August 11, 2003

Some Optimism in the Forecasts

Forecasters are beginning to expect that higher corporate profits will lead to more investment spending. Unfortunately, forecasters seem to see no declines in the unemployment rate until next summer...

WSJ.com - Spending by Corporations May Give Economy a Jolt: Though wary from rallies that never materialized and economic bright spots that quickly faded, economists are beginning to feel more confident: They have raised expectations for third-quarter growth, and say a rebound in corporate profits should prompt companies to finally boost capital spending and investment. "All through the downturn I've felt that all that we have seen are false starts. But for the first time, I have to say, I think we're headed into the real thing," said Allen Sinai, chief global economist at Decision Economics in New York.

The average forecast of the 54 economists who participated in The Wall Street Journal Online's economic survey this month put growth for the current quarter at an inflation-adjusted annualized rate of 3.6%, up from the 3.5% average forecast in a survey conducted in June. Expectations for an acceleration in growth late this year and early next year were unchanged. In the second quarter, gross domestic product -- the broadest measure of economic activity -- grew at an annual rate of just 2.4%, according to the Commerce Department's initial reading on the quarter, released last week. Economic optimism is out of fashion in these cautious days -- and predictions of a recovery have been wrong many times before -- but economists point to undeniable signs that some segments of the economy are at least gaining a toehold: The rebound in consumer spending during the second quarter appears to be carrying over into the current quarter; auto sales ballooned to an annualized selling rate of 17.3 million vehicles in July, stronger than the 16.1 million rate for the first half of the year; and orders to manufacturers are holding at strong levels, suggesting that the rise in demand in the second quarter was more than a temporary spike.

But each of those things has been an ingredient of previous false starts, economists noted. The secret weapon this time: corporate profits, which appear to be solidly on the rise. The 1,336 companies included in the Dow Jones Total Market Index that had posted second-quarter earnings as of Wednesday reported combined net income of $115.87 billion, up from $74.12 billion a year earlier. An overwhelming 92% of economists in the survey said they believe the rise in profits will prompt companies to boost capital spending and investment in the next six months. Such investment will be key to sustaining a meaningful recovery...

Posted by DeLong at August 11, 2003 07:49 AM | TrackBack

Comments

Hurray for the apparent rise in corporate profits. However, I don't understand why they would boost capital spending unless capacity utilization also goes up significantly. Is capacity utilization expected to increase significantly? I have yet to see any positive predictions on that account.

Posted by: claude tessier on August 11, 2003 08:03 AM

Yes, hurray for profits - but conspicuous by its absence from the Journal story was any mention of revenue growth. My impression is that this remains anemic, and I can't see why a productivity-led improvement in profitability should be enough to spark a revival in capital expenditure. Only clear evidence of stronger demand will do that - so, what are you planning to do with your child tax credits?

Posted by: Dave L on August 11, 2003 08:12 AM

If readers recall, the unemployment stayed very low well into the economic downturn. It's obviously a lagging indicator. I'm doubtful about a real sustained return in corporate profits. Too many companies are still unconfident, but if they do rise, they will be hiring

Posted by: Joseph W on August 11, 2003 08:35 AM

If readers recall, the unemployment stayed very low well into the economic downturn. It's obviously a lagging indicator. I'm doubtful about a real sustained return in corporate profits. Too many companies are still unconfident, but if they do rise, they will be hiring

Posted by: Joseph W on August 11, 2003 08:37 AM

Good news.

However, I was reading an interesting but disturbing article about computer programmers in the US training their replacements in India and elsewhere before being let go. Companies are replacing $60/h US workers with $6/h foreigners in high tech jobs. Ouch. BW is highlighting this.

http://www.businessweek.com/magazine/content/03_34/b3846027.htm

How much is this contributing to productivity gains?

Posted by: bakho on August 11, 2003 09:09 AM

"Yes, hurray for profits - but conspicuous by its absence from the Journal story was any mention of revenue growth."

When firms are more profitable they will expand faster (or at least shrink more slowly)--profitability serves as the signal running throughout the economy to encourage a level of growth. Productivity gains definitely contribute to profits, as well as do lower wages, but this does not have to lead to a downward spiral of unemployment and lower consumer spending. If monetary and fiscal policy are loose enough the spending level will be maintained by those still employed until higher profits cause an expansion.

"I don't understand why they would boost capital spending unless capacity utilization also goes up significantly"

Capital spending is not a yes/no function because capital is not a homogeneous substance. It differs in things like age and function, and this means that a rise in profitability may lead to increased capital spending even if there are many types which are still in excess.

Posted by: snsterling on August 11, 2003 09:42 AM

Dave L:

To make clearer what I said above, also consider what would happen if (marginal) profit levels did not yet give a sufficient incentive to exapand production but spending was increased with fiscal and monetary policy. The companies would still not have an incentive to increase production because the profitability of increasing quantity is still too low. Yet at the same time higher demand would cause inflation. Not that we couldn't use a little of that at the moment.

