Productivity, Baumol's Disease and the Cliff Just Ahead

Rising productivity is the foundation of increased wealth. As expenses have risen faster than productivity, the U.S. has filled the gap with borrowed money. That is increasingly unsustainable.

Those who want everything packaged into a neat ideological bundle, "liberal" or "conservative," prepare to be disappointed yet again. Today we cover a critically important topic: productivity.

Why is is important? Other than discovering vast reserves of gold/silver, or conquering such reserves at a low cost (as per the Spanish Empire, circa 1525), increasing productivity is the primary source of new wealth. Not nominal wealth, which can go up due to inflation, but real wealth measured by this simple formula: an hour of labor buys more goods and services than it did in the past.

That increase in purchasing power is the result of increasing productivity.

Correspondent Tom H. recently posed a very insightful question on productivity and wealth: productivity has been rising, but where is the gain going? The average worker's earnings have been essentially stagnant for 35 years, so it certainly isn't going into greater purchasing power for the average worker, as Tom notes. Here is a chart which illustrates the long-term uptrend in productivity and the stagnant wages.

Here is Tom's commentary:

Like many others, I've read your blog frequently over the past few years. You seem to have a knack for making sense of difficult topics, and I thought this may provide you with some food for thought:

It seems that technological developments should create greater productivity because we can do more work with less human effort. As people employ technology, they gain a higher standard of living because their higher level of production gives them more stuff to trade for the other things they need in life. The guy mining using a bulldozer usually earns more money than the guy using a shovel, and the engineer using a computer beats the one using a slide rule.

If we can produce more stuff in less time, then it appears that we could either increase our level of consumption by working the same length of time, or we could work fewer hours and maintain a similar level of consumption to the time before we had implemented the technology.

Looking back at U.S. Government statistics (Bureau of Labor Statistics), I compounded their numbers and arrived at a figure of 3.9 times more production per unit time worked in 2009 than in 1947.

If that were true, it seems that we could consume twice as much now than in 1947 while working just half the time! Instead, where most households used to have just one breadwinner, we typically have two and many of them are barely making ends meet.

So, the question follows: where did the productivity in the US go? There have been epic technological developments in the past sixty years in essentially every sector of the economy, so how come making ends meet still poses such a challenge?

Thank you, Tom, for a question that is central to our understanding of the next decade's devolution of the status quo. By happy happenstance, correspondent Don Jewett from the University of California-San Francisco (UCSF) brought my attention to a key factor in understanding the relationship between productivity and society-wide costs:Baumol's cost disease, named after economist William J. Baumol, who with William G. Bowen described a very interesting difference between goods-producing and labor-intensive work.

Baumol and Bowen noted that if productivity/wages rose by 2.2% a year and costs rose by 2%, then over time workers could buy more of everything--goods, services and government services paid for with taxes.

They also observed a critical, long-term difference between the rates of productivity growth in goods-producing industries and labor-intensive industries such as nursing and teaching. (I would also include the Armed Forces as an example.)

Goods-producing industries could achieve very high productivity growth as labor-saving automation and supply-chain efficiencies scaled up, while nursing and teaching required the same number of hours with patients or students as in years past. In other words, productivity in labor-intensive services had intrinsically lower rates of productivity increases than did goods-producing industries.

Baumol and Bowen then described the peculiar result of this: as GDP increased due to goods-producing improvements in productivity, the relative share of low-growth-productivity services would rise.

This has a direct bearing on government service costs, as the Wikipedia entry explains:

Since many public administration activities are heavily labor-intensive there is little growth in productivity over time because productivity gains come essentially from a better capital technology. As a result, growth in the GDP will generate little more resources to be spent in public sector. Thus public sector production is more dependent on taxation level than growth in the GDP.

Baumol also explained the dynamic behind higher salaries for low-productivity fields. His example was performing arts: it takes the same time to learn and play a Mozart concerto now as it did in 1790, so productivity gains will be modest. Baumol proposed that the scarcity of people willing to do the low-productivity jobs would lead to high salaries for the few who pursued such careers.

So as the U.S. GDP has doubled, tripled and quadrupled as productivity soared in scalable industries, the relative share of low-growth-productivity services such as education and healthcare rose. We as a nation used the increases in GDP to buy more of everything: more goods, more services and more government services. But services which lagged in productivity took a larger share of GDP.

This can be clearly seen in this chart of the consumer price index, 1977-2005:

Note how manufactured goods such as TVs, clothing and autos fell in price while education and healthcare soared. As for the cost increases in transportation and housing, we can look to the rising price of oil and the relatively low productivity gains in certain aspects of transport and housing for causes.

