Productivity Takes the Wheel, Driving Economic Growth

We all recognize the difference between productivity and inactivity. For the purposes of this column, I want to define productivity from an economist's point of view. Productivity is the value of business output produced per unit of an input, for example, per an hour of labor. An increase in labor productivity means that more can be produced for a given amount of labor. In other words, the labor cost per unit of output is lower, which either increases profit margins, enables the output to be sold more cheaply, allows an increase in wages paid to workers without an increase in price or reduction in profit, or some combination of the three.

Since the mid-1990s, labor productivity in the United States has grown at an annualized rate of 3 percent, more than double the 1.4 percent pace of the previous 20 years. The shift to a higher level of labor productivity growth has helped to pull inflation down to a 40-year low. The sharp pickup in productivity gains over the past year also explains why the economy grew 4 percent last year, while payroll employment was flat. Productivity gains accelerated to a 9.3 percent annualized rate during the third quarter of last year—the best since 1984—and the nation's gross domestic product (GDP) growth jumped to an annualized 8.2 percent rate. Productivity gains in 2004 should return to the 3 percent trend of the past decade, enabling the economy to grow faster, labor income to increase, and price inflation and long-term interest rates to remain low.

Falling Unit Labor Costs Pull Inflation Down

The United States also enjoyed strong productivity growth after World War II. Between 1956 and 1976, labor productivity grew at an annualized rate of 2.6 percent. But then productivity growth slowed after the mid-1970s. While the reasons for the slower growth are still debated, rising regulatory costs and constraints were one reason. Another was the entry of young Baby Boom workers—young workers are traditionally less skilled and can reduce average output measures—into the labor force. A third was the continuing decline in the share of workers employed in manufacturing. The return this past decade to 3 percent annualized productivity gains can be linked to technological gains attributable to declining computer costs, better technology integration and the use of the Internet for business and consumer transactions.

The output gains have caused unit labor costs to fall for the past two years, the longest stretch of declining unit costs in more than 40 years, as shown in Exhibit 1. Unit labor costs are strongly related to inflation in the "core" components of the Consumer Price Index (CPI), that is, after netting out the two most volatile components, food and energy. The drop in unit labor costs continues to exert downward pressure on the core of the CPI and is an important reason why the core of the CPI was up only 1.1 percent during 2003, the lowest annual inflation figure since 1966.

Exhibit: 1 Productivity Surge Reduces Unit Labor Cost, Inflation

Productivity Gains in the Housing and Mortgage Industries

Labor productivity has also increased in the housing and mortgage industries over time as new materials and technologies have been developed. For example, there have been a number of innovations in home construction, including the introduction of new mechanized tools and greater use of prefabricated components. Nonetheless, studies of productivity growth in home building generally show that gains have been muted and far less significant than what has occurred in the overall economy. Home building is less capital intensive than manufacturing, for example, which limits the productivity gains from new technologies. Additional regulatory and zoning requirements may have limited the productivity gains, too.

The mortgage industry has gained from the development of automated underwriting, servicing, and valuation systems. These developments have significantly reduced the cost of obtaining a new loan and increased the speed and capacity of the housing finance system to respond to families' credit needs. Exhibit 2 shows the increase in mortgage origination volumes since 1975. The mortgage industry processed three times the number of originations in 2003 than in 1986, the year of the first modern-day refinance boom. The industry didn't have the processing bottlenecks or the spike in relative mortgage interest rates (that is, relative to 10-year Treasury yields) that occurred during 1986, a testament to the importance of technology in enabling the mortgage finance system to respond appropriately to consumers' credit needs.

Exhibit: 2 Productivity Gains From Technology Enabled Record Mortgage Originations Volume In 2003

As a measure of labor productivity in the mortgage market, one can look at the "output-per-labor" of the secondary mortgage market as an indicator. One measure of "output-per-labor" is the real (i.e., inflation adjusted) dollar volume of the serviced mortgage portfolio per employee at Freddie Mac. Over the 20-year period from the end of 1982 (the first full calendar year of the Freddie Mac Guarantor security) to the end of 2002, this measure grew by 1.8 percent per year—similar to the 2.1 percent annualized growth in non-farm business productivity over this period. The gains in labor productivity in the mortgage industry translate into greatly reduced costs for mortgage borrowers, just as declines in per-unit labor costs means lower consumer price inflation in the overall economy.