Unproductive Landing

Expect some bad news about US productivity in the coming quarters – and remember to ignore it. It is well known (though often forgotten) that productivity follows a consistent pattern over the business cycle. During recoveries, it rises rapidly, as firms ramp up production before adding staff; during (and just prior to) recessions, it falls (or slows down), as firms hold on to more staff than they need (presumably in anticipation of an eventual recovery). It is less well-known – because it has only happened once – how productivity behaves during “soft landings.” In principle, however, a soft landing could be even worse, productivity-wise, than a recession.

A recession involves – more or less by definition – declining employment, which reduces the denominator of the productivity ratio and moderates the decline in productivity. A soft landing probably doesn’t involve declining employment. (If it did, I wouldn’t call it a soft landing. Would you?) The ideal soft landing presumably brings firms just to the brink of the point where they would reduce employment. To adjust to weaker demand without reducing employment, firms would have to reduce the numerator (output) of the productivity ratio without substantially reducing the denominator (although they would reduce it a little by using fewer hours from current employees). Thus a soft landing might well bring us to the worst part of the productivity cycle.

Just to substantiate this point empirically, yes, productivity did fall during the 1995 soft landing. During the first 2 quarters of 1995, it fell at annualized rate of 0.9%. For the full year (Q4 to Q4), it rose at the anemic rate of 0.7%. And productivity growth also slowed during the “soft quasi-landings” of 1967 and 1986.

So whether we have a recession or a soft landing, my psychic powers are sensing some unpleasant productivity numbers in our future. Of course, my psychic powers could be wrong, mostly because we may have neither a soft landing nor a recession. We could have a “non-recessionary hard landing,” during which employment falls but the cheerleaders continue yelling “GDP is growing! GDP is growing!” and the NBER refuses to declare a recession. To my knowledge, nothing like that has ever happened in the US, but similar things have happened elsewhere, such as in Japan. Alternatively, if the Iranian nuclear crisis gets solved, the Lebanon cease-fire holds up, Iraq avoids a civil war, and the hurricane season spares oil production, we could conceivably have a “perfect landing” in which declining energy prices allow normal growth to resume quickly without prompting the Fed to slow it down again. If that happens, then we’ve already had our soft landing. (Did you notice all the complaints about second quarter productivity growth?) Or…we could have a soft landing – or even a recession – that coincides with enough technological improvement to mask the productivity effect.

None of these 3 alternative scenarios seems likely, so I’d bet with my familiar spirit on this one. Although 2nd quarter productivity may be revised upward, don’t be disappointed when the subsequent quarters’ data come out. And by the way, measuring from the peak productivity of Q2 2000, the average productivity growth rate this time around has been 2.9%. That tops the previous (widely celebrated) productivity cycle (starting from the peak in Q4 1994) by a good 40 basis points. So if Q2 2006 turns out to be a peak, it’s been a damn good cycle!