The Labour Market, Unemployment, and Inflation

Revisiting Productivity: Its Decline Appears to Be Cyclical

LEAD STORY-DATELINE: Wall Street Journal, May 9, 2001. American workers' productivity fell in the first quarter for the first time in six years, dealing a setback to New Economy optimists. The New Economy enthusiasts tell the story of productivity this way. Following up two decades of growing at only 1.4 percent per year in the U.S., labor productivity, or output per hour, soared to a nearly three percent annual rate from 1995 through 2000. In many respects, these productivity gains sustained steady expansion, low unemployment rates, tame inflation, rising profits, and modest wage gains. Now in the midst of an economic slowdown or outright recession, however, output per hour fell at a seasonally adjusted 0.1 percent annual rate in the first quarter of 2001 from the fourth quarter of 2000. Moreover, manufacturing-productivity growth fell to a 0.3 percent annual rate in the fourth quarter of last year. These data raise new questions about the role of the New Economy in boosting productivity. The more each of us produces, the more our wages and profits can grow without prices rising. Rising productivity is a key to rising living standards. But if productivity is slowing because of a slowdown in the economy, that supports the view that much of the productivity gains were "cyclical," or temporary. If true, estimates of longterm sustainable growth rates will drop and the natural rate of unemployment or its twin, the nonaccelerating inflation rate of unemployment (NAIRU), will rise. Economists seldom speak with one voice. Robert Gordon, an economics professor at Northwestern University and New Economy skeptic, says that, "forty years of history told us productivity growth was bound to slow down when the economy slowed." The slowdown and then outright decline in productivity "reinforced that longstanding view in spades." Much of the productivity gain had come from technology manufacturers themselves; since technology production has borne the brunt of economic slowdown, this has made the deceleration all the more acute, argues Gordon. However, Martin Baily, senior fellow at the Institute for International Economics and chairperson of the Council of Economic Advisers under former President Clinton, says that he doesn't "see anything in the productivity numbers yet that's inconsistent with a productivity trend of around 2.5 percent or so." He notes that businesses have been very quick to cut hours late last year when demand slumped, which is why productivity grew a better-than-expected two percent in the fourth quarter. In the first quarter, as business recovered a bit, some companies may have overreacted and added hours again. Still, argues Baily, a return to the two percent trend rate will require continued slow job growth "or even some continued job loss." Two reactions to Baily's remarks: (1) he has lowered productivity growth expectations from three to 2.5 percent; and (2) he sees slow job growth as a way to recover productivity gains, an effect consistent with a cyclical downswing.

TALKING IT OVER AND THINKING IT THROUGH! 1. Why do employers react the way they do during an economic slowdown? 2. Why does NAIRU rise when long-run labour productivity falls? 3. What happens to the short-run Phillips curve when the labour productivity growth slows? Why? 4. If the recent productivity slowdown and decline is cyclical rather than part of the long-run evolution of a New Economy, will this complicate the making of monetary policy by the Fed and Alan Greenspan? Why or why not? 5. Why is sustained productivity growth important for U.S. economic growth?

THINKING ABOUT THE FUTURE! Has the emergence of the New Economy made the business cycle obsolete? The business cycle became a modern phenomenon after the Industrial Revolution in England. That "New Economy" required larger scale capital centralized in a factory. In turn, the economy depended more than before on a continuing expansion in real investment. When business investment slowed, so did the economy and unemployment increased. In today's "New Economy," much of the investment boom has been concentrated in new technology such as computerized systems and software. However, when business slowed and less new technology was purchased, the technology production industries bore the brunt of the economic slowdown. If anything, this New Economy may be even more vulnerable to the business cycle. Innovation is something that firms can

do without for a considerable time; thus, their first cutbacks in spending might well be on new technology. Such productivity-enhancing investment can be postponed. If it is postponed for a long time, economic growth also will suffer.

SOURCES: Ip, Greg. "Productivity Falls for First Time in 6 Years", Wall Street Journal, May 9, 2001, P. A2. "Was Turbocharged Productivity a Fluke?", Business Week, April 23, 2001, P. 44.

Fueling Inflation?
LEAD STORY-DATELINE: The Economist, March 11, 2000.

