percent. At the same time, real wages have slowed and workforce participation has declined.” Most OECD countries have seen similar declines in labor productivity growth over the past 15 years.

Regaining the historical 2.2 percent annual productivity growth rate would add $10 trillion to US GDP between now and 2030, — the equivalent of $15,000 per household, the report added. “Workforce shortages, debt, inflation, and the cost of the energy transition are powerful headwinds. All will be easier to confront with higher productivity.”

Rising labor productivity has not translated into broad increases in income over the past four decades. Between 1948 and 1970, productivity growth averaged 2.8% annually while incomes grew in lock-step at 3.0%. But then came the so-called great divergence, when real compensation lagged productivity growth.

To illustrate how annual income growth has been falling behind average annual productivity growth between 1971 and 2019, the report lists productivity vs income for four different time periods in that time span:

• 1971-1988 — productivity 1.8%, income 1.1%;
• 1989-1994 — productivity 1.5%, income 0.3%;
• 1995-2004 — productivity 3.0%, income 1.9%; and
• 2005-2019 — productivity 1.4%, income 0.7%.

“Worse, not everyone has shared equally in the relatively low gains in income, and labor participation rates have fallen from 67 percent in the 1990s to 63 percent in 2019, as millions have become discouraged about work.”

In other words, while the U.S. has witnessed major technological innovations and higher productivity gains over the past several decades, the median wages of workers have barely changed, with most of the wage benefits of higher productivity going to high earners. Other advanced economies have experienced similar economic, technological and global forces but their workers have fared much better.

Let me summarize some of the report’s key findings.

Averages obscure important variation across sectors, firms, and cities

In the 1990s, the internet was supposed to usher a much more open, decentralized, democratic economy and society. But, as we well know, it did’t quite work out as expected. Instead, the internet ushered the rise of superstar firms, sectors and cities. Companies with innovative business models were able to reach customers anywhere, anytime. Vertically integrated firms became virtual enterprises, increasingly relying on supply chain partners for many of the functions once done in-house. A small number of companies have become category kings dominating the rest of their competitors in their particular sectors and markets.

In addition, the demands for high-skill jobs significantly expanded, with the earnings of the college educated workers needed to fill such jobs rising steadily. Talent became the linchpin asset of the knowledge economy, making capital highly dependent on high-skill experts to navigate our increasingly complex business environment.

“Sectors with the highest and fastest-growing productivity have often been powered by a combination of advances in digital technology and an advantageous place in global industries,” said the McKinsey report. “In a 2015 study, we observed a 70 percent correlation between sectors’ productivity growth and their level of digitization over the previous 30 years.”

According to the report the leading productivity sectors include information, at 5.5% CGR productivity growth; finance and insurance — 1.5%; wholesale trade — 2.1%; and mining — 2.9%. However, it adds that as a result of their high productivity, leading sectors supply a disproportionately small number of jobs. While accounting for 24.5% of economic output in 2019, leading sectors only accounted for 14.5% of working hours. On the other hand, lagging sectors with low and slowing productivity, including healthcare and social assistance, transportation and warehousing, construction, and accommodation and food services account for 23.7% of economic output and a significantly higher 36.7% of working hours.

The most productive firms in every sector have continued to outpace the rest. “In fact, the gap between the most and least productive is wider within sectors than in any other dimension we studied.” For example, leading manufacturing firms operate at 5.4 times more productivity than laggard firms. In particular, leading semiconductor manufacturers are 38 times more productive than the least-productive.

Leading firms tend to be larger. They “invest 2.6 times more in technology and other intangibles such as research and intellectual property, and attract and invest in more skilled talent.” As a result, the gap between leading and laggard firms has grown over the past 30 years. In manufacturing, for example, the gap was 25 percent wider in 2019 than it was in 1989. Industry dynamism has also fallen, with the rate of new firm formations declining 29% from 1989 to 2019.

In the 1990s, some even predicted that the internet would lead to the decline of cities. People could now work and shop from home; be in touch with their friends over e-mail, video calls, and text messaging; and get access to all kinds of information and entertainment online. Why would anyone choose to live in a crowded, expensive, crime-prone urban area when they could lead a more relaxing, affordable life in an outer suburb or small town?

But, as has been the case over the past few decades, cities and metropolitan areas are “the engine of US productivity, bringing together ecosystems of firms and talent to create self-reinforcing agglomeration effects. … When firms set up shop near each other, they can benefit from pools of skilled talent, shared expertise, and local ecosystems of suppliers and customers. Urban inventors who are nearer to their competitors or peers produce more patents, and the flow of knowledge among different fields facilitates innovation based on atypical knowledge combinations.”

A number of leading coastal cities, — e.g., San Jose, San Francisco, Seattle, Houston, San Diego, Los Angeles, New York, and Boston, — have particularly benefited from these urban effects, jumping ahead of other US areas. “But being a city is no guarantee of growth; some cities have lost ground as they failed to spark agglomeration effects or find renewal as once-productive sectors shrank. Even among the 40 fastest-growing metropolitan areas, several historically vibrant cities (Chicago, Detroit, Orlando) have seen flat or negative productivity growth since 2005.”

Looming challenges make productivity growth an imperative

“Capturing the $10 trillion opportunity by returning US productivity to its long-term trend of 2.2 percent annual growth will require addressing existing challenges,” notes McKinsey. “All will be easier to confront with higher productivity.” Let me mention some of these challenges.

• Workforce shortages — “Skilled-worker shortages remain a significant constraint on productivity growth across the spectrum of sectors and firms, especially as technology investment grows.”
• Lagging investments. “Understanding the factors constraining investment is important since too little investment may dampen long-term productivity growth.”
• Energy transition trade-offs. “As firms now embark on the transition to net-zero emissions, the rising cost of energy could turn into a headwind for productivity.”
• Technology benefits aren’t broadly shared. “A colossal opportunity awaits if the country can collect the benefits of today’s technologies (never mind what’s to come) and ensure that its dividends are spread economy-wide.”

“Returning labor productivity growth to its historical level is among the most important challenges facing the US economy,” said the McKinsey report in conclusion. “Success will deliver not only greater prosperity, but also help finance the net-zero transition, bring workers back to the job even as the population ages, and put the brakes on rising inequality. Fortunately, the wellspring of American innovation remains strong even if unevenly distributed. By taking action on several fronts, business leaders and policy makers can accelerate productivity and create a more sustainable and inclusive economy in the new era.”

Comments

[Ken Halbrecht]

One of the points in this article was covered on 60 minutes a week ago: The dramatic consolidation of Suppliers to the DOD has resulted in massive increases in costs of systems and lack of innovation.