If Federal Reserve policymakers were to look solely at headline labor market indicators, they might be tempted to conclude that the U.S. economy had finally reached cruising altitude. The unemployment rate has fallen from a peak of 10 percent in 2009 to 5.5 percent, within the range considered to be full employment. Nonfarm payroll growth has averaged 275,000 a month over the last year, a pace last seen in the roaring '90s.
Yet nothing else has that '90s feel: not the pace of economic growth, not capital investment, not productivity growth, not even Nasdaq 5000. The juxtaposition of solid job growth and tepid economic growth describes what the current expansion lacks: dynamism and innovation. These are the forces that drive productivity growth, allowing companies to produce more with less and provide a higher real wage to workers.
Almost all of the increase in real GDP since the start of 2010 has come from growth in labor inputs, according to Douglas Holtz-Eakin, president of American Action Forum, a center-right think tank, and a former director of the Congressional Budget Office. Labor inputs include the number of jobs and the number of hours worked. The contribution of productivity has been miniscule.
Source: American Action Forum
Nonfarm business productivity growth averaged 1.3 percent since the end of the recession compared with a long-term trend of 2.3 percent dating back to 1947. With the exception of a short-lived spurt in 2009, productivity never experienced its typical pro-cyclical surge as businesses satisfy increased demand by working existing employees harder.
"Firms are adding workers to meet demand instead of getting existing workers to become more productive," Holtz-Eakin says. "The question is why."
One answer is the declining pace of new business formation, historically the main source of job creation. There is a considerable body of research establishing the link between "creative destruction" and productivity growth. Small start-ups tend to be more productive than large, entrenched businesses. As the new supplant the old, labor and capital are put to more efficient use. Voila productivity.
In addition, the share of new firms as a percent of total establishments has been shrinking for three decades. In the 1980s, new firms accounted for 12.4 percent of all businesses, according to the Kauffman Foundation. (The Census Bureau's most recent Business Dynamic Statistics are for 2012.) In the 1990s, new entries were 10.8 percent of the total. Between 2008 and 2012, the share dipped to 8.3 percent.
The decline has been broad-based across all sectors and geographic regions. Slowing population growth in the West, Southwest, and Southeast (a supply-side effect) and increased business consolidation explain the reduced pace of firm formation, according to a study of major metropolitan areas by Robert Litan, a non-resident senior fellow at the Brookings Institution.
Certainly new rules and regulations act as barriers to entry, but Litan's three-decade study encompasses periods of both deregulation and reregulation.
The pace of start-ups has shown little improvement from the all-time low set in 2010. Initially, potential entrepreneurs may have been hampered by a lack of access to credit caused by new Dodd-Frank rules. Even as credit conditions loosened up, venture capital shied away from early-stage investment in start-ups, waiting to see proof of revenue and profitability before committing capital, says Kauffman senior fellow Ted Zoller, a professor of entrepreneurship at the University of North Carolina's Kenan-Flagler Business School.
The ongoing shift to an economy dominated by less-productive services industries is another possible contributor to anemic productivity growth. Even with a resurgence of American manufacturing, services account for almost 80 percent of U.S. output.
Productivity is set to take another dive in the first quarter if the Federal Reserve Bank of Atlanta's GDPNow model is correct. Its "nowcast," based on publicly released economic indicators to date, points to first-quarter real GDP growth of 0.3 percent. The model was just updated Tuesday to reflect weak reports on February retail sales, industrial production and housing starts. And it's sure to be a part of the discussion at the Fed meeting currently underway.
Many economists are pointing to weather as the culprit. The one statistic seemingly unaffected is employment. In fact, the jobs numbers seem so out of sync with everything else that analysts at Arbor Research and Trading LLC decided to quantify the gap. They compared the increase in nonfarm payrolls to the implied change based on a composite basket of major economic indicators, including industrial production, durable goods orders and personal income. They found that nonfarm payrolls outpaced the composite by more than 1 million jobs in the past year. "The last time the gap was that wide was during the dot-com bubble," says Benjamin Breitholtz, senior vice president of Arbor's quantitative analytics group.
Another gap has opened up between consensus economic forecasts and actual data as reflected in Citigroup's Economic Surprise Index. The index has taken a precipitous dive in 2015, with reality underperforming expectations by a long shot. The discrepancy may be a manifestation of forecaster optimism—the perennial 3-percent-growth-next-year—rather than any new, dire straits in which the U.S. economy finds itself.
If only some of that optimism would rub off on entrepreneurs.