Global Macro Research Top of Mind October 5, 2015 Issue 39 Picking Apart the Productivity Paradox From the editor: US productivity growth has been strikingly low over the past decade despite a seeming explosion of technological progress and innovation. Economists have debated this paradox for years: Is subdued productivity growth a sign of stagnation or just a case of measurement error? Rising pressure for the US to carry global growth— even amid softer domestic data and a stronger dollar—has made this question Top of Mind. We feature opposing views from Northwestern University colleagues Robert Gordon (the best innovations are behind us, and productivity growth will likely remain low) and Joel Mokyr (official statistics don’t adequately capture recent innovation, and the sky is the limit on technological progress). Jan Hatzius offers his own conclusion that IT-related measurement error could be playing a large role in the apparent productivity slump. Finally, we drill down into two areas with promise for incremental productivity gains—commodities, and industrials companies on the Internet of Things (IoT) frontier. Inside Interview with Robert Gordon 4 Professor of Economics, Northwestern University Productivity paradox v2.0 6 Jan Hatzius, GS Economics Research Interview with Joel Mokyr 8 Professor of Economics and History, Northwestern University The commodities case study 11 Christian Lelong, GS Commodities Research Is the IoT the next industrial revolution? 12 Joe Ritchie, GS Multi-Industry Equity Research Source: www.istockphoto.com We’re using software and [Weak productivity growth] Product innovation has… computers now that are very looks inconsistent not just with [in my view] been particularly similar to the ones we used ten everyday experience…but also pronounced in the past 20 years. years ago. So it is no surprise that with several aspects of current And if that’s the case, productivity productivity growth has been macroeconomic conditions… [A statistics systematically under- slower over this decade.” plausible hypothesis is] that a measure the rate of technological significant part of the slowdown progress and its implications for reflects growing measurement economic welfare.” error in the IT sector.” Robert Gordon Jan Hatzius Joel Mokyr Editors: Allison Nathan | [email protected] | Marina Grushin | [email protected] Macro Executive Committee: Jeffrey Currie | Jan Hatzius | Kathy Matsui | Timothy Moe | Peter Oppenheimer Investors should consider this report as only a single factor in making their investment decision. For Reg AC certification, see the end of the text. Other important disclosures follow the Reg AC certification, or go to www.gs.com/research/hedge.html. The Goldman Sachs Group, Inc. Goldman Sachs Global Investment Research Top of Mind Issue 39 MacroEl news and views We provide a brief snapshot on the most important economies for the global markets US Japan Latest GS proprietary datapoints/major changes in views Latest GS proprietary datapoints/major changes in views • No major changes in views. • No major changes in views. Datapoints/ trends we’re focused on Datapoints/trends we’re focused on • The disappointing Sept. employment report; amid slowing • The first negative core CPI reading yoy since QQE began. activity and a lack of improvement in inflation or financial • A ¥600tn nominal GDP target under PM Abe’s recently conditions, this makes liftoff in Dec. a close call. More bad announced “three new arrows” program, which looks news could justify a much longer period of near-zero rates. unrealistic vs. FY2014 nominal GDP of ¥490tn. • Weakness in the manufacturing sector in particular, signaling • A drop in company CPI outlooks even 5 years out, supporting at least some possibility of a larger-than-expected drag from the case for further BOJ easing on Oct. 30, if not sooner. tighter financial conditions and weaker global growth. September disappointments Shooting for the stars Average of key manufacturing indices, percent balance Japan nominal GDP under various growth assumptions, ¥ tn Percent balance ¥ tn 40 700 PM Abe's new nominal GDP target 30 650 20 600 550 10 500 0 450 -10 400 -20 350 Series3 Nominal GDP growth: +5% -30 300 +3% Recession -40 250 +1.7% (average since Abenomics) Empire State & Philadelphia Fed Manufacturing Index (average) +0.6% (average since 2000, excluding GFC period) -50 200 2001 2003 2005 2007 2009 2011 2013 2015 1980 1990 2000 2010 2020 2030 2040 Source: FRBNY. FRB of Philadelphia. GS Global Investment Research. Source: Cabinet Office, Goldman Sachs Global Investment Research. Euro Area (EA) Emerging Markets (EM) Latest GS proprietary datapoints/major changes in views Latest GS proprietary datapoints/major changes in views • No major changes in views. • No major changes in views. Datapoints/trends we’re focused on Datapoints/trends we’re focused on • Negative headline inflation in Sept. (-0.1% yoy on energy). • A slight increase in China’s official manufacturing PMI—the • A rise in the German Ifo business survey, suggesting first positive activity data point in months; data later this impacts of the China