Posted by: snsterling on August 11, 2003 10:05 AM

Why is the profitability of an increase in production still too low? Especially if there is inflation in the price of products the firm is selling?

Posted by: Jack on August 11, 2003 11:08 AM

Jack is correct. It should read "might still not have an incentive". It depends on how out of whack were profits originally and how much is the added inflation. I didn't mean to imply inflation is not also a way out of a recession.

Posted by: snsterling on August 11, 2003 12:00 PM

bakho wrote, "However, I was reading an interesting but disturbing article about computer programmers in the US training their replacements in India and elsewhere before being let go. ... How much is this contributing to productivity gains?"

I'm curious about that also.

snsterling wrote, "When firms are more profitable they will expand faster (or at least shrink more slowly)--profitability serves as the signal running throughout the economy to encourage a level of growth." Why does it follow that increased profitability will lead to growth? Certainly, it can't hurt, but it's no guarantee.

Posted by: Stephen J Fromm on August 11, 2003 12:47 PM

Perhaps bakho's point gives us another view - there is job growth happening, but it's happening in India and China and Malaysia and the Phillipines.

Posted by: agnosticus on August 11, 2003 01:01 PM

Employment lags in a recovery from recession, but never has the lag been 20 months and counting after a recession. The mean lag has been just over 2 months, and this lag is longer and deeper in job losses and wage sluggishness than the lags after 1991 or 1981.

With ample global supply channels, slow growth in demand and little price leverage, why should corporations add much to employment in America?

No, I am not finding enough reason to think a spurt in hiring is in the offing or even a spurt in GDP growth past 3.5%.

Posted by: anne on August 11, 2003 02:36 PM

[1] Bathko asked a probing question, which a couple of other contributors here took up . . . without answering it. Let me take a stab, adding that as a political scientist with a shared Ph.D. in economics, I would rather have a specialist in productivity --- not just an economist, but someone who specializes in this difficult area and knows the measurement problems --- be the one to answer Bathko.

[2] Bathko notes this, with his query appended at the end:

"However, I was reading an interesting but disturbing article about computer programmers in the US training their replacements in India and elsewhere before being let go. Companies are replacing $60/h US workers with $6/h foreigners in high tech jobs. Ouch. BW is highlighting this.

http://www.businessweek.com/magazine/content/03_34/b3846027.htm

How much is this contributing to productivity gains?"

[3] As far as I can tell, the question as it stands confuses two things: measurement of overall US business-sector productivity --- something the Bureau of Labor does quarterly --- with its efforts, far more controversial, to measure the productivity of specific industries.

For the more general measure of business-sector productivity --- which excludes general government, non-profit organizations, , and one or two other things --- the BLS take quarterly and annual GDP, deflate it for inflation, subtract the excluded factors just mentioned, and get the Output numerator.

For the denominator, the BLS runs surveys to calculate worker hours, and that together with the numerator gives the productivity of worker-hours in the business sector for the quarter or year. More specifically, of course, the resulting figure reflects the growth of the output side (real GDP contributed to by businesses) and the growth of labor hours . . . if any.

There has been something of a flap about whether the BLS surveys reflect accurately the hours worked by Americans in the denominator, but an intelligent study carried out at Princeton by Alan Krueger and a group in 2000 or so found that there wasn't much discrepancy from what they found and the BLS reports. See http://www.irs.princeton.edu/krueger/produc3.htm

[4] Against this background, we should be able to answer Bakho's query. Remember first, real GDP can be measured in two different ways n the National Income and Product accounts: on one side, by the production of consumption goods C, business investment I, government goods G, and X-M (exports - imports). For business sector productivity, exclude government goods. On the income side, you have personal income (wages, interest, profits), which can be divided in the accounts into C, S (savings), and T (taxes). Again, to answer Bakho, subtract government employee incomes.

[5] Hence the general answer. If a computer firm substitutes foreign workers for high-paid American workers, GDP would go down on the National Income side of the accounts . . . and assume now that the displaced workers are unemployed in the next four quarters or year. Presumably then, output in the numerator is down, but with unemployment now down, productivity might not have changed as much. It might not fall at all. It might rise even. It all depends.


[6] If, however, we look at it differently here --- GDP goes down on the Income side, but the displaced workers end up in low-productive jobs and work as many hours as before --- then productivity in the aggregate would go down for the business sector of the US economy. There would be lower output (lower National Income), and yet on the denominator side there would be the same number of hours worked by the displaced computer programmers in less productive, less numerative work.

[7] For the computer industry itself, there could be certainly a reduction in labor costs (which the Bureau of Labor calculates along with productivity), but whether productivity would have risen, fallen, or stayed the same couldn't be calculated without far more information than we have.

Or so it seems.


Michael Gordon
http://www.thebuggyprofessor.org

P.S. Just promised to take my wife and dog for a walk, so I don't have time to review the reasoning or prose here.

