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Potential Output and Productivity GEORGE L. PERRY Brookings Institution Potential Ou tput an 'roductivity THE UNUSUAL TURMOIL in the U.S. economy during the 1970s has forced a reexaminationof many of its macroeconomiccharacteristics. In- flationhas been the most surprisingfeature of the period and the investi- gationof its causesand searchfor cureshave been intense.The worsening of the relationbetween inflation and unemploymenthas been a focus of that investigationand has been linked,in part,to the veryhigh unemploy- ment ratesexperienced by youngermembers of the workforce and to the remarkablerise in participationrates of young personsand adultwomen. These same developmentsbear on the measurementof potential gross national product, an importantunderpinning of both macroeconomic analysisand economic policymaking. The 1974-75 recessionand its aftermathhave sparkedreestimates of potentialGNP that are substantiallylower than the previousofficial esti- mates and that anticipatea slower growth of potentialin coming years than previous official projections.The Council of Economic Advisers lowered the former estimate of 1976 potential by $58 billion (1972 prices), reducing the gap between potential and actual GNP to $99 billion.' One elementin this revisionis a changein the unemploymentrate at which potentialis definedfrom the traditional4 percentto a shifting rate that was 4.9 percentin 1976. This adjustmentis relatedto the higher unemploymentrates experiencedby youngerworkers and the declining Note: I am grateful to Lisa L. Blum for extensive research assistance, to Evelyn M. E. Taylor for typing, and to Andrea V. Mills for computational help. Edward F. Denison kindly provided me with data from his own forthcomingstudy. 1. Economic ReDortof the President.January 1977. PP. 52-56. 11 12 Brookings Papers on Economic Activity, 1:1977 proportionof adult males in the total work force. Another important element in the CEA revisionsis the observedweakness in productivity since 1973. Outputper hourin the (nonresidentialnonfarm) business sec- tor declinedby 31/2percent in 1974, the firstdecline of any size in the post- war years. Despite a sharpincrease during the 1976 economicrecovery, productivitythat year was still only 21/4percent above the 1973 level. The CEA analysisassociates this weaknesswith an inadequaterate of capital accumulationand with the sharprise in energyprices that coincidedwith the recession.These factors also lead them to projecta potentialgrowth rate of only 31/2percent a year through1980.2 Data Resources,Inc., has publishedan analysisthat lowers the estimateof the presentgrowth rate of potentialeven further, to 3.35 percent.3 A differentchallenge to traditionalestimates of potential output has come fromthose who questionthe effect of unemploymenton laborforce participation.The sustainedgrowth of the labor force right throughthe 1974-75 recessionyears surprisedmany observers.If this recentstrength of participationrates is viewed as evidence of their insensitivityto un- employment,the traditionalmarkup of the laborforce of secondarywork- ers that is used in calculatingpotential output is called into question. Withouta large induced rise in the work force between today's actual economyand its potential,the present GNP gap would be substantially smallerthan calculationssuch as Okun'slaw imply. Theoreticalreasons for questioningany directlink betweenunemployment and the size of the laborforce have been providedby economistswho look, instead,for a sub- stantialresponse of laborforce palticipationto wages and prices.Michael Wachterhas raised such doubts about the cyclicalbehavior of participa- tionrates in his own empiricalestimates of laborforce behavior.4 This paperwill reevaluatethe evidenceon the recent and prospective behavior of potential output. The issues just raised will be examined againstthe backgroundof a previouslysuccessful approach to estimating potential.5The analysiswill startwith the growthin the laborforce, which 2. The analytic backgroundfor the CEA revisions is available in Peter K. Clark, "A New Estimate of Potential GNP" (Council of Economic Advisers, 1977; pro- cessed). 3. Roger Brinner, "Potential Growth to 1980," in Otto Eckstein and others, Economic Issues and Parametersof the Next 4 Years (Data Resources, Inc., 1977). 4. Michael L. Wachter, "A Labor Supply Model for SecondaryWorkers," Review of Economics and Statistics,vol. 54 (May 1972), pp. 141-51. 