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January 1, 1992
©GONOMIG
GOMM6NTCIRY
Federal Reserve Bank of Cleveland
Unbalanced Growth and
the U.S. Productivity Slowdown
by Paul W. Bauer
X he single most important factor in
determining a nation's standard of living
in the long run is the productivity of its
resources (primarily labor and capital). If
maintained over time, even relatively
small productivity growth rates can have
large effects on living standards. For example, if productivity grew at a moderate 2.0 percent each year, the overall
standard of living would double in only
35 years.
Private business productivity, though
increasing in the postwar years, has
slowed over time (see figure 1). The
deceleration is especially easy to detect
after 1970. Obviously, productivity
growth displays a great deal of cyclical
variation, tending to rise during expansions and fall during recessions. Of
concern is the trend productivity growth
rate, which is estimated by the fitted
curve in figure 1. Its gradual arc over
the past two decades indicates a dramatic drop-off in the growth of private
business productivity.
Given its large potential impact on the
quality of life, this slower trend rate of
productivity growth in recent years is a
serious concern. Indeed, if the rate had
been only half a percent higher from
1970 to the present, GNP would have
been $600 billion more in 1991 alone—
roughly twice the current defense budget.
Understanding why the productivity
growth rate has been decreasing is crucial
in order to formulate public policy to attempt to reverse the trend. The standard
ISSN 0428-1276
explanations attribute the slowdown to
a failure of U.S. resource management.
Examples include declines in labor
quality, slower capital accumulation
(due in part to a historically low personal saving rate), expanded government regulation, a decline in the rate of
investment in public infrastructure, and
shortcomings by both private and
public managers (for example, failure
to implement new manufacturing techniques such as just-in-time inventories
at a sufficiently rapid pace). The slower
accumulation of new capital is considered particularly important, because
technological advances are often
embodied in new capital goods. In
short, these explanations argue that
some economic institutions, in either
the public or private arenas, are performing worse now than they were in
previous years.
Instead of blaming the downturn on
some institutional failure, this Economic
Commentary presents the case that at
least some of the long-run U.S. productivity growth slowdown is a natural
response to unbalanced growth. This
explanation contends that structural issues are at the root of slower productivity
growth as the economy evolves. Specifically, unbalanced growth appears to be
shifting resources from sectors in which
the productivity growth rate is higher
(such as farming and manufacturing) to
sectors in which that rate is lower (such
as services), thus driving down overall
productivity gains.
The trend rate of U.S. productivity
growth has slowed dramatically over
the past two decades, leading to a
slower improvement in our standard
of living. Although many would attribute this trend to failed resource
management, some of the slowdown
may be a natural response to unbalanced growth. In this scenario, resources are shifted from sectors with
higher productivity growth rates to
those with lower rates—such as the
rapidly expanding service sector—
thus slowing overall productivity gains.
• What Causes Growth
to Be Unbalanced?
Although the downturn in private business productivity growth over time is
clearly evident, not all sectors of the
economy have shared in the decline.
Specifically, manufacturing productivity growth has been fairly steady in the
long run despite its short-run cyclical
variability (see figure 2).1 This suggests that the problem is not economywide, but is instead related to the
changing composition of the economy.
To illustrate how unbalanced growth
can lead to an overall productivity
slowdown, consider an economy in
which there are only two sectors, a progressive one that experiences productivity growth and a stagnant one that
does not. (We can simplify this
analysis without any loss if we further
assume that labor is the only resource.)
As productivity gains accrue, workers
in the progressive sector achieve
greater output, while workers in the
stagnant sector continue to produce the
same amount of output. In such an
economy, the cost of output in the stagnant sector must rise relative to that in
the progressive sector over time.
If the demand for goods produced in the
stagnant sector falls as the prices of the
goods increase, then output and employment in the stagnant sector will recede.
Eventually, the stagnant sector will disappear and productivity growth for the
economy as a whole (now just the progressive sector) will continue unabated.
Many services that were once commonplace have followed this process. How
many milkmen have you seen lately?
FIGURE 1 PRIVATE BUSINESS PRODUCTIVITY
GROWTH, 1948-1989
Multifactor productivity3
4.3 -
4.1
1948
1958
FIGURE 2
1968
1978
1988
MANUFACTURING PRODUCTIVITY
GROWTH, 1948-1989
Multifactor productivity
5.00
4.25 -
Another outcome is possible, though.
The demand for the goods produced in
the stagnant sector might not diminish
much as the costs of the goods rise.
Moreover, if the demand for goods produced in the stagnant sector increases
as the economy grows and incomes
rise, then this demand will actually
tend to grow over time. In such a case,
an increasing share of the economy's
workers will be absorbed by the stagnant sector. As this happens, the overall
productivity growth rate of the economy will slow. As an example, compare the fate of the nearly extinct milkman to the proliferation of the pizza
delivery industry in the past several
years. Delivered pizza appears to be a
product whose demand increases with
income by an amount that is more than
enough to compensate for its relatively
higher price.