Posted by: michael gordon on August 11, 2003 06:40 PM

Buggy -- aren't relative wage levels derived from the productivity? So if a computer programmer is well paid it is because of some unmet need, and then if it turns out there are tens of millions of workers overseas qualified to do this same job there is no longer an unmet need and the high value added job is now a low value added one. Presumably the out of work programmer believes work is available at a wage above what the overseas programmer makes, or else would take a pay cut to that level. So if the 100K job becomes a 20K job overseas and new work as a housecleaner is found at 30K, shouldn't that be an easy case to be made that productivity has risen? Maybe we are just used to programmer being higher value added and housecleaner being lower.


Stephen -- Greed I suppose. If at the prevailing price, wage, and productivity levels a particular investment returns a risk adjusted 15% doesn't it make sense to take out a loan or find some investors and build it and staff it? If it returned only risk adjusted 5% then why bother. There should always exist some level of profitability that gets people off their butts and try to make themselves wealthy.

Posted by: snsterling on August 11, 2003 09:31 PM

Increased profits are good.

But these same economists have been telling us how things are going to improve for some time now.

They don't exactly have a good record of prediction.

Still, they'll be right eventually.

Posted by: Ian Welsh on August 11, 2003 09:36 PM

Ian, you are right, they don't, but I think that profitability is a very good indicator of something.

As mentioned above, profitability (both absolute and relative) is often used as a signal for when it is time to invest. This investment can take the form of greenfield or mergers & aquisitions and can spur economic growth (as it did in the 90's).

However, there are circumstances under which the relative profitability of some companies can increase under stagnant conditions: inflation. Under inflation, some companies can raise prices faster than others and hence they profit *relative to other companies.*

Of course, this is based on a political economic framework and not on pure economics, and I'm probably misunderstanding the theory I'm citing so I could be wrong.

Posted by: Lorenzo on August 12, 2003 06:15 AM

To restate my question as a more concrete example:

Consider a software product made by a manufacturer in the USA.

Assume that 50% of the cost of that software product is the cost of writing the computer code.

Assume the manufacturer replaces all the local programmers with programmers contracted offshore.

Assume that programming offshore costs 10% of the cost of a local programming.

The cost to produce the software drops by 45%.


Affects on productivity:

Assume the value of the product has not changed.

The number of American workers (who are counted) goes down. If these workers are unemployed, they don't count in productivity calculations. (Is this correct? The number is based on workers and not total population?)

Offshore workers would not be counted. The purchase price of the software they were contracted to write is counted. (Is this a correct assumption?)

Given these assumptions, I calculate that the denominator (hours worked) should go down while the numerator (goods produced) stays the same. This would give an increase in productivity. I wonder how large an effect this scenario is having on the whole economy?

Posted by: bakho on August 12, 2003 11:01 AM

Whatever the theory, snsterling is right on the reality. Capacity use rates have proven quite misleading as a guide to capital investment in some prior expansions. Profits (before tax, if I recall, is the best guide - snsterling?) have served better. Now the question is, if as noted in other posts at this cite, there has been a pretty good pace of unit investment in high tech capital goods, masked by falling prices, where does that fit into a) doubts about capital spending and b) the link between capital spending and profits? Are dollars spent the right unit of measure?

Posted by: K Harris on August 12, 2003 11:09 AM

snsterling, "Stephen -- Greed I suppose. If at the prevailing price, wage, and productivity levels a particular investment returns a risk adjusted 15% doesn't it make sense to take out a loan or find some investors and build it and staff it? If it returned only risk adjusted 5% then why bother. There should always exist some level of profitability that gets people off their butts and try to make themselves wealthy."

Right, I assumed you meant that. The problem is that you're assuming capital markets are efficient. I don't see any reason for that assumption, particularly given all the wasted investment during the recent bubble.

More to the point, who's to say that the firms won't return the profits to shareholders, who will then use the money for all sorts of unproductive things? Right, I know that the $$ has to end up somewhere, but...

Posted by: Stephen J Fromm on August 12, 2003 11:13 AM

"I know that the $$ has to end up somewhere, but..."

But hopefully not in cash! You are right that nothing stops corporate boards or investors from demanding 30-40-50% returns on equity and holding cash if sentiment is low. Similarly, consumers might limit their purchases to the most important and hold cash if they become scared.

Only the Fed stands between this preference for cash and willingness to take risk in new investments or purchases. And now they only have 1 percentage point to their name. What is really needed, but will not come to pass, is a way to implement negative rates during deflationary emergencies. This subject came up on this blog several months ago. There's nothing like the prospect of making -5% on your cash to encourage new investment, and this is really useful when there is panic or if there is deflation.

I'm not as worried about bad investments. It makes us less well off (especially those investors!) but it's not going to cause a depression. In a free society the decisions usually end up in capable hands even though a lesson still needs to be learned occasionally as a refresher.

