Is the US Economy Operating Above Its Capacity?

01/17/2022 12:00am

Many economists, including me, have been attributing the high inflation of the last year to problems associated with reopening from the pandemic. According to this view, price increases in many areas will slow soon, and in some cases, like new and used cars, be largely reversed. In this view, the problem with inflation is temporary and will be resolved without major policy changes in the not distant future.

However, there is an alternative view, pushed by economists like Larry Summers and Jason Furman, that the stimulus provided by the American Recovery Act, and the prior CARES Acts passed in 2020, provided too large a boost to the economy. They pushed the economy beyond its ability to produce goods and services. In this view, the inflation problem is not temporary; we are likely to see continuing problems with inflation unless the Fed takes steps to clamp down on demand and slow the economy.

The basic logic of this argument is that GDP in the last quarter of 2021 will be well above the level of output in the fourth quarter in 2019 (the last pre-pandemic quarter), even though employment is still well below the 2019 level. Since we also saw a drop in investment, the capital stock will be below its trend growth path. This should mean that productivity should be lower than its pre-pandemic trend path. And, the pandemic has raised costs in many areas, putting further pressure on prices.

I will make three points as to why I don’t view these arguments as compelling:

  • The drop in hours worked is less than the drop in employment, due to the lengthening of average workweeks. This means that total hours are not far below the level in the fourth quarter of 2019.
  • The drop in investment was actually small compared to prior recessions, with structure investment seeing the largest falloff. Furthermore, the relationship between investment and near-term productivity growth is very weak in any case.
  • There is an easily identifiable source of substantial productivity gains – less business travel – which could have increased productivity over this period by more than 0.5 percentage points.

The Drop in Hours and the Drop in Employment

Taking these in turn, it is important to recognize that there has been a substantial increase in the length of the average workweek from before the pandemic. This presumably reflects the decision by employers who can’t hire more workers to have their existing workforce put in more hours. The length of the average workweek was 34.3 hours in the fourth quarter of 2019. It was 34.7 hours in the fourth quarter of last year.

While the drop in employment between the fourth quarter of 2019 and the fourth quarter of 2021 was almost 2.0 percent, the drop in hours using the Bureau of Labor Statistics index of aggregate hours was less than 0.7 percent.

Furthermore, the payroll data misses a substantial increase in the number of people reporting that they are self-employed. This figure was almost 400,000 higher (combining incorporated and non-incorporated self-employed) in the fourth quarter of 2021 than the fourth quarter of 2019. If we assume the self-employed put in the same number of hours on average as payroll employees, this reduces the drop in total hours over these two years to just 0.4 percent.

If we assume that fourth-quarter GDP growth will be 5.0 percent (the latest projection from the Atlanta Fed’s GDPNOW model), then GDP will be 2.7 percent higher in the fourth quarter of 2021 than in 2019. If we add in the 0.4 percent decline in hours over these two periods, that implies productivity growth of 3.1 percent over the last two years, 1.6 percent annually. That is somewhat higher than the 1.0 percent average since the end of the Great Recession, but almost exactly in line with the 1.5 percent average productivity growth in the three years before the pandemic hit.

This means that we don’t need to postulate any extraordinary uptick in productivity growth to say that the economy is still operating within its potential, if it was at its potential in the fourth quarter of 2019. Of course, it is possible that even in the fourth quarter of 2019 the economy was still somewhat below its potential. While the unemployment rate was very low, the prime-age employment to population ratio was still below prior peaks. And, there was no evidence of accelerating inflation at the time. If there was still some slack in the economy at the end of 2019, there is less reason to believe that we are operating above the economy’s potential level of output now.

Investment and Productivity

Clearly, there is some link between investment and productivity growth, but it is not a strong one and certainly not an immediate one. In the 2001 recession, non-residential investment fell by 2.2 percent from its 2000 level. It fell further in 2002 so that it was 8.9 percent below its 2000 level. Even in 2003, it was still 6.6 below its 2000 level.

Nonetheless, productivity growth soared in these years. It averaged 3.8 percent between 2000 and 2003. It is almost certainly true that productivity growth would have been even quicker without the falloff in investment, but even this large drop did not prevent rapid increases in productivity.

By comparison, investment was 5.3 percent below its 2019 level in 2020. It’s on a path to be more than 2.0 percent above its 2019 level in 2021. It seems unlikely that the relatively modest drop in investment in 2020 coupled with the still below trend path level in 2021 would have a major impact on productivity this year.

The Wonders of the Internet and Productivity Growth

The pandemic has forced companies to change the way they do business. One change has been that there is far less business travel. The money spent on business travel in the United States fell from $291 billion in 2019 to $131 billion in 2020, and then rebounded slightly to $157 billion in 2021.   

Business travel is in effect an expense of doing business, like the steel used to construct an office building or the energy used to power a factory. If companies can produce the same output, with less business travel, it is effectively an increase in productivity, just as if they needed less steel to put up a building or less energy to operate their factories.

While it may be the case that businesses are actually less productive as a result of the decline in business travel, it is reasonable to believe that this is not the case. As it stands, we are producing a slightly higher level of GDP with much less business travel. (It’s possible there will be some long-term effect, where we see smaller productivity gains in future years because of less person-to-person contact, but we’ll have to hold off in assessing that one.)

Anyhow, it might go against our economist instincts to think that companies would needlessly waste money sending their employees flying around the country and the world, but it is at least possible that this is the case. If we treat the reduction in travel as eliminating waste, then we went from spending 1.5 percent of GDP on business travel to 0.8 percent of GDP in 2021, implying a gain in productivity from this pandemic induced innovation of 0.7 percentage points, equivalent to 0.4 percentage points of annual growth over the last two years. This strengthens the case that the economy is operating well within its capacity.[1]     

Are We Demanding Too Much from the Economy in 2022?

There is no doubt that we are still seeing considerable supply disruptions from both the rapid reopening and the ongoing pandemic. But these are not easily or well-addressed by cutting back demand. We will still see lots of people getting sick and missing work even if the Fed raised rates by two or three percentage points.

It will take some time to work through these issues. Also, there is clearly a large-scale reshuffling of the workforce, as many workers are taking the opportunity to leave jobs they don’t like for better ones. This is disruptive to the economy, but a big positive for workers who have this freedom. We will likely see job churn settle down to more normal levels, as the same workers are not likely to continue to quit jobs every few weeks, and employers become more effective in providing incentives to retain workers. Also, some bad employers will simply go out of business.

Anyhow, there is little reason to believe that, if we can get the pandemic under control, the supply problems we are now seeing (along with pretty much every other wealthy country) will not dissipate over the course of the year. And, with prices stabilizing or reversing in many areas, workers will have seen substantial wage gains since the start of the pandemic.  

[1] To make this an apples-to-apples comparison, we would need to factor in the increased expenses companies incurred from using Zoom and similar services. I’m too lazy to try to do that, but I’m pretty confident that the additional spending would not come close to the savings from reduced business travel. 

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