Is Productivity Growth Back in Grips of Baumol's Disease

Is Productivity Growth Back in Grips of Baumol's Disease?

By Brian Blackstone

1191 words

13 August 2007

The Wall Street Journal

English

IS BAUMOL'S DISEASE back?

Named for economist William Baumol, the theory argues that the labor-intensive nature of some services acts as a constraint on productivity growth in an economy that increasingly produces services. It's relevant again years after some economists pronounced it "cured."

Between the mid-1970s and mid-1990s, annual productivity growth in the U.S. nonfarm business sector averaged about 1.5%. In the past decade, it has averaged about 2.6%. For a couple of years in the early 2000s it was near 4%, and Mr. Baumol's idea looked destined to join others in economics that looked good in theory but wrong in practice.

Yet last week's downward revisions of U.S. productivity growth for the past three years suggests that the trend is closer to 2%, and shows that productivity growth has slowed for four straight years.

At the same time, employment in traditionally less-productive sectors such as health care and leisure is growing rapidly, while employment in higher-productivity business services is growing more slowly; in manufacturing and retail trade, it is flat or shrinking. Therein may lie clues into whether the recent dip in productivity growth is a major turn or a temporary lull.

That's where Baumol's disease comes in.

In the 1960s, Mr. Baumol, now at New York University, and William G. Bowen, an economist who later became president of Princeton University, argued that because productivity growth in labor-intensive service industries lags behind that in manufacturing, productivity growth in service-oriented economies tends to sag.

Their famous example was a classical string quartet -- there are always four players in a quartet and it always takes about the same amount of time to perform a set piece of music. You can't get any more music out of the same number of musicians over that same period of time. Broadening that to other types of services, the implication is that rich countries such as the U.S. that tend to veer toward services would face higher prices as wages and costs rise.

BUT SOMETHING happened in the last decade.

The information-technology boom led to rapid efficiency gains not just in the production of high-tech equipment, as expected, but also in services such as retailing -- which had long been assumed to have little prospect for much improvement. The quartet can now be heard on iPods and even cellphones, meaning that even if musicians themselves aren't more productive, the methods of distribution are.

In fact, it is in services -- particularly in retail and wholesale trade, in something called the " Wal-Mart effect" -- where economists credit a good part of productivity gains in the late 1990s and early 2000s. That led Brookings Institution economists Barry Bosworth and Jack Triplett to conclude in an influential 2003 paper that Baumol's disease "has been cured."

Along similar lines, a pair of economists from the Federal Reserve -- Carol Corrado and Paul Lengermann -- argued in a recent paper that much of the growth in the U.S. economy since 2000 can be accounted for by strong multifactor productivity growth -- which includes labor as well as inputs such as capital and materials -- in industry, a "remarkable turnaround" in finance and business services, and an "end to the drops" in productivity in personal and cultural services.

Still, the Fed economists and their co-authors estimated that from 2000 to 2004, multifactor productivity growth averaged just 0.2% a year in personal and cultural services (which include health care, social assistance, recreation and food services, among others), compared with almost 2% for finance and business, 2.6% for distribution and 5.4% for high tech.

Sectors where productivity is high and average labor cost low "are those things that can be automated and mass-produced," Mr. Baumol, now in his mid-80s and still teaching, said in an interview. "And things where labor-saving is below average are things that need personal care -- these are health care, education, police protection, live stage performance . . . and restaurants."

UH-OH.

U.S. job growth has been concentrated in those latter sectors. More than half of the 1.6 million jobs added in the private sector in the past year have been in food services, health care and social services. Food services alone account for more than 20% of all new jobs this year, including government.

Going back to Baumol's disease, it still takes a bartender the same two minutes it always has to make a gin-and-tonic. And an "end to the drops" in productivity referred to in the Fed paper may not be enough to sustain living standards over generations.

While there's surely a cyclical component to recent job gains and losses -- areas such as health care and personal services tend to lag the business cycle -- there are longer-term forces at work.

Population aging will shift more of the U.S. economy toward one-on-one services. The Labor Department estimates that between 2004 and 2014, seven of the 10 fastest-growing occupations will be in health care, and health-care employment will double the national average. Employment in leisure and hospitality will also outpace the average, though not by as much.

"If what we're starting to see is an increase in personal services -- nursing homes, care for the elderly -- as they become bigger and bigger, that would create a very important composition story," says Martin Baily, a productivity scholar at the Peterson Institute for International Economics, a Washington think tank.

If employment and sector-specific productivity trends continue, "I would start heading toward 1.5%" annual productivity growth over the long term, says Mr. Bosworth. Still, he doesn't think that will happen; he stands by his notion that Baumol's disease has been cured, in part because medical care -- the ultimate test of Baumol's theory because it's set to account for so much of the economy -- holds promise for "big productivity gains."

There are other reasons for optimism. The U.S. is very competitive globally in high-paying and high-productivity services, so any expansion of trade could positively affect the job mix domestically.

Asked whether Baumol's disease spells doom for productivity, its namesake replies "yes and no."

"It is true that in money terms our productivity will be slowed down by the shift in labor from agriculture, manufacturing and services like telecommunications into services like health care and education," Mr. Baumol says.

"But if you count the number of students who have graduated or the number of people who have been taken care of after a heart malfunction, that is not going down." And the benefits of education and health care, on future output, can be hard to measure.

As for the disease that bears his name, not only does Mr. Baumol say it hasn't been cured, he adds: "I can brag and apologize that we've made the longest-lasting [correct] prediction that's ever been made in economics."

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