Posted by: snsterling on August 12, 2003 12:41 PM

SNS:

Many thanks for your stimulating reply, which is set out here again:

"Buggy -- aren't relative wage levels derived from the productivity? So if a computer programmer is well paid it is because of some unmet need, and then if it turns out there are tens of millions of workers overseas qualified to do this same job there is no longer an unmet need and the high value added job is now a low value added one. Presumably the out of work programmer believes work is available at a wage above what the overseas programmer makes, or else would take a pay cut to that level. So if the 100K job becomes a 20K job overseas and new work as a housecleaner is found at 30K, shouldn't that be an easy case to be made that productivity has risen? Maybe we are just used to programmer being higher value added and housecleaner being lower."

[1]You seem to be confusing productivity --- either of a firm or the economy as a whole --- with labor costs . . . and in the case of Indian programmers compared to American ones, relative wage costs.

[2] Aggregate labor productivity is defined as Output / hours worked by the Bureau of Labor, where output is GDP minus the government sector and non-profit organizations to get business sector output, deflated for any price increases. Since the mid-1980s, I believe, the Bureau also tries to weigh the contributions of specific industries to the resulting Business-Sector output, so that the more important an industry is in accounting for GDP, the more heavily it's output is weighted against the hours worked by the employees in it.

[2b] Keep in mind that GDP output in this sense doesn't just reflect labor contributions: it also reflects anything that causes GDP, including the growth of capital inputs, the growth of capital productivity (hard to measure, but not impossible even across countries), ever better management and marketing, and technological progress of a general sense. For that matter, the productivity in the use of raw materials and fuels.

An example: international comparisons of manufacturing undertaken by the McKinsey Global Institute in the late 1990s showed that British labor productivity in mfg. was about 10-15% below that of German and French mfg, but by contrast capital productivity --- the growing efficiency of output / unit of capital investment measured in dollar terms --- was about 10% higher, and the result was that British manufacturing was just about as efficient.

Despite that, German wage costs in manufacturing were extraordinarily high --- way above any productivity difference compared to the rest of the EU or the US --- because of skyrocketing social security taxes. In 1995, if I recall --- given the DM/$ ratio --- German mfg. labor's basic wage was about $20 hour, slightly higher than the US but not by much. But after taking into account social security taxes and medical payments etc, US wages in mfg. rose only by about 10% to $21 or so, whereas German wages rose to around $37 an hour! (The DM went down about 35- 40% against the dollar in the late 1990s, then as the euro another 25% between 1999 and the start of 2002, only to rise about 25% since then again.)

[2c]All this still on the numerator side, and GDP can be calculated either on the product side or the income side (wages, profits, interests), again for the business sector. The two sides of national income should, of course, be equal, and they usually are, though there was a strange wedge driven between them in the early and mid-1990s.

[3] The Denominator.

Surveys are taken to check on the hours worked, and there are efforts by the Bureau, it seems, to subtract paid vacations and paid leave from the output side where no hours are worked by the employees. Also, efforts to consider benefits not included in gross income per se. (There are also further refinements about supervisory and non-supervisory employees, with different survey and reporting techniques).

[4]Wage costs.

Whether a firm pays on an average higher wages or not --- ditto the firms in a specific industry --- isn't part of this defintion of either in the numerator or denominator in the equation (where wages are wages, in a gross sense). True, higher productive industries --- which may be higher value ones (not necessarily) --- will pay, on an average higher wages; and within a specific firm or industry as a whole, certain workers will also get higher wages depending on their roles (managers vs. non-supervisory) or education and talents and the scarcity of not of such labor. But the causal influence runs from higher productivity to higher wages, not vice versa.

[5] Generally, it's true in the abstract, firms won't make a profit in competitive markets if they pay wages higher than productivity increases justify in the long-run . . . something that would be reflected in rising wage costs that would eat up profit margins and eventually all profits.

[5b] But note.

Some firms or industries may also pay higher than average wages --- or wages not justified by their levels of productivity --- and still stay in business for long periods of time, making a profit in the process. How? That will normally be because they're protected from foreign competition by tariffs or quotas or subsidies, and possibly from domestic competition (new start-ups as potential competitors) by various regulations. Either way, the costs are passed on to other businesses (think of high-priced steel in the US economy when new protection was added last year) or to end-consumers.

This happens all the time, and especially in the EU, where on the Continent lots of small retail and department stores are protected by laws that regulate how many discount stores can be started in a region or municipality, and where they locate and so on.

[6]Oppositely, a firm or an industry can have higher levels of productivity and still not be competitive internationally.

Take general steel-making in the US (as opposed to specialized steel-makers). At one time, in the 1970s and 1980s, their output (a ton of steel, say) / per man-hour lagged noticeably behind EU, Japanese, and Korean steelmakers. Since then, having shed 50% or more of the labor force and modernized, US general steelmakers have just about the highest productivity in the world, somewhere around 4 man-hours per ton compared to the 10 hours it took in the 1970s and 1980s.

And generally, as opposed to the 1970s and early 1980s, wages (including benefits) don't exceed the level of producitivty any more.

All the same, in part because of subsidized steel in Europe and Japan --- less so in the rest of Asia or Brazil --- but also because of very high pension costs to retired workers, US steelmakers face declining market-share in the US and protest they can't meet the competition head-on.

