Inflation and the Productivity Decline

Abstract

During the past fifteen years, the United States has experienced a dramatic decline in productivity growth. In the two decades before the mid-1960's, real output per hour of labor input in the private nonfarm sector grew at an average rate of 2-1/2 percent a year, fueling a dramatic rise in both the amount of goods and services produced and the average real wage of American workers. Since then, productivity performance has been much poorer, falling to about 2 percent per year between 1965 and 1973, and then to less than two-thirds of a percent per year between 1973 and 1979. Recent experience is particularly discouraging: current estimates indicate that productivity in the private nonfarm sector is still lower than it was in 1977. While the productivity slowdown has rekindled interest in the sources of growth, none of the new research has yielded a satisfactory solution to the Great Productivity Mystery. Most growth accounting studies have indicated that less than half of the observed slowdown in the growth of output per unit of labor input can be explained by the capital intensity of production, the education and experience of workers, increased regulation, and the age of the capital stock. Some researchers claim that the increase in energy prices (and the resulting reduction in energy input) is responsible for much of the decline, but their case is far from proven. Little attention has been paid to the close correlation between slower productivity growth in the United States and the other major economic development since World War II: the shift from price stability before the mid-1960's to persistent inflation since then. The timing of reductions in productivity growth strongly suggest that the productivity slowdown is related to the inflationary process. Labor productivity started increasing more slowly in the mid1960's, just as the current inflationary spiral began to gain momentum. In the 1970's, as inflation increased, productivity performance deteriorated even further. The negative correlation between inflation and productivity growth is particularly striking when the cumulative deviation of the price level from its pre-1965 trend is compared to the cumulative deviation of productivity from its trend over the same period, as in Figure 1. Abstracting from cyclical wiggles in productivity, the increases in the inflation rate closely track the reductions in productivity growth that the economy has experienced. Over the past fifteen years, each increase of one percentage point in the annual inflation rate has been accompanied by a reduction in labor productivity growth of about one-fourth of a percentage point per year. A number of sound theoretical reasons suggest that this correlation is more than a statistical accident, and that inflation has been a major cause of the recent productivity slowdown. First, by increasing the variance of relative prices, inflation may have reduced the ability of the price system to transmit information and cut into real efficiency gains. Second, inflation may have created a downward bias in the measurement of real output, producing a fictitious reduction in productivity growth. Third, energy price increases may have generated significant reductions in productivity growth, either by causing a shift toward more labor-intensive means of production or by altering the environment in which technical progress takes place. Fourth, inflation has eroded tax deductions for depreciation and raised the rental price of capital services, which may have retarded the growth of capital per worker. In addition to these possibilities, which have causation running from higher inflation to lower productivity growth, the correlation between productivity and the price level may have been *Federal Reserve Board of Governors. The views expressed in this paper are my own, and do not necessarily represent those of the Board of Governors or the staff of the Federal Reserve System. A bibliography for this article is available from the author on request.

Cite this work

No public copy is stored for this record, so only the metadata is cited.

Stored only when both papers are in the corpus — 39 citations exist upstream.