Non-farm labor productivity was down for a third straight quarter, according to Wednesday's numbers. Such consecutive drops in productivity have not been seen since 1979, the Wall Street Journal reported. In fact, this is a pattern we would normally see only during economic recessions. So, what is behind the recent weakness in productivity and should we be concerned about this key driver of income growth and living-standard improvements?
First of all, the weakness shouldn't come as a huge surprise given the sluggish pace of economic growth we've been enduring. GDP growth has averaged less than 1 percent over the past three quarters, with relative strength in personal consumption (consumer spending) more than offsetting weakness in other areas.
Private investment, which accounts for only about 17 percent of total GDP, has been the biggest drag. This category includes business investment in things like facilities, equipment, software and inventories. Companies, in the aggregate, have largely been foregoing, or at least deferring, capital investments even as they have been hiring new workers at a pretty solid pace.
The improvement in the labor market, in turn, has provided consumers with the means and willingness to spend more. In fact, the Personal Consumption component of GDP has grown at an average pace of 2.7 percent over the past three quarters – well above the average of 1 percent for the economy overall. Fortunately for us (for the time being), consumer spending, at nearly 70 percent of GDP, is a much larger component of GDP than private investment.
So, we have dodged a recessionary bullet thanks to the consumer's continued willingness to spend. But, second quarter the spending growth was fueled by raiding the cookie jar. Spending growth well outpaced income growth in the quarter, leading to a drop in the savings rate to 5.5 percent in the second quarter from 6.1 percent in the first quarter. This is quite a dramatic drop in one quarter. In any case, as long as the consumer keeps spending at a pretty good clip and offsetting the weakness in business investment, we shouldn't be at risk of recession, right? Not so fast.
What, if anything, does the recent weakness in labor productivity portend for the future pace of consumer spending and economic growth? First let's look at how productivity is measured. Productivity is simply aggregate economic output dividend by aggregate hours worked. This metric simply tracks how much the average worker contributes to the economy per hour of work.
Changes in productivity can be driven by a variety of factors. According to the web site Investopedia, growth in labor productivity "is directly attributable to fluctuations in physical capital, new technology and human capital. If labor productivity is growing, it can be traced back to growth in one of these three areas." So, growth in labor productivity would generally be associated with increases in business capital investment, improvements in technology and innovation, and improvements in education. Intuitively, this makes sense. Each of these factors should help workers produce more goods and service in the same amount of time.
Alternatively, decreases in labor productivity can be attributable to corporate America's unwillingness to invest in the things that improve worker productivity, like new facilities, equipment, software, training, and research and development. The drop in business investment we've been seeing within the private investment sector of recent quarterly GDP reports is proof that companies are not investing in productivity-enhancing initiatives.
Instead, it appears as though companies have opted to add more workers rather than investing in the productivity of the ones they already have. They have done so, in part, because the supply of labor had been abundant and cheap in the wake of the biggest recession in decades. But they have also done so because they have not seen enough demand for their products and services to justify major investment outlays.
And finally, many companies have foregone capital investments because investors have been rewarding stock buybacks, dividend increases and, in some cases, acquisitions more highly than anything else. When it's all said and done, corporate management teams do whatever makes their stock price go up.