[7] In all these cases, then, we can say this: wages in a firm or industry will ordinarily reflect levels of labor productivity (if this can be measured directly, as in steel output per man hour), but only if the markets are competitive and there aren't inherited fixed costs, etc.

But there are several other considerations that might work contrary to competition or cause inescapable high costs (like high pension costs that will take decades to run down).

[8] One more complication here though --- and a significant one.

As a general thing, the wages of workers in any firm or industry compared across countries will also reflect not just whether the firm or industry is a high or low-productive one, but also average wages across the country itself.

That's why Indian programmers, who might be as talented as American programmers --- some of whom are Indian immigrants anyway --- can get far lower wages. What's at stake here is average levels of productivity in the US and India as calcuated by GDP/hours worked in the business sector, and not just the contributions of Indian programmers to final output of the US multinational.

The multinational firm might, in the process, reap higher profits, but productivity within the firm across its US and foreign branches could stay the same. In the case just described, to repeat, assume that the Indian programmer in Bombay is just as productive as his Indian immigrant counterpart here.

Productivity within the firm hasn't changed, only wage costs and profit margins.

[9] One further point, nothing more. It deals with alternative definitions of labor productivity.

As we noted, labor productivity is ordinarily calculated in aggregate terms by using hours worked in the denominator. Nonetheless, alternative definitions may be more useful for cross-country comparisons: for instance, GDP/worker or even GDP/population. (The latter, of course, gives you per capita income).

The reason for preferring at times alternative definitions for comparative purposes? There may be big differences in the hours worked across countries, as well as the participation ratio of the work force: the percentage of adults, say 18-65, working. There may also be jobs being created, but part-time or temporary, rather than full-time. And much of these differences may not reflect preferences for leisure vs. work.

To clarify briefly, assume what some specialists say --- specifically, assume that in the EU, there is more preference among the population for leisure as opposed to work compared with the US. That preference shows up in hours worked per year on an average: the US worker recording around 1900 hours, and say at the opposite end the German worker around 1550. A huge difference. As Robert Gordon showed in a study earlier this year, taking into acount the preference for leisure here reduces the per capita income gap --- a proxy for labor productivity (with of course all other contributions like capital efficiency and multifactor productivity reflected in the GDP output that labor hours have nothing to do with) --- by about half. In particular, the gap with the US rises from roughly 70% of the US average in per capita income to about 85% for the EU.

But note: what if lots of German and EU workers want to work more hours, but can't? Or, more plausibly, what if they're in part-time jobs only --- most of the EU jobs created since the early 1990s seem to be this --- and can't get full-time jobs because of rigid labor markets, high minimum wages, union rules, problems with lay-offs etc. Or, more to the point still, since about a third of EU youth (16-late 20's in age)aren't employed but almost certainly would like to be --- or are in endless undergrad or grad programs with no payoff (with the average age of a German student's getting his first degree now 29 years!) --- then using GDP/hours worked might be very misleading as an accurate gauge of productivity.

From that viewpoint, per capita income (GDP/population) or GDP/worker might be better estimates across countries.

[10] For the Robert Gordon study and further reflections on this, see the buggy prof article in an exchange with a lawyer in this country who worked a long stint in the EU that appeared this last February:

http://www.thebuggyprofessor.org/archives/00000041.php

(I add that owing to a hacker attack, the archives are still scrambled, with my web manager promising to fix them. This, though, is the accurate IP for the article, found thanks to Google.)

Posted by: michael gordon on August 12, 2003 12:51 PM

Just wanted to add a postscript remark or two to the lengthy set of comments I made here earlier today. These remarks are prompted, I add, by my chasing down the original Robert Gordon paper comparing EU and US differences in productivity levels and living standards (per capita income, in purchasing power parity terms), and finding some curious data about both --- especially the EU living standards compared to the US's.

1) Robert Gordon's paper can be found at http://faculty-web.at.northwestern.edu/economics/gordon/355.pdf
In it, he uses data from two sources --- the IMF and OECD --- that lead to two findings as a basis of his later explanatory efforts: 1. in 2000, EU living standard (per capita income) is 77% of the US's, whereas 2] its productivity ratio is 93%. (see p. 10 in his article, based on data explained and used in charts),

[2] On that basis --- with a very useful long-term historical perspective, I add (it's a good paper except for this starting data, as I'll show in a moment) --- he seeks in his paper at two points to find explanatory influences that would narrow the gap between living standards (the EU ratio is 77% of the US's) and labor productivity levels (93%). His conclusion? That the actual figure for both should be about 85% of the US's levels.

[3] In short, the EU living standard is higher by about 15%, and the productivity level lower by about the same amount (slightly more).

[4] The problem is, the EU Commission --- which puts out careful studies each year of EU economic prospects and especially the EU's commitment, languishing, to make the EU the dynamo of the world economy's information and communications technology --- finds far different living standards and productivity levels in the EU compared to the US.

