Poor Productivity Is an Overlooked Source of Inflation

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By Edward J. Perkin, CFAChief Investment Officer, Eaton Vance Equity

Boston - U.S. labor productivity hasn't been this dismal since the Cold War started and the Marshall Plan was proposed to restore the economic infrastructure of postwar Europe.

US Labor Productivity Output Per Hour, Nonfarm Business Sector Quarter-on-Quarter


Source: Bloomberg as of 8/5/2022.

Milton Friedman's enduring yet crude definition of inflation: "too much money chasing too few goods," seems as relevant as ever. Nonfarm business employee output per hour slumped for a second-consecutive quarter, the steepest decline since the Labor Department began tracking it in 1948.1

If Friedman's famous words are true, poor productivity is inflationary. In other words, we have a supply-side problem.

There are many factors contributing to this downturn.

There was a dramatic mix shift in the labor force as the pandemic unfurled. Low-skilled service workers were the first to be laid off, so productivity initially spiked. As those workers returned to the workforce, the trend reversed.

Supply-chain disruptions, early retirement of highly experienced and more productive workers, and remote working, may also explain the dramatic drop. A shrinking economy, surging labor costs, and a tight job market, may also be at play.

Labor costs are the biggest expense for many businesses, leading them to upgrade equipment and rely on new technology to boost productivity and tame the inflationary impact of higher wages.

How to Solve Supply-Side Challenges

The Fed is using an extremely blunt instrument in its effort to solve a highly nuanced inflation problem. History tells us that supply-side challenges are best addressed by lowering corporate and marginal tax rates and reducing excessive regulation. It remains unclear how the Fed raising the cost of capital on new investment helps solve our productivity woes. Arguably, it pushes in the opposite direction. That said, I do think productivity will improve, which is one of the reasons I believe that inflation rates have peaked.

There's good reason for us to uphold Friedman's wisdom on productivity and the often-counterproductive effects of government interference in the economy. A favorite story of economists highlights that insight infused with humor.

While visiting a worksite in a developing Asian country in the 1960s where a new canal was being built, Friedman was shocked to see road builders using shovels rather than tractors to move earth. He asked why there were so few machines, and a government bureaucrat explained: "You don't understand. This is a jobs program." Milton playfully quipped: "Oh, I thought you were trying to build a canal. If it's jobs you want, then you should give these workers spoons, not shovels."2

The cure for today's troubles is informed by this decades-old, beloved anecdote. A well-trained, well-educated, motivated, incentivized worker with the best tools and equipment will produce more. Fewer workers will be needed for that specific activity, and those excess workers can redeploy into other high-value areas of the economy. Per capita real GDP will expand, stimulating higher standards of living.

Bottom line: It's easy to blame the pandemic for the steepest drop in labor productivity since 1947, but boosting how much a worker can produce in a given time is no easy task. Encouraging, training, and empowering workers is an obvious solution, but it's essential to consider the link with inflation and to learn from history.

1 U.S. Bureau of Labor Statistics, "Productivity and Costs, Second Quarter 2022, Revised. Published September 1, 2022.

2 Information Resources Management Association, "Research Anthology on Measuring and Achieving Sustainable Development Goals," page 188. Published by IGI Global, December 30, 2021.