Productivity growth and IT in advanced economies

RAPID ECONOMIC growth in the U.S. over the past five years and the accompanying sharp increase in productivity growth have caused many observers to suggest that fundamental changes are underway in the U.S. economy.

Recent evidence suggests that the pickup in productivity growth in the second half of the 1990s has been led by rapid advances in the information technology (IT) sector and the application of these technologies in other areas of the economy. This possibility of a ``new economy has sparked considerable interest in the U.S. and also in other faster-growing advanced economies, some of which have shown a similar pickup in productivity growth.

(Definitions of the new economy are not precise, but typically include one or more of the following characteristics: (1) a higher rate of productivity growth related to investment in IT, (2) a rise in total factor productivity growth due to IT utilisation across the economy and resulting spillover effects; (3) an increase in factor utilisation - for example, a decline in the non-accelerating inflation rate of unemployment).

However, a number of uncertainties remain, in particular whether these recent improvements in performance will spread to other economies that have yet to show new economy phenomena, and how sustainable they ultimately will prove to be.

The `New Economy' in the U.S.

The rapid pace of U.S. output growth in the second half of the 1990s was made possible - as in many other countries - by both rising labour utilisation and accelerating labour productivity. Expanding employment added approximately 1.75 percentage points to growth over the period, with this rise reflecting both an increasing labour force (1.25 per cent a year) and a decline in the unemployment rate from 6 per cent in 1994 to nearly 4 per cent by early 1999.

Productivity growth in the non-farm business sector jumped to 2.5 per cent a year, compared with a relatively stable rate of 1.5 per cent a year during 1973-95. As the rise in productivity growth is relatively recent, and given the empirical difficulties in identifying the causes and nature of productivity shocks, most analysts have been reluctant to conclude that there had been a change in trend, despite speculation that advances in IT may have played a role. However, this is starting to change as supporting evidence accumulates.

A rise in productivity growth can be linked to computers and information technology through three channels:

Direct productivity gains in industries that produce information technology goods add to economy-wide productivity. These gains have driven computer and related equipment prices down, especially on a quality adjusted basis.

Capital deepening increases the capital-labour ratio and therefore labour productivity through investment. Investment in information technologies has been strong, reflecting falling computer prices and new ways technology can help accomplish old tasks with fewer inputs. Spillover effects occur when returns to an investment increase because others makesimilar investments.

Some positive effect is plausible with IT investment - for example, the returns to an Internet-capable computer rise as more consumers and businesses connect to the Internet.

An assessment of IT's impact on productivity growth is complicated by serious statistical problems. First, output and investment data for the IT sector are not readily available on a timely basis for many countries (the U.S. being a key exception), and therefore provide little information on technology's contribution to the recent increases in aggregate productivity.

Second, real output in the IT sector may be mismeasured, or at least measured inconsistently across countries. The U.S, Canada, and Japan are among the countries that adjust IT equipment price index data for quality improvements - for example, to account for a personal computer today being more powerful than last year's model that sold for the same price or more.

To the extent that these new capabilities are incorporated in basic models and are not always fully used by consumers, however, price declines and real output increases would be overstated. Other countries (such as Germany and Italy) do not make this type of adjustment, and therefore data may understate output gains. Third, estimates of the capital services provided by IT equipment are subject to wide uncertainty because rapid technological progress itself makes it difficult to determine economic depreciation and useful service lives.

Finally, the areas where output is likely to have the biggest impact - service industries - are those where output and productivity are the least well measured in the national accounts.

These problems notwithstanding, several new studies have concluded that IT accounted for about 0.5 to 0.75 percentage point of the estimated one percentage point rise in U.S. productivity growth in the second half of the 1990s.

Of this, investment in IT equipment (capital deepening) produced up to a 0.5 percentage point increase in productivity growth. There is a wider range of reported spillover effects, probably because these cannot be measured directly and are approximated in the studies by total factor productivity (TFP) calculations.

For the total economy, TFP is estimated to have contributed between 0.25 and 1 percentage point to the increase in productivity growth. Of this, TFP growth in the IT sector itself contributed up to 0.5 percentage point, while TFP in all other sectors added up to 0.75 percentage point to the increase in productivity growth.