4b)
. Go to chapter one of the EU Competitiveness Report 2002, p. 20, and look at the chart and table.
http://europa.eu.int/comm/enterprise/enterprise_policy/competitiveness/doc/competitiveness_report_2002/cr_2002.pdf

The EU average per capita income --- in PPP terms --- is 69% of the US's in 2001 (the ratio will have fallen to about 65% given differential growth in 2002 and likely 2003 for the entire year). That is far below the 77% that Robert Gordon starts with.

4c) Now jump to table 1.4 on p. 22 of the report, and you get the EU figures for labor productivity in the EU and Japan as a ratio of the US's in 2001. As you can see there, the EU ratio is 78% (and Japan's 67%). Again, this is far lower than the 93% that Robert Gordon starts with for the year 2000.

[5] I cannot account for the big discrepancy in Robert Gordon's use of figures for the ratio of either per capita income in the EU compared to the US or its ratio of labor productivity. An excellent scholar, there's no reason to think he was being careless with the figures. (And to repeat, he not only uses good sources like the stats put out by the IMF and the OECD, he also has written a very stimulating article on the sources of US productivity advantage -- originally in the 19th century and throughout the 20th despite in his view the EU's narrowing this gap (a gap that is actually, it seems, far lower than his astonishing figure of 93% for the EU/US ratio instead of the EU's 78%).

5b) On the other hand, while estimates of labor productivity across countries can vary depending on whether you use Output/labor hours vs. Output/ worker --- with the former narrowing the productivity ratio for the EU whatever the actual starting ratio might be for the latter --- it is confounding to figure out why there should be such discrepancy in GDP (output)/ population figures and the resulting ratio of per capita income.

5c) Remember, GDP has to be real (essentially, the deflators on both sides of the Atlantic aren't that different), and then translated into Purchasing Power Parity terms . . . itself a pretty reliable way to bring prices in line with one another for comparative purposes. At most, depending perhaps on different index-years for the dollar or Euro in different PPP surveys, you might get a different of 3-5% for countries or regions like the US and the EU. At least, I've never seen any that diverge beyond that range. (When it comes to comparing, on the other hand, the US and China in per capita terms, PPP comparisons are much more dubious . . . what with the large percentage of non-market transactions, including sheer barter, that comprise the living standards of developing countries. Large numbers of people, especially in the countryside and small towns, build their own shelters, raise their own food, engage in barter, etc.)

6) I would add one more remark. The underground economy --- outright criminal activities as well as non-criminal economic activities that aren't reported in order to escape taxation --- is much higher in the EU than in the US. Even in Scandinavia, traditionally know for its civic discipline, decades of high taxation and a sense of grievance --- why the hell is that organized group getting more from the government than my group? --- have led to large and inefficient use of barter and fraud to avoid taxing.

6b) Essentially, the undeground economy is about 15-20% of GDP in the EU and about 7% in the US, according to the best study of this that uses a variety of ingenious cross-checking techniques:
see the link to the Austrian team headed by Schneider and Frey, and to their findings as cited in a gordon-newspost article, the now defunct listserver subscription daily commentary that I put out for a few years:

https://mail.lsit.ucsb.edu/pipermail/gordon-newspost/2002-May/002511.html

That listserver, which is indexed by google (enter gordon-newspost and try an economic or political topic: there were a couple of thousand articles or so it catalogued), has been superseded by http://wwws.thebuggyprofessor.org

6c) Note that though including the underground economy would raise GDP in the EU compared to the US --- and hence per capita income --- it would, oppositely, lower productivity in any meaningful sense. After all, the techniques used for tax evasion such as a dentist fixing the teeth of a Mercedes car mechanic free in return for his fixing the dentist's car --- or slipping capital abroad --- are notoriously inefficient. And that leads to big problems, mentioned earlier by me, of making sense of productivity calculations . . . especially on a cross-country basis.

--- Michael Gordon

Posted by: michael gordon on August 12, 2003 06:13 PM

Buggy Prof,

I'm still a bit confused about this because I am having trouble figuring out how productivity statistics know whether or not we are better off because we are clever or because we are trading at very beneficial terms.

In particular I'm unsure about the numerator. Let's say that poor programmer worked for Bill Gates, who pockets the 80K/yr (100k-20k) rather than lower prices. The programmer finds work at a lower price.... let's upgrade him to medical technician @ 50k because he still has his skills but he is out of 50K/yr (100-50). But between Bill Gates and Programmer Guy they are up 30K. (the utility of money differs greatly for the two, but that is another story)

If Programmer Guy worked for a more competitive firm, the price difference should be passed on within a reasonable time as all firms in competition hire Indian programmers and bid down their prices (maybe IBM bid lower on an outsourcing contract assuming they could move the IT to India). So now IBM doesn't get the money, Programmer guy is out 50K/yr, and the (perfectly competitive) firm which outsourced finds they have the extra 80K which they initially pocket but eventually realize all the competition did the same thing and it gets passed to consumers.