Baumol foresaw the crunch that his theory predicted: as healthcare and education took a larger share of the national income/GDP, taxes would have to rise substantially to pay for those services.

He described the social choices we faced in a seminal 1993 paper: Health care, education and the cost disease: A looming crisis for public choice. Baumol thought that increases in Federal taxes (from roughly 19% of GDP to 25% of GDP) would, if accompanied by continued productivity growth in the goods-producing sectors, allow the U.S. to afford more of everything, including goods and government services.

As far back as 1971, shortly after Baumol and Bowen's original work was published, Dr. Jewett foresaw the need for increases in educational productivity. His paper from that era, Query-Directed Lecturing as a Means of Increasing Teaching Productivity in Science Education, proposes one way to increase the effectiveness of the time teachers spent on lecturing.

A sudden spurt in productivity between 1995 and 2000--the era when the Internet created new opportunities for service productivity gains--led some economists to claim that "Baumol’s Disease" Has Been Cured. Alas, it seems that optimism was misplaced, as I will demonstrate in the following charts.

Much has happened since 1993 and Baumol's hopeful paper. One change is China, which took on much of the goods-producing industries as U.S. shed manufacturing to lower costs.

Another is that public employee wages and benefits have raced far ahead of their private-sector counterparts. While Baumol's disease predicts an overall increase in pubic-sector costs as a percentage of GDP, it doesn't explain why public employee hourly wages now exceed equivalent private-sector compensation $40/hour to $27.50/hour:Who will demand reductions in public employee benefits?

As this article documents, a public-sector worker stands to retire with a nestegg of almost $900,000, compared to a 401K-type private sector retirement of $179,000-- a mere quarter of the public-employee's retirement.

Many observers trace this not to Baumol's disease but to a fatal extrapolation of rising productivity in 1995-2000. As the stock market soared to the heavens, politicians plugged in 8% annual returns forever and granted retirement benefits based on that unrealistic basis.

Others note that public-sector unions have effectively "captured" legislatures in many states, muscling in huge leaps in benefits as their lobbying dollars have bought politicos' favors.

This burst of largesse in the 1995-2000 era is now haunting states and local governments with insolvency:

SIEPR report shows California's local pensions underfunded by $200 billion:

Nation's findings, issued by SIEPR on Thursday, follow a previous study conducted by four Stanford students who estimated that the three state employee pension plans – CalPERS, CalSTRS and the University of California Retirement System – could be underfunded to the tune of $500 billion.

The new study concludes that local governments are likely to spend about half their payroll over the next 18 years to meet unfunded pension obligations as well as other retirement and health care benefits.

Healthcare costs seem to be growing much faster than even Baumol's theory would suggest. Rather, healthcare costs seem to reflect a non-competitive cartel environment, a subject I explore in Can Health Care Reform Possibly Control Costs? Notice how fully socialist and quasi-socialist healthcare costs are rising, as per Baumol's disease, but the U.S. is skyrocketing above its socialized competitors who manage to provide superior care for half (or less) of what the U.S. spends per capita.

In classic Capitalism (as opposed to the State/Crony Capitalism which dominates the U.S. economy), competition would suppress prices, presumably under those experienced by government-operated systems. Instead, the U.S. "healthcare" system is exploding in cost: strong evidence that there is no real competition or government cost control, but rather a State-enabled cartel capitalism that is free to pass along cost increases without competitive or State constraint.

How else can you explain this chart?

courtesy of The Big Picture blog

Projections of entitlement spending--Social Security, Medicare and Medicaid-- reveal that Federal government spending will soon consume 30% of the U.S. GDP. Though I am not familiar with Baumol's work to say, I suspect he might not have had accurate demographic projections in 1993. I also suspect he did not anticipate a decade or longer of slow-no growth--the Japanese model that many expect will result from the "extend and pretend" financial and political follies which both parties are indulging in.

In other words, the rapid increase in the elderly populace as people live longer, coupled with a low-growth GDP, means the actuarial basis of Medicare and Social Security are doomed. When the actuary expects 3 workers to fund each retiree's benefits, and there are only 130 million workers (at best) and 75 million retirees-- well, it's clear that the system is unsustainable. Each worker's pay would mostly be devoted to paying retirees' Social Security and Medicare benefits--never mind the Pentagon, Department of Homeland Security and all the rest of the Federal government.

There's another tiny little problem with those projections: according to Hauser's Law, tax revenues never exceed 20% of GDP: The Revenue Limits of Tax and SpendWhether rates are high or low, evidence shows our tax system won't collect more than 20% of GDP.