slowdown have been limited so far. month will confirm if sequential growth improved in Sept. • Acceleration of net immigration into Germany this year, • New record lows in Brazil’s consumer and business implying upside risk to our growth forecast of 1.9% for 2016. confidence amid rising inflation, taxes, and interest rates. • Increased political risk in Spain after recent Catalan elections. • A positive inflation impulse from FX weakness likely to show up across a number of EMs in the next six months. Migration matters Tough times in Brazil Trend growth for the German economy, % yoy Brazilian consumer confidence, points (s.a.) 1.9% Points (s.a.) FGV Consumer Confidence Including immigration 150 Current Conditions Excluding immigration 1.7% 140 Expectations 130 1.5% 120 110 1.3% 100 1.1% 90 Immigration could push trend growth for the 80 0.9% German economy up by around 0.5 pp by 2019 70 0.7% 60 2014 2015 2016 2017 2018 2019 2020 Jan-10 Nov-10 Sep-11 Jul-12 May-13 Mar-14 Jan-15 Source: Goldman Sachs Global Investment Research. Source: FGV. Goldman Sachs Global Investment Research 2 Top of Mind Issue 39 PickingEl apart the productivity paradox Productivity growth in the United States, as in some other developed countries, has been strikingly low over the last How do we define productivity? decade despite a seeming explosion of technological progress Productivity typically refers to productivity of labor, and innovation. Economists have debated this paradox for measured as output per hour of work or output per worker. years: Is subdued productivity growth—along with its stifling Labor productivity growth is generally decomposed into contributions from improvements in the quality of labor effects on wages, profits, and competitiveness—the new (e.g., from educational attainment and skill development) normal? Or do official measures of productivity simply fail to and from the availability of capital (i.e., having more or capture recent gains from innovation? With pressure rising for better tools and equipment for workers to use). Any the United States to carry global growth—even amid softer residual productivity growth that these measurable changes domestic data and a stronger dollar—this question has become cannot explain is termed total factor productivity (TFP, increasingly Top of Mind. sometimes referred to as multi-factor productivity or the Solow residual). The TFP contribution to labor productivity We begin by interviewing two outspoken voices on the topic— growth can represent gains from technological innovation, friends and Northwestern University colleagues Robert Gordon buildup of institutional knowledge, and better organizational and Joel Mokyr. Gordon, an economist, believes productivity management, among other things. growth is faltering because society has exhausted the best benefits of innovation. In his view, productivity improvements Looking beneath the macro level, we explore two areas of the in the modern era can hardly compare to breakthroughs like economy with promise for incremental productivity gains. electricity, and are insufficient to outweigh demographic and Senior Commodities Strategist Christian Lelong asserts that other headwinds to economic performance. As such, he disciplined management and the pressure to cut costs should forecasts continued low productivity and GDP growth. extend productivity growth in energy and mining well into the Economic historian and techno-optimist Joel Mokyr disagrees, next decade, reinforcing our forecast of lower-for-longer arguing that official statistics are out of step with the modern commodity prices. And US Multi-Industry Analyst Joe Ritchie economy and often fail to account for tangible improvements in writes that industrials companies, the bulwarks of the “old technology, medicine, and quality of life. He considers economy,” are in fact positioned to achieve substantial technological change a “tailwind of tornado strength” that can efficiency gains by adopting the Internet of Things (IoT). While overcome even powerful economic headwinds. obstacles to the industrial IoT revolution remain, the potential We then turn to our Chief Economist, Jan Hatzius, whose energy and cost savings are enormous—and give some reason research suggests that IT-related measurement error could in not to despair over subdued productivity growth. fact explain a sizable share of the apparent productivity slump. Among other things, this implies that inflation is even lower Allison Nathan, Editor than the measured rate, supporting the case for continued Email: [email protected] accommodative monetary policy at the margin. More broadly, it Tel: 212-357-7504 Goldman, Sachs & Co. affirms our sound long-run outlook for the US economy at a time when growth feels vulnerable. Putting productivity growth in perspective 4.5% 1956: President Eisenhower Goldman Sachs 2001: Tech economists 4.0% signs legislation authorizing the funding and construction of the stock bubble expect 1.5% interstate highway system. bursts. trend productivity 1973: The first oil price shock growth over the 3.5% ushers in an era of inflation and next decade.