So my question is, for these cases, is it accurate that real GDP is up by 30K? In the first case the extra income is tangible.... Bill has it. In the second case it is less tangible, but millions of people saved a cent and if it were possible to have a perfectly accurate deflator GDP would be adjusted up by much more than the 50K that programmer guy lost.

Or am I doing something wrong?

Posted by: snsterling on August 12, 2003 07:05 PM

SNS and Bahko and Others:

Well, one more last stab at this complicated subject of measuring productivity . . . especially in the scenario orginally set out by Bakho. Consider it a more carefully thought-through analysis of the queries and puzzles that the Bahko scenario entails.

First we begin with the Bakho scenario, then there follows my more considered buggy response. Unless anyone else can throw light on these matters, I hope that this ends our discussion. Alternatively, you're welcome to post your replies (if you do have them) either here or at the buggy prof site . . . where the more considered response that follows, along some other comments, is also set out. See http//www.thebuggyprofessor.org

1] Mr. Bakho asked a probing question, which a couple of other contributors here took up . . . without answering it. Let me take a stab, adding that as a political scientist with a shared Ph.D. in economics, I would rather have a specialist in productivity --- not just an economist, but someone who specializes in this difficult area and knows the measurement problems --- be the one to answer Bathko.

Here's Bakho's comment and then his query:

"However, I was reading an interesting but disturbing article about computer programmers in the US training their replacements in India and elsewhere before being let go. Companies are replacing $60/h US workers with $6/h foreigners in high tech jobs. Ouch. BW is highlighting this.
http://www.businessweek.com/magazine/content/03_34/b3846027.htm
How much is this contributing to productivity gains?"

Posted by: bakho on August 11, 2003 09:09 AM

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The Buggy Response:

[1] As far as I can tell, the question as it stands confuses two things: measurement of overall US business-sector productivity --- something the Bureau of Labor does quarterly --- with its efforts, far more controversial, to measure the productivity of specific industries.
For the more general measure of business-sector productivity --- which excludes general government, non-profit organizations, , and one or two other things --- the BL stats (BLS) take quarterly and annual GDP, deflate it for inflation, subtract the excluded factors just mentioned, and get the Output numerator.

For the denominator, the BLS runs surveys to calculate worker hours, and that together with the numerator gives the productivity of worker-hours in the business sector for the quarter or year. More specifically, of course, the resulting figure reflects the growth of the output side (real GDP contributed to by businesses) and the growth of labor hours . . . if any.

There has been something of a flap about whether the BLS surveys reflect accurately the hours worked by Americans in the denominator, but an intelligent study carried out at Princeton by Alan Krueger and a group in 2000 or so found that there wasn't much discrepancy from what they found and the BLS reports. See http://www.irs.princeton.edu/krueger/produc3.htm

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[2] Against this background, we should be able to answer Bakho's query.

Remember first, real GDP can be measured in two different ways in the National Income and Product accounts: on one side, by the production of consumption goods C, business investment I, government goods G, and X-M (exports - imports). For business sector productivity, exclude government goods. On the income side, you have personal income (wages, interest, profits), which can be divided in the accounts into C, S (savings), and T (taxes). Again, to answer Bakho, subtract government employee incomes and non-profit organizations and their incomes in order to pin down the business sector. (The Bureau of Labor also divides the business sector further into non-agricultural productivity trends, manufacturing, durables and so on.)

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[3] What follows?

If a computer firm substitutes foreign workers for high-paid American workers, productivity in the firm remains the same on one assumption: the Indian programmers are just as efficient as the American programmers. The same number of software programs and their quality that the firm sells to other business firms and to end-users haven't changed at all. The firm, though --- faced with lower wage costs --- reaps higher profits, assuming further that the price of its software programs to its customers remains the same. Alternatively, the firm could reduce the price, but it then sells more software programs over the year, and its profits still rise.

3a) In that case, nothing has changed as far as the Bureau of Labor's productivity analysis goes, either for the firm or for general US business sector productivity. The firm's ouput --- software programs --- doesn't change, only its labor costs. And though lower labor costs in the aggregate for the US business sector are down, they are offset by an equal amount of reported profits.

If, alternatively, the Indian programmers are more efficient --- they write software programs faster for the firm to sell --- the productivity will go up for the firm, and GDP (the numerator in the productivity equation) goes up too because the firm now reports higher profits. Oppositely, though, the inverse could happen. If the Indian programmers are less efficient --- fewer programs are written and hence sold --- the firm's productivity is reduced, and for the US in the aggregate business sector productivity would fall off because fewer profits might be reported. The latter, to happen, would require profits to fall faster than the reduction in the wage-costs that occurs when the high-wage US programmers are replaced by the low-wage Indian programmers.

