TCS Daily

The Most Important Economic News of the Year

By Arnold Kling - December 29, 2005 12:00 AM

"[P]roductivity is the best single measure of what leads to differences in economic performance. Even though GDP per capita is the all-encompassing measure, GDP per capita is determined primarily, almost entirely, by productivity. People basically work in order to have a place to sleep and something to eat and so on and so forth. The huge differences around the world are the efficiencies with which they work -- their productivity."
-- William Lewis

Politicians and pundits re-assess the state of the economy often. They look at many short-term indicators and statistics. They follow statistics, such as the unemployment rate and inflation, which come out monthly. The sickest addicts even pay attention to other data that comes out weekly. My understanding is that the President receives a daily briefing on economic data.

Personally, I find this bizarre. The way I see it, there is no rational reason to try to assess the economy more frequently than every six months. The thrill that many journalists and economists obtain from "digesting" the daily minutia of economic reports is as puzzling to me as the enjoyment people get from playing the slot machines in Las Vegas.

My favorite indicator of the state of the U.S. economy is productivity, as measured by output per hour for the nonfarm business sector. This information is compiled by the Bureau of Labor Statistics (BLS), and it only comes out four times a year.

Even though productivity data are reported quarterly, it is not wise to pay attention to quarterly fluctuations. Most of us who follow productivity try to look for long-term trends. For this essay, I took the average annual growth rate of productivity over five-year periods. Taking a five-year average tends to smooth out the quarterly fluctuations. Although many experts use more sophisticated methods for filtering out short-term fluctuations, all of these methods result in minimizing the impact of any one quarter's data. If all the President wanted were a briefing on trend productivity, he could see his economic advisers once a term rather than once a day.

The table below presents annualized productivity growth for various five-year periods, starting with the period 1955-1960 (from the fourth quarter of 1955 to the fourth quarter of 1960).

Five-year average annual productivity growth, first quarter to first quarter:


Average Productivity Growth





















What the table says is that the economy today is in great shape. The average productivity growth rate in the last five years is the highest over the past half century.

No Political Point-Scoring

What does this outstanding productivity performance say about economic policy under President Bush? Nothing. Let me repeat. Nothing. There is no political point-scoring to be made out of the news on productivity.

First of all, it is important to understand that, for the most part, productivity growth is the economy's gift to policymakers, not the other way around. It would be foolish to attribute to tax cuts that which ought to be attributed to Moore's Law.

Second, even when economic policy affects productivity growth, the effect comes with a long lag. We do not know how much of today's productivity growth reflects Clinton-era policies or Reagan-era policies or even the deregulation that began under President Carter.

Finally, one should not necessarily use these productivity figures to brag about anyone's economic policy. One could argue that our productivity growth really ought to be higher. In a column I wrote called Rationally Exuberant, I pointed out that computers are an ever larger-share of the economy. Suppose that productivity growth in the traditional economy is 1 percent per year and that productivity growth in computers is 50 percent per year. In that case, an economy that is 6 percent computers and 94 percent everything else should grow at a rate of 3.94 percent per year. If so, then perhaps from a policy perspective the question we ought to be asking is, "What are we doing wrong?"

The Great Race, Revisited

In a recent TCS interview, Robert Fogel suggested that productivity growth of 2 percent per year would be sufficient to ensure the soundness of Social Security. With three percent productivity growth, even Medicare may be sound.

In The Great Race, I argued that our economic future boils down to two trends. Moore's Law is raising productivity, helping to increase the size of the economy relative to government spending. On the other hand, Medicare is growing, which tends to increase government spending relative to the size of the economy.

In the 2-1/2 years since I wrote that essay, nothing has been done to slow the growth of Medicare. However, if the economy can sustain or increase its rate of productivity growth, the long-term outlook may be reasonably good. We are headed for the scenario that I called "affordable welfare state," meaning that the lavish benefits that we have promised ourselves when we get older will require relatively modest increases in tax rates. Tax revenues will be high because incomes and payrolls will be high.

The politicians have done nothing to slow the growth of entitlements. The mainstream media have totally missed the most important economic news of the early 21st century, which is the strong productivity growth. The state of the economy in 2005 is that it is performing well in spite of both the pols and the pundits.

Arnold Kling is the author of Learning Economics.



Medicare Solvency
"With three percent productivity growth, even Medicare may be sound."

It is dubious that productivity alone can save 2005 Medicare as is. There are three interacting causes:
1) Those eligible for Medicare are heavy consumers of health services (compared to other demographic age groups).
2) Life span is expanding steadily. Advances in technology are likely to accelerate this trend. By the middle of this century, being 103 years old may be considered "middle age".
3) The "Baby Boom" effect...steadily declining ratio of Medicare consumers to Medicare taxpayers.

