Total Factor Productivity, Innovation and the Sluggish Economy

There is a very little-discussed (at least by the mainstream media) measure of economic health that provides us with a picture of how innovative the economy has become, particularly since the 1980s and the impact that this has had on economic growth.  We can also see how a lack of innovation has had an impact on growth levels since the end of the Great Recession.  It is innovation that is responsible for economic growth and without it, the economy will grow at a sluggish rate, a fact that has become quite apparent over the past seven years.  To measure this factor, economists use total factor productivity (TFP).

Let's start by defining total factor productivity:

Total factor productivity is defined as the portion of economic output that is not explained by the amount of inputs used in production.  As such, its level is determined by how efficiently and intensely inputs are used in production.  

In its simplest terms, total factor productivity can be thought of how technologically dynamic an economy is or the rate of technical change in an economy.  TFP plays a very important role in economic fluctuation and economic growth and is strongly correlated with output and hours worked.  A large portion of TFP growth is created by innovations that have significant implications for the business cycle.  Here are four examples in no particular order:

1.) The development and implementation of computers and the internet (i.e. information technology) by businesses during the period from the mid-1980s onward.  

2.) The food production technological changes that took place during the 20th century that has now allowed the world to feed 7 billion people since the farming technology used in 1900 would have made the task impossible. 

3.) The technological changes that took place which have allowed the discovery and production of various natural resources that would not have been discovered using 1950's technology.  Two examples specific to the oil industry include the use of 3-D seismic and the development of multi-stage fracking.

4.) Electrification of both urban and rural areas throughout America.  This allowed the introduction of electrical consumer appliances and improved efficiencies in the manufacturing sector.

All four of these innovations have allowed the economy to expand at a far faster rate than it would have without them.

If we look back in time, we can see that the annual rate of total factor productivity has varied greatly as shown on this table:

It is interesting to note that high rates of total factor productivity lead to improvements in living standards which add to life expectancy and vice versa.  In fact, between 1900 and 1938, life expectancy rose by 25 percent, from 48 years to nearly 60 years, a very significant improvement over such a short period of time and much of this can be attributed to innovations, including the creation of antibiotics.   We can also see from the table that, while information technology had an impact on the business cycle, it was rather modest compared to other innovations.

From FRED, here is a graph showing total factor productivity from January 1950 to June 2005:

We can see how TFP really took off during the early 1980s as the computer age came to be.

Now, let's add in the period from June 2005 to 2011:

Unfortunately, FRED doesn't supply us with data beyond 2011, however, it is quite clear that TFP seems to have reached a plateau in the mid-2000s.

Fortunately, the Conference Board supplies us with data showing the growth rate of TFP.  Here is a graph showing what has happened to the annual growth of TFP for the United States from 1990 to 2014:

It is quite clear that, excluding 2010, since the end of the Great Recession, improvements in America's total factor productivity have been modest at best.  This suggests that productivity improvements in both labour and capital have not been terribly impressive and that the economy can best be described as "sluggish".

If we look globally, according to the Conference Board Total Economic Database, TFP continues to hover around zero for the third year in a row compared to average growth of 1 percent from 1999 to 2006 and 0.5 percent from 2007 to 2012 as shown on this table:

Mature economies including the United States, Japan and Europe show near zero or negative TFP growth and  China also shows negative TFP growth as shown on this table:

History has shown us that without significant innovation, economic growth will be modest at best.  With both local and global total factor productivity hitting decades-long lows, it is no wonder that the so-called recovery doesn't feel much like a recovery and that long-term real growth projections will be far under the annual average of 2 percent that the world experienced between 1870 and 2010.  It also suggests that, no matter how hard the world's central banks try to prod the economy back to life, their actions are simply pushing a very large stone up a very steep hill.  It's also telling us that yet another iteration of Apple's iPhone can hardly be considered "an innovation".