Unbalanced growth offers an intriguing
interpretation of the productivity slowdown: It is not due to U.S. institutions'
failure in areas where they used to succeed, but is instead merely a reflection of
the nation's success in achieving productivity growth in a slowly growing sector
of the economy, which has freed resources required to expand production in
the more stagnant (but faster growing)
sector. If unbalanced growth is part of the
4.00
1948
1958
1968
1978
1988
a. Natural log of the multifactor productivity index, with base year of 1982.
NOTE: Fitted curve is represented by dashed line. Shaded areas indicate recessions.
SOURCE: U.S. Department of Labor, Bureau of Labor Statistics, Office of Productivity and Technology.
explanation for the productivity slowdown, then there must be some inherently stagnant economic sectors with
price-insensitive demand for output.
Not only would productivity growth in
these sectors be slower than in others,
but employment and output prices
would increase faster than in other sectors, because of the price insensitivity
of the stagnant sectors' output.
• Evidence
It has been suggested that the most likely candidates for stagnant sectors are
services in which the labor is an end in
itself—that is, where quality is judged
directly in terms of the amount of
labor.3 In particular, government, education, retail trade, hospital services,
and entertainment are likely to have relatively stagnant productivity growth
rates. For these services, personal attention is a key component of the product,
making it difficult to substitute capital
for labor. These stagnant sectors are
similar to those cited in the late nine-
teenth century by Alfred Marshall, who
emphasized that these are areas in
which "...the improvements of machinery help us but little.,,4
Support for the unbalanced growth view
can be found by dividing the U.S. economy into two sectors, a goods-producing
sector and a service-producing sector.
Services, which include the activities
mentioned above, have historically had
a much slower rate of productivity
growth than the goods-producing sector. Multifactor productivity growth,
which is a measure of the joint productivity of labor and capital, averaged
only 1.4 percent in the service sector
from 1948 to 1987, but in the goodsproducing sector it averaged more than
2.1 percent.
Although not all services can be considered stagnant (graphics services have
clearly experienced rapid technological
progress since the introduction of computers) and not all goods can be considered progressive (the production of hand-
FIGURE 3
EMPLOYMENT SHARES, 1946-1990
level of education and training than in
the past, so that public investment in
education should expand even faster
than it has already done.
Percent of total
80
Services
••
60
• ••
Goods
40 F
• i
20
1946
1956
1
1966
....
s
r—-
1
1976
1986
NOTE: Shaded areas indicate recessions.
SOURCE: Council of Economic Advisers, Economic Report of the President. Washington, D.C.:
U.S. Government Printing Office, February 1991.
blown crystal has experienced relatively
little productivity growth), the conjecture about services' inherent poor prospects for productivity growth appears
to hold in the postwar U.S. economy.5
These examples suggest the importance
of an industry's capital-labor ratio in its
prospects for productivity growth. While
in general the service sector is less capital
intensive than the goods sector, there are
many counterexamples. Telephone services experienced rapid multifactor productivity growth (2.9 percent between
1948 and 1979) as the industry became
increasingly capital intensive. Given the
advances in computer and related technologies, it is likely that further capital deepening will continue to boost productivity
growth for this and similar services.
Further evidence of the unbalanced
growth view is that services' employment
share has increased greatly relative to
goods' employment share since the 1950s
(see figure 3), having grown to 77 percent
of the labor force in 1990 from 59 percent
in 1948. The increasing use of outsourcing in manufacturing has contributed to
the growth in service employment, but it
is not the major cause.
Finally, although not strictly comparable to the sector definitions used
above, components of the Consumer
Price Index indicate that the prices of
services have increased more rapidly
than those for commodities over this
same period: 5.3 percent versus 3.9 percent. Again, this is consistent with the
unbalanced growth explanation that the
stagnant sector's prices will increase
relatively faster than those of the proO
gressive sector.
• Conclusion and
Policy Implications
Clearly, part of the U.S. productivity
slowdown is the result of unbalanced
growth—a rapidly expanding service
sector with relatively small productivity gains combined with a slowgrowing manufacturing sector, where
productivity growth is stronger. The
relatively stagnant growth of servicesector productivity partly reflects the
fact that many services are inherently
labor intensive, making it difficult to
achieve productivity gains by substituting capital for labor.
If the prospects for technological
change in the service sector remain
limited, then the overall rate of productivity growth will continue to languish.
However, given the labor intensiveness
of many service-sector jobs, investment in human capital through education and training may help to improve
productivity. If new technology tends
to be embodied in new capital equipment in industries where physical capital is important (such as manufacturing), it is reasonable to infer that new
technology may be embodied in new
human capital in the service sector.9
The spillover benefits from investing in
education and training are probably
large enough to justify public policies
directed at promoting these activities.
In fact, there is reason to believe that
the average job today requires a higher
Also, the prospects for productivity gains
in the service sector may not be as
meager in the future as they have been in
the past. One reason for this suspicion is
that computers have yet to be fully integrated into the service sector (or into
the manufacturing sector, for that matter).