What do these time periods have in common: 1973-74, 1979-80, 1990, and 2000? Your answer is "They are all times at which there was an oil-price shock?" Is that your final answer? You are CORRECT! From March 1999 to March 2000, the price of a barrel of crude oil rose more than threefold, just as it did in 1973-74, 1979-80, and 1990. In late 1998, a barrel could be gotten for about US$10. This prompted the members of OPEC to restrict their production, and by March 2000, the price was hovering around a lofty $30 or so. In the previous three episodes, such a spike in oil prices led to increased inflation and to recession. So economists are getting worried now, right? Well, not really. Even with the jump, the real price of oil is less than half of what it was in 1981. Furthermore, there have been important changes in the structure of industrial economies over the last decade or two. These economies use oil about twice as efficiently as they did before the first oil shock. Each dollar of rich countries' real GDP in 1972 was associated with about twice the oil consumption associated with a dollar of 2000 real GDP for those countries. There are a few reasons for this change. First, it is true that the short run price elasticity for oil is rather small (it takes a big change in oil prices to have an appreciable effect on consumption in the short run), but things are different in the long run. Over time, firms replace their capital with more energy-efficient equipment, consumers buy more fuel-conscious vehicles, and buildings are made to be more miserly in their energy requirements. Also, OECD governments have decided that they would prefer their economies to be less susceptible to the whims and wiggles of Middle Eastern politics, and have invested heavily in energy-smart technology research. While economists may debate the cost-benefit wisdom of these investments, they have had an effect on industrial economies' energy intensity. In 1973, a tripling of the price of oil from $10/bbl to $30/bbl raised rich countries' import bill by over 2% of GDP; such an increase has less than half the effect now. Finally, economists note that the previous three oil shocks took place when inflation was already on the rise. This is not the case now - The Economist's non-oil commodity price index has increased by less than 5% from March 1999 to March 2000. Compare that to 1973, when the index increased by 70%. More importantly, inflationary expectations have largely been wrung out of industrialized economies compared with 1973. These lower inflationary expectations that may be the most important factor mitigating the macroeconomic effects of higher oil prices. We will use the AS/AD framework and the Phillips Curve concept to help understand the economic impacts of the recent increase in the price of oil, and how this case might compare to the previous three oil shocks.

TALKING IT OVER AND THINKING IT THROUGH! 1. What is the effect on the AS curve of an upward spike in oil prices? What effect would this have the equilibrium price level? 2. What would be the effect on the labour supply curve of an increase in the expected rate of inflation? On the equilibrium nominal wage? 3. Based on your answer to question 2, what effect would an increase in the expected rate of inflation have on the AS curve? 4. Does higher expected inflation increase or decrease the impact of an upward spike in oil prices? 5. Suppose that there is an increase in the expected rate of inflation, and that fiscal and monetary policy were to be designed to minimize the effects on output and unemployment levels. Would the AD curve then have to shift right more or less in order to maintain output at a given level following an upward spike in the price of oil? 6. What effect does an increase in expected inflation have on the actual inflation rate associated with maintaining output and unemployment levels in the aftermath of a negative oil price shock? 7. Based on your answers to questions 1-6, what is the effect on the Phillips Curve of a simultaneous increase in oil prices and in expected inflation? 8. Would the Phillips Curve for a more energy-efficient economy be more or less affected by a simultaneous rise in oil prices and expected inflation? Why?

THINKING ABOUT THE FUTURE! In late March 2000, OPEC responded to U.S. diplomatic pressure and decided to increase production by 1.7 million bbls/day. Another factor in OPEC's decision was the possible effect of high oil prices on the

Asian economies just beginning to recover from the currency crises of the last few years. OPEC did not want to see demand for their product dry up because high prices had put fragile economies back into recession. The effect of the production increase was nearly immediate, with the price dropping from about $34/bbl on March 7th to about $23/bbl in mid-April. This is good news for American drivers looking forward to summer vacations and the tourist industries they love. But it is bad news for OPEC, who hasn't seen the real price of oil ever return to its 1979-80 high. The whole episode does not bode well for OPEC's future power in raising the price of oil and making it stick.

SOURCES: "Fueling Inflation?", The Economist, March 11, 2000, p.77.