Will productivity growth remain high ?

There are no clear answers. Over the next few years, it is likely that the recent higher rates of productivity growth will persist as businesses adapt to new technologies such as the Internet. Productivity growth would come through further investment and capital deepening or spillover effects, for example as workers and managers become increasingly familiar with the new technologies. There are risks, however, that productivity growth could slow in the near term.

One set of risks is captured in the harder landing scenario in which greater than expected inflation pressures, tighter monetary policies, and a re-evaluation of economic prospects by financial markets cause the U.S. economy to slow. Weaker investment growth in this scenario would slow capital deepening and thus productivity growth. Another possibility is that some part of the recent pickup in productivity growth is cyclical, as noted above. Even though such an acceleration in productivity is not typical in a mature expansion, it is possible that firms have met an uptick in demand by intensifying resource use beyond normal, sustainable levels. If this proves true, productivity growth could slow.

From a longer-term perspective, it is possible that the U.S. is experiencing a shift in the level of productivity rather than its growth rate. While it is difficult to distinguish the two when productivity is rising, and indeed there may be little practical difference during this period, it is important to note that a permanent productivity pickup implies continuous innovation.

But almost by definition, the effects of innovations such as the personal computer, the Internet, and their useful purposes are impossible to predict with certainty. Thus, policymakers face unavoidable uncertainty concerning both near - and longer - term productivity prospects.

Scope for new economies elsewhere

Several other advanced economies performed as well or better than the U.S. in terms of economic growth in the second half of the 1990s (chart). In Canada, the Netherlands, and Spain, economic growth appears to have primarily reflected labour market developments, with structural reforms paving the way for strong employment growth. In the remaining countries (in the chart), labour productivity gains owing to TFP or capital deepening contributed to output growth. While very little analytic work has been done on the role of IT in productivity increases, interest is growing.

What is the evidence so far? Australia has experienced a pickup in labour productivity through TFP growth and capital deepening while Ireland, Finland, and Sweden have experienced pickups to varying degrees through TFP growth. The extent to which these contributions to growth can be attributed to IT is not clear, however. Capital deepening through investment in IT equipment may be contributing to the aggregate growth shown in chart, as these countries spent at least five per cent of GDP on IT equipment in 1997, the most recent year for which data are available.

The TFP growth for the business sector could partly reflect the spillover effects of a new economy, but the magnitudes - especially for Ireland and Finland - are far larger than the IT spillover effects estimated for the U.S. (up to one percentage point). This suggests that much of the increase in productivity growth is probably coming from other areas.

More research is needed to estimate the impact of IT using sector-specific, detailed data. High productivity growth in the IT sector itself also may be contributing to aggregate productivity gains in some cases.

In Finland and Sweden, IT equipment accounts for approximately 4 to 5 per cent of output in each economy, well above most other advanced economies. While still a relatively small part of each economy, the IT sector could be adding about 0.25 percentage point to economy-wide productivity growth, assuming that productivity growth in the industry is similar to that in the U.S.

At the same time, not all higher productivity countries have a significant IT producing sector. IT spending as a share of GDP is extremely high in Australia, but production of IT equipment is a small share of total output

Will the effects of IT spread to industrial countries beyond the U.S. ? The answer is almost certainly yes, but the speed and scope are uncertain. Spending on IT equipment is a significant share of business sector output in most of these economies, and in principle there is no reason why IT should not play a role similar to that in the U.S., with the exception in many cases of the contribution of the IT equipment sector. The timing will depend on several factors, however, including a high rate of investment in IT capital and a supportive environment.

Some studies indicate that productivity gains lag IT investment because of the learning needed to use the new technology efficiently. The learning process could explain why IT did not boost productivity before the 1990s in the U.S. and why more definitive signs are not seen elsewhere.

In this connection, structural reforms to ensure dynamic and mobile labour markets, available capital for start-ups, and entry into the telecommunications sector are an important part of fostering profitable IT investment. IT is also likely to have an impact on other advanced and emerging markets - some of which have very large IT sectors - provided the structural conditions just listed are in place.

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