Computers are used in almost every office in America, but business practices
are only beginning to be refashioned to
utilize their capabilities fully. It took 30
years for firms to exploit the advantages
of electric over steam power in the manufacturing process by redesigning the flow
of work on the manufacturing line and by
employing a separate electric motor for
each machine rather than relying on a
single power source, as had been the case
in plants driven by steam and water
power. If the service sector follows this
pattern of development, the greatest
productivity gains from the computer
revolution remain ahead.
Because the productivity slowdown is
not economy wide (being concentrated in
the nonfarm, nonmanufacturing sectors
of the economy), there appears to be little
reason to suspect that our economic institutions are performing any worse now
than in the past. The United States continues to have the highest productivity
levels in the world. Real gross domestic
product per U.S. worker is about a third
higher than in Japan or the OECD, our
chief economic competitors.
The
higher productivity growth rates in
these nations partly reflect the fact that
it is easier to acquire advanced techniques from others than to develop
them from scratch.
However, this does not mean that the
United States can be complacent about
its current rate of productivity growth.
All feasible measures for boosting
productivity should be considered. But
there is no reason to suspect that the
profit motive is any less powerful now
than in the past, or that we as a nation
are any less clever.
•
Footnotes
1. Some researchers have argued that
productivity in manufacturing has been overestimated because manufacturing output is
overstated. (See Lawrence Mishel, "Manufacturing Numbers: How Inaccurate Statistics
Conceal U.S. Industrial Decline," Washington, D.C.: Economic Policy Institute, 1988.)
Without a detailed study, it is impossible to
determine whether these potential problems
outweigh other measurement errors, such as
product innovation omissions, that work in
the opposite direction.
2. Although the idea was most fully developed by William J. Baumol ("Macroeconomics of Unbalanced Growth: The Anatomy of
Urban Crisis," American Economic Review,
vol. 57, no. 3 [June 1967], pp. 414-26), it has a
long history. Alfred Marshall discusses why
the labor released by productivity gains in
agriculture was going to the service sector
rather than to the more technologically progressive manufacturing sector in his Principles
of Economics, first published in 1890 (London: Macmillan and Co., 1961, eighth edition).
3. See Baumol, "Macroeconomics of Unbalanced Growth."
4. Of course, machines have boosted productivity for at least some of these activities.
For example, technology has increased the
productivity of string quartets by enabling
them to produce recordings in addition to
live concerts. However, this is a one-time
boost to productivity that cannot be repeated.
Although the quality of the recordings may
improve marginally and the cost of the equipment to record the music may diminish somewhat, no similar large jump in productivity is
possible for these groups.
Federal Reserve Bank of Cleveland
Research Department
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5. In fact, the whole stone/clay/glass products sector experienced multifactor productivity growth of only 0.07 percent between 1948
and 1979. See Dale Jorgenson, Frank Gollop,
and Barbara Fraumeni, Productivity and U.S.
Economic Growth. Cambridge, Mass.: Harvard University Press, 1987.
10. For details, see PA. David, "Computer
and Dynamo: The Modern Productivity
Paradox in a Not-Too-Distant Mirror," Technology and Productivity: The Challenge for
Economic Policy. Paris: Organisation for
Economic Co-operation and Development,
1991, pp. 315-47.
6. Ibid.
11. See John W. Kendrick, "U.S. Productivity Performance in Perspective," Business
Economics, vol. 26, no. 4 (October 1991),
pp. 7-11.
7. See Patricia E. Beeson and Michael F.
Bryan, "The Emerging Service Economy,"
Federal Reserve Bank of Cleveland,
Economic Commentary, June 15, 1986.
8. Another explanation for the faster
increase in service-sector prices argues that
accelerated demand for services relative to
commodities caused the wages of service
workers to increase more rapidly than those
of manufacturing workers. Although this can
account for differential price increases of a
cyclical length, it is a less-convincing explanation of the long-run differential considered
here. For more details, see Peter Rappoport,
"Inflation in the Service Sector," Federal Reserve Bank of New York, Quarterly Review,
vol. 11, no. 4 (Winter 1986-87), pp. 35^5.
9. Investment in education is also important
because, in general, workers in the service
sector require two more years of education to
match the age-earnings profile of manufacturing workers (see Randall Eberts and Erica
Groshen, "Do the Earnings of Manufacturing
and Service Workers Grow at the Same Rate
over Their Careers?" Federal Reserve Bank
of Cleveland, Economic Review, vol. 24, no. 4
(Quarter 4 1988), pp. 2-10.
Paul W. Bauer is an economist at the Federal
Reserve Bank of Cleveland. The author
would like to thank Patricia Beeson, Michael
Bryan, Randall Eberts, and Erica Groshen
for their helpful comments. Kristin Priscak
provided valuable research assistance.
The views stated herein are those of the
author and not necessarily those of the
Federal Reserve Bank of Cleveland or of the
Board of Governors of the Federal Reserve
System.
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