There is a potential technology solution to the extreme healthcare costs of ageing. Medical technologies could be (will likely be) developed that essentially cure the degenerative effects of ageing. The question is…at what cost. If it cost a million dollars/year to maintain 35 year old adult health equivalency, these treatments will hardly be mass market products. Yet once regenerative treatments are proven, the political pressure for their inclusion as an "entitlement" of Medicare (A conservative Congress passed a Medicare drug benefit without financing it!) will likely succeed. This could extend the threat of Medicare insolvency indefinitely.

In the long run, there are four options for Medicare solvency:
1) Increasingly higher taxes.
2) Benefit caps and rationing.
3) Privatization...lifetime HSA accounts in conjunction with catastrophic insurance policies underwritten/regulated by HHS.
4) Some combination of the above.

Current demographics combined with ongoing medical innovation have and will continue to increase medical costs as pace far in excess of overall improvement in productivity. The "entitlement" nature of Medicare will lead to higher taxes and rationing...unless the system is fundamentally reformed (see option 3 above). And if the US adapts (move towards) the “single payer” infrastructure supported by many, higher taxes, rationing and benefits caps are guaranteed.

"Affordable welfare state" -- Perish the Thought
We are headed for the scenario that I called "affordable welfare state," meaning that the lavish benefits that we have promised ourselves when we get older will require relatively modest increases in tax rates. Tax revenues will be high because incomes and payrolls will be high.

The real issue here is how much better off we would have been without this montrous welfare state in which we have obligated ourselves to the tune of trillions of dollars of unfunded liability. I maintain that leaving the wealth in the hands of C instead of G would create even more growth and better quality health care and we would not have forfeited our choices in these matters.

Furthermore, these "modest increases" in tax rates are burdens on our children. Intergenerational taxation is morally wrong, and this applies to medicare as well as to social security.


I fail to see how productivity rising 2 to 3 % a year can overcome something increasing 5 to 15 % a
The problem is still the same. The price of medicare is increasing so rapidly that eventually medicare will over take the increase and force increases in taxes that will slow the growth in productivity.

More over this nutso administration has passed a monster entitlement, prescription drugs for seniors, that will rise just as fast if not faster than medicare.

So even if our productivity growth can sustain social security and medicare, it can not possibly sustain the appitite of presidents and congresses for more entitlements.

incomes might not be high
"Tax revenues will be high because incomes and payrolls will be high."

How can they be high when all high-incomes even now are under pressure due to globalization? Already we are seeing college students avoiding engineering and computer science because the ROI over a career's length for pursuing such majors have fallen and will continue to rapidly fall because of outsourcing.

Sure, new jobs will be created. But such rapid Schumpeterian churning of our economy will brutally collide with the reality that people can not change so quickly to new economic conditions. This is especially true when you consider that jobs will become even more specialized, not less, in order for our economy to advance as well.

Then there is the deflationary nature of rapidly increasing productivity. It, in and of itself, is not a bad thing. But it will add fuel to the fire.

Thus, I predict that average incomes will fall, not rise. The tax base WILL have to be shifted from taxing income & investment throughout the product cycle to taxing just retail consumption activities at the point-of-sale in order for any hope of having your 'affordable welfare state'. This will have to include services as well as goods.

The government could also just sell off its estimated $15 trillion in real assets it is sitting on to pay off the debt while simultaneously rescuing SS and medicare. But that has nothing to do with productivity and would only provide -- for maybe two generations -- short term relief to the entitlement problems.

productivity has nothing to do with economic policy?
I have to take issue with the assertion that recent policy choices have been irrelevant to strong productivty performance. Productivity improvements arise out of an environment conducive to capital formation and risk taking that is intimately connected to the direction of economic policy. In particular, by cutting taxes on investment returns, with the stroke of a pen the Bush administration increased the expected after tax returns to investment, reducing the cost of capital and thereby encouraging a sharp increase in real investment spending. This is the foundation of solid productivity growth and to suggest otherwise is to imply that the economic processes ultimately responsible for a rising standard of living -- which is the real payoff of productivity growth -- are totally random and exogenous, outside the realm of proper policy concern. That's just wrong.

What nonsense about productivity
By citing government statistics Kling is showing his ignorance. Not one economist in the world beleives the numbers coming from Washington today unless pa*** to do so. Thirty years ago I made a great living working forty hours a week. Now that productivity has doubled I should be working twenty hours a week! I am working fifty or more hours a week and going backwards along with 95% of Americans.

Exactly what part of the economy is more productive???
Medicine? No.
Government? No.
Law? No.
Education? No.
Services? No.

Well, that accounts for 80% of the economy!

We consume more by going into debt. Is that an increase in productivity? We've lost most of our industries and import nearly everything. Is that an increase in productivity?

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