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4. There are other scenarios too, all depending on what happens to the displaced US programmers themselves. Specifically:

4a. On one assumption, assume that the laid-off US programmers are unemployed for a whole year. Assume further these laid-off programmers get unemployment insurance for half the year, and live the remaining half on their savings and loans or help from others. Well, nothing would change in overall productivity even if they got unemployment benefits for the whole year. Why? Well, GDP might go up for the year --- with unemployment compensation now paid to the laid-off workers (financed, let's say, by growing national debt for the year, not taxes) --- but not in the business sector. The laid-off workers aren't in the business sector at all. In that case, business sector productivity isn't affected at all.

4b. On another assumption, assume that the laid-off programmers get jobs flipping hamburgers at McDonald's and Wendy's. How would aggregate business sector productivity then be affected? The answer: well, for the numerator, there would now be an increase in reported GDP as calculated by national income (profits, wages, and interest). But, on the denominator side of the productivity equation, the hours worked would rise too; and what with the lower level of overall productivity in such hamburger joints compared to that of software firms, the hours worked in the aggregate for the US economy would likely rise even faster. The result? Lower aggregate national productivity in the business sector.

4c. On yet a third assumption, conceivably business sector productivity could rise even if all the laid-off programmers are hired by McDonald's and Wendy's as burger-flippers. How so? Much brighter than the average employee at those firms, the former programmers might see various ways to improve the number of hamburgers --- and possibly the quality too --- and McDonald's and Wendy's would report higher profits. Alternatively, the number of hamburgers and quality could stay the same, but the mentally agile programmers think of ways to cut costs. Either way, the corporate firms reap higher profits.

Alternatively, the heads of these chains (locally and nationally) might share the profits by awarding higher wages to the astute, efficiency-minded. And in the aggregate --- given this third assumption --- the US economy's overall productivity would rise too: there'd be more profits and more income reported for the numerator (GDP in the business sector).

Posted by: michael gordon on August 13, 2003 06:21 PM

(also my last post here... not like there are any other readers though)

According to the law of comparative advantage, when one country with an absolute advantage trades with a country with an absolute disadvantage, one direction of the trade will involve increasing productivity, and the other direction of the trade will involve decreasing productivity. The key is that the increase of the one side will exceed the decrease of the other side.

There's no question outsourcing to India reduces a firms productivity (ever try getting customer service from Dell? Anyway, this is not Bakho's question). In exchange we send them an airplane or capital equipment or farm products at which comparatively they are much much worse at producing. This benefit is indeed reflected as an increase in both countries' GDP and productivity, as both countries get more stuff once in equilibrium than before the trade. Prof. Gordon, you do not properly compute the change in GDP according to the equation you yourself provide. You ignore that increased profit and/or the drop in prices is *added* to the income from the new job (see the math from my previous post). Taking advantage of comparative advantage leaves extra workers on both sides, and you really must account for this.

So now I would also like to know, along with Bakho and Stephen how much of the rise in GDP/hours is not a direct result of technological/organizational improvement but as a result of trade with China and India (although technology might allow the trade to occur).

Posted by: snsterling on August 13, 2003 08:24 PM

snsterling wrote "According to the law of comparative advantage,..."

The problem is that it's not so clear that c.a. is the governing dynamic here.

One thing to note is that (IIRC) Ricardo's original description posits no capital flows between countries. Though to be fair, I once found a very intelligent sounding post by a left-wing economist who thought the c.a. model had problems, but that the issue of capital flows wasn't actually pertinent.

Posted by: Stephen J Fromm on August 14, 2003 05:33 AM

Wow, Stephen is still reading. Stephen--

Yes, I agree C.A. may not always apply, but I also think in this particular instance there is a strong case to be made that India has a C.A. of having underutilized brainpower (especially in nerdy type fields) while the US has a shortage of this but has the C.A. of better organization, even if it is just because of entrenched companies.

But the GDP & productivity gain should occur even if the C.A. is not really there.

Are you worried that some of the reported productivity might actually be out of equilibrium trades which don't have a C.A. once for example China is developed? When I realized this last night I got really worried. It implies that you can take the import numbers and multiply them by some factor, leaving the US with a trade deficit much worse than it is now. Could it possibly account for a couple or a few percent of GDP? That would mean if the situation were to unwind over the next couple of decades it could lop 2%off of reported productivity?

Is this what you and Bakho are getting at? Because while I knew we temporarily benefitted from trade with China at beneficial terms it had never occurred to me before that productivity numbers could be pumped up by it.

Posted by: snsterling on August 14, 2003 07:13 AM

Prof Gordon --

A couple of loose ends in my case. The main case that may potentially lead to lower productivity occurs when the US worker is not smart enough to take a pay cut. Example... employer saves only 20k by outsourcing, but employee does not realize his worth has decreased by 50k and so makes the incorrect decision of not offering 25K pay reduction in lieu of being fired.

Also, retiring from workforce is difficult to analyze, if a low productivity worker retires it tends to raise productivity (like might be the case in Europe, according to Buggy web site), and if a high productivity worker retires it tends to lower it except now we must also account for increase in profit from the outsourcing, so very difficult to determine.

Posted by: snsterling on August 14, 2003 08:33 AM
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