Note: Each decade begin with year”00” and end with year “09”.

The above chart reflects a fairly strong positive correlation between productivity growth and GDP growth from the fifties to the eighties but then the relationship breaks down over the last two decades. In the nineties GDP growth barely moved when productivity growth accelerated. In the last decade productivity grew the fastest of all decades while GDP grew the least. Even the eighties do not quite follow the script as GDP held up better relative to productivity. If productivity was the main driver of GDP growth one would have expected GDP growth to follow the trend line in Chart G2 below.

From the above charts it would be fair to say that the link between productivity growth and GDP growth has disconnected. If GDP followed the above projected trend line, the US economy would have been in a very healthy state with growth of over 50% for the last decade instead of a paltry 16%. This poses a major challenge to the conventional wisdom that greater worker efficiency will improve growth and prosperity for all. It is no secret that corporate profits and top income earners benefited from the relative high growth in productivity in the last decade, because just about all gains from productivity flowed to them. In other words, they have taken a bigger slice from the economic pie which is growing at an increasing slower pace. Add to this the negative growth in real income for middle class America over the past decade and ask yourself the question as to how higher productivity and lower taxes are going to rescue the United States from future stagnation and decline. If the United States does not find a way to distribute the gains and profits from increased productivity more evenly in order to strengthen demand (See Part IV of The Dominant Causes of the Credit Crisis), it is facing a future of even slower growth and possibly long term contraction.

Charts (G3 & G4) show the relationship between GDP and productivity growth (percentage) on a five year basis. The positive correlation remained strong until the first half of the seventies but then started to unravel. See the dark blue columns which highlight the anomalies.

The inconsistency of the relationship between productivity growth and GDP growth over the last four decades is clearly illustrated by the next chart.

The obvious question is why is there such a disconnect and whether other economic factors exercised a stronger influence than productivity on GDP growth over the last four decades.

There are of course a number of single economic events which may interrupt the relationship over short periods of time like the oil shock of 1973. Other factors like shifts in trade balances, budget deficits (stimulus effect), private and government fix investment, growing income, expanding credit (bringing demand forward) and low interest all had an influence on GDP growth.   None of the above factors however explains the increasing trend of disconnect between GDP and productivity. In fact, most of the above factors were favourable to growth, especially in the last decade. Although the above charts seem to indicate that productivity was an important driver of GDP growth in the fifties and sixties, it also seems to indicate that other stronger forces blunted its impact in the last three to four decades. What are these forces?

In Part VI of the “The Dominant Causes of the Credit Crisis” we referred to the various forces that were favourable to economic growth over the last three decades and to the opposing negative force of income concentration. In Part VIII of the “The Dominant Causes of the Credit Crisis”, we will show the close relationship between changes in income dispersion and GDP growth over the last 100 years.

Growth in Personal Income versus GDP growth

If we look at some of the personal income data it seems as if there is a stronger correlation between these income events and GDP than productivity and GDP. This is obvious enough because consumption expenditure growth, which makes up more than two thirds of GDP, is closely related to total income growth. Income growth will flow through to GDP but the reverse is also true – a chicken and egg situation. Chart G5 below shows the relative strong positive correlation between real family income growth and GDP growth as against the total disconnect between productivity and GDP growth in the last decade.

Changes in the Distribution of Income and Productivity versus GDP Growth

The more relevant question is how changes in the distribution of income and productivity influenced the rate of GDP and total income growth over time. Chart G6 below shows how the relative rise in median family income, calculated as a percentage of the corresponding rise in productivity (of all persons relating to nonfarm business) for each 5 year period, compare to GDP growth over the last three decades.

The above chart indicates that when the median family gets a relatively bigger slice of the fruits of growth in productivity, GDP grows faster and when their slice gets smaller or negative, GDP growth slows. This makes sense because a fairer distribution of the fruits of productivity creates bigger demand resulting in extra consumption which in turns flow through to GDP growth, additional fixed investment and larger incomes. The mechanics of this process are discussed in more detail in Part IV of “The Dominant Causes of the Credit Crisis”.

Chart G7 below shows that even where productivity and GDP growth moves in opposite directions, the relative rise or fall in family income correlates positively with the movement in GDP growth. During the 75/79 five year period, GDP growth went up sharply despite the drop in productivity growth. The relative rise in real family income seems to have buoyed the GDP growth for this period. The 00/04 five year period in turn shows a drop in GDP growth while productivity reached its highest level since the forties for a comparative five year period. This trend continued in the 05/09 five year period which is rather alarming. It implies that although workers’ output per hour is rising at a relative fast pace, the median income for employees are in serious decline. It raises the question as to where the demand will come from to consume the growing output produced by increased productivity. In response, employee entrepreneurs may react by reducing output and increase layoffs in order to optimise profits. Avoiding expansion and investment (especially more employment) may be a good strategy for individual corporates but not for the economy as a whole as the consequences of such policies would most likely result in even slower growth.

Although there may be other factors that distort the correlation between GDP and productivity growth, it seems as if the more equal distribution of the fruits (profits and/or personal income) of productivity growth had more influence on GDP growth than productivity growth by itself.

The above shows fairly conclusively that productivity growth is not the decisive factor in GDP growth (at least not anymore) and that many will look in vain to productivity growth to pull us out of the current growth quagmire. Due to mechanisation, improving technology, innovation and further layoffs, productivity can continue to improve significantly from here onwards without bolstering economic or job growth. Without a robust increase in demand, which can only come from a better sharing of the fruits brought about by increased productivity and a consequent rise in income for the middle class Americans, rising productivity will remain impotent.

Although the strong relationship between median income growth and GDP growth does not constitute conclusive proof that a more equal distribution in income will necessarily result in higher GPD growth, it’s certainly strongly supportive of such an argument. In our next article we will expand on the effect of growing income concentration on GDP growth and show how it influenced the United States over the past century.

© Copyright David Collett 2010.

Whilst every effort was made to ensure the accuracy of this article,  neither this document; nor its author, David Collett; nor any publisher of this article; offer any warranties (whether express, implied or otherwise) as to the reliability, accuracy or completeness of the information appearing in this article. Neither do any of the above parties assume any liability for the consequences of any reliance placed on opinions expressed or any other information contained in the above article, or any omissions from it. Its content is subject to change without notice. Any information offered, is intended to be general in nature and does not represent any investment or business advice of any nature whatsoever. If you choose to rely on such information you do so entirely at your own risk. Neither David Collett nor any third party involved in publishing this article, assume any responsibility or liability for the outcome of such reliance.

-- Posted Friday, 2 December 2011 | Digg This Article