5. George L. Perry, "LaborForce Structure,Potential Output,and Productivity," BPE1, 3:1971, pp. 533-65. George L. Perry 13 is an importantbuilding block in estimatesof potenitialand is of con- siderableinterest in itself. LaborForce Participation The substantialdifferences in the labor force behavior of different demographicgroups make it essentialto analyzegrowth in the laborforce on a disaggregatedbasis. At a minimum,data are availableby age-sex categories;and with some sacrificein statisticalreliability and historical continuity,some furtherdisaggregations are possible.For a givenpopula- tion cell, it is useful to decomposelabor force growth into changes in the populationand changesin participationrates-the proportionof the populationin the workforce. Analysisof laborforce growththen focuses on participationrates of individualpopulation groups. Rising participationby teenagersand womenhas been the outstanding and surprisingfeature behind the rapid growthof the labor force in the past decade. Sociologicalhypotheses to explain this changingbehavior come readilyto mind:the greaterindependence of teenagers,the changing values and attitudesfostered by the women'smovement, the betterfamily planningmade possibleby superiorcontraceptives, all must be involved. More narrowlyeconomic hypotheses can be offeredas well, built around the inflationof the last decade and the change in real living standards comparedwith expectations. To analyzethe presentlevel of potentialoutput and its past growth,one needs estimatesof the cyclicalresponse of participationrates so that the laborinput available along the potentialpath can be measured.I startwith some conventionallyestimated equations for participationrates and then consider whether alternativehypotheses about the observed growth in participationcan improvethese calculations. CYCLICAL VARIATIONS IN PARTICIPATION Accordingto the conventionalview, participationrates for some demo- graphicgroups vary both cyclically,with a largerfraction of the popula- tion in the labor force when unemploymentis low, and secularly,for reasonsthat are independent of the unemploymentrate. Lacking any good way to identifyand quantifythe factorsbehind secular changes, past re- searchhas generallyallowed for themby usingtime-trend variables. After 14 Brookings Papers on Economic Activity, 1:1977 some experimenting,the followingform of estimatingequation was used for eachof fourteendemographic groups in the presentanalysis: (1) log (LIP) = Ao+ aju*+ a2U*(- 1) + a3T54+ a4T67, whereL is the total laborforce and P is population;u* and u* (-1 ) are this year'sand last year'sweighted unemployment rates, respectively; and T54 and T67 are time-trendvariables starting at 1 in 1954 and 1967, respectively,and risingby 1 each year.6The conceptof a weightedunem- ploymentrate as a measureof labormarket tightness is by now familiar.7 The formof the dependentvariable was chosen aftersome preliminary comparisonsbetween it and log (1 - L/P), the "nonparticipationrate," showedno persistentsuperiority for either.One workedslightly better for some groupsand slightlyworse for others.Using the nonparticipationrate requiredmore abrupttrend changes (since it makes trends in participa- tion rise more slowly with time when, in fact, they speededup for some groups). And, while a constanttrend growthrate in participationrates such as equation1 implies cannot go on forever,that only warnsagainst extrapolatingit too far into the future. The choice of a second time trend startingin 1967 was made after experimentingwith startingpoints in 1964 and 1970. Once again, some trendsfitted better for some populationgroups and worse for others.The trend startingin 1964 sometimesreduced the estimatedcyclical respon- siveness of participationrates, presumablybecause more of the strong rise that occurred as unemploymentfell between 1964 and 1966 was attributedto trend.These equationsgenerally did not fit the data quite as well as the others.And 1964 predatedthe sociological changesthat are hypothesizedto lie behindthe stronglyrising participation trends of teen- agersand younger women. Therewas less differencebetween the estimatesusing the time trends 6. The data on the labor force, employment, and unemployment used here and throughout the paper (except as noted) are official estimates and are adjusted for Census-year changes and the changes in definition introduced in 1967. They are further adjustedto an employment basis (largely an establishmentbasis) that corre- sponds to the output categories in the GNP accounts. The adjustmentsare described in the appendixto Perry, "LaborForce Structure."The necessary data for the adjust- ment to an employment basis correspondingto GNP were provided by Edward F. Denison from his worksheetsfor a forthcoming study. 7. The version in this paper uses the proportionsof differentdemographic groups in the labor force in 1966 together with the relative-wageand average-hourfactors of each group that were explained in George L. Perry, "ChangingLabor Markets and Inflation,"BPEA, 3:1970, pp. 411-41. George L. Perry 15 startingin 1967 and 1970, and also less a prioribasis for preferringone
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