"Hauser's Law," as I call this formula, reveals a kind of capacity ceiling for federal tax receipts at about 19% of GDP.

What's the origin of this limit beyond which it is impossible to extract any more revenue from tax payers? The tax base is not something that the government can kick around at will. It represents a living economic system that makes its own collective choices. In a tax code of 70,000 pages there are innumerable ways for high-income earners to seek out and use ambiguities and loopholes. The more they are incentivized to make an effort to game the system, the less the federal government will get to collect. That would explain why, as Mr. Hauser has shown, conventional methods of forecasting tax receipts from increases in future tax rates are prone to over-predict revenue.

Right now, Federal expenditures ($3.55 trillion) are almost 25% of GDP ($14.5 trillion). Roughly $1.2 trillion (9% of GDP and 37% of the budget) is borrowed. Stupendous borrowing in the past few years has driven total Federal debt to $14 trillion, roughly the same size as the nation's GDP. Despite the inability on agreeing on anything else, Americans seem to understand that this level of borrowing is unsustainable.

Given the long-term validity of Hauser's Law, the gap between 20% of GDP and 25% of GDP (and soon, 30%) can only be filled by borrowing--the very path that is clearly unsustainable.

This reliance on debt, both public and private, to "fill the shortfalls" is visible in this chart: (courtesy of The Market Ticker)

Healthcare costs were over $2.5 trillion 2009--about 18% of GDP--and steadily rising toward 20% and beyond. This is up from a few percentage points of GDP early in the postwar boom.

One factor Baumol could not have foreseen is the decreasing health of the American public:

Sadly, for both individuals and our society, more than half of Americans will have diabetes or be prediabetic by 2020 at a cost to the U.S. health care system of $3.35 trillion if current trends go on unabated.

If youy refer to the first chart of productivity and wages, you will see that wages have actually declined while benefit costs (read healthcare insurance) have been rising sharply. This suggests that while earnigns may appear flat to employees, employers have seen total compensation costs (wages plus benefits) increase dramatically.

If we combine these charts, we see that skyrocketing healthcare costs are absorbing a significant share of the nation's productivity gains.

Another factor Baumol might not have anticipated is the growing dominance of Corporate America. Correspondent David K. and I have been engaged in a fruitful exchange over corporate America's rising share of the national income (we have also been exchanging data and ideas on taxation, among other related topics).

Some of the gains in productivity are being channeled into corporate profits, which recently hit a record high of $1.66 trillion. As a share of gross domestic product (GDP), corporate profits also have been increasing, and they now represent 11.2 percent of GDP.

This breakneck pace can be partly attributed to strong productivity growth — which means companies have been able to make more with less — as well as the fact that some of the profits of American companies come from abroad.

So gains in productivity have gone to rising healthcare costs and corporate profits.There is one last piece of the puzzle of "where did the productivity gains go?"-- rising income disparity.

If you examine these charts, the conclusion is inescapable: most of the gains in income (and thus in productivity) have flowed to the top 1%, and to a lesser degree, to the top 20% (with gains increasing as you move up to the top 10%, top 5%, the top 1% and finally to the top 1/10 of 1%).

Some observers attribute this to the greater productivity increases gained by "knowledge workers" in an increasingly global economy, and this is undoubtedly a significant factor.

But we should not overlook the parallel increase in political power of the Financial Elites who are gaining ever-larger shares of the national incomes--a theme I explore in the following posts, which I encourage you to re-read:

Entitlements, Taxes, Inequality and Three-Way Class Warfare (September 20, 2010)

Perverse Incentives and Unintended Consequences (September 23, 2010)

Oversupply of Old Failed Ideas, Undersupply of New Pragmatic Ideas (July 16, 2010)

Last but not least, U.S. GDP growth rates have been falling for decades. That means the expansion of purchasing power Baumol was counting on is slipping-- and what expansion has occurred has flowed to corporate profits, Financial Elites and the healthcare cartels.

Add all this up and you get a very bleak picture of the Status Quo's chances for survival going forward. Things will change, and what many now consider "impossible" (like the housing bubble bursting, the global financial meltdown, etc. etc. etc.) will come to pass.

Next week I will focus on a variety of "impossible" solutions that most will reject as "dangerous," "radical," (insert term of fearful derision). As I have said before, as the Status Quo crumbles and devolves, our natural reactions will track Kubler-Ross's stages of grief and loss: denial, anger, blaming others, cutting a deal with God to save us, resignation and finally acceptance.

We as a society have not yet even exited denial. The sooner we do, the sooner we can move to acceptance and making the best of a difficult situation.

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