Determinants Of Economic Growth Part II

Nov 30, 2023

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In our report Determinants of Economic Growth Part I - Labor Supply dated May 10, 2023, we referred to the Phillips curve construct. We noted that for it to be credible, changes in unemployment and inflation must be the result of shifts in aggregate demand while supply remains stable. But over the past few years supply constraining shifts have been significant, first from tariffs, then from the pandemic, and then from the War in Ukraine. Indeed, in a recent analysis former Fed Chair Ben Bernanke and Olivier Blanchard identified supply shocks as one cause of the recent bout of high inflation.

Our report defined the natural rate of unemployment as the rate arising from all sources except fluctuations in aggregate demand. The Congressional Budget Office (CBO) estimates the natural rate at 4.24% versus the current actual rate of 3.4%. The Federal Reserve's forecasting models rely on the Phillips curve construct among other inputs. With supply shifts having dominated recently, the suggestion is that the Fed's efforts to reduce inflation by raising interest rates to reduce demand may be problematic if not counterproductive.

Our recent report focused exclusively on labor supply. In January 2020 CBO projected that the civilian labor force would increase by 2.86 million workers from 2019 to 2022. In fact, the increase was only 757K. This is not the first time that significant labor supply disruptions occurred. As detailed in our reports Preparing for the 2020s Stock Market dated August 3, 2022 and The Post Pandemic World – Lion or Lamb dated January 20, 2021 we noted similar labor supply disruption. World War I and the flu pandemic reduced the labor force, particularly for able bodied young men. Restrictions on immigration into the USA occurred in the early 1920s. And in the 1920s various restrictions on child labor were enacted. There was a concomitant spike in inflation in 1919-1920 followed by a deep recession in 1920-21.

Following that recession was the roaring 1920s, which was free of both inflation and recession. The decade of the twenties was characterized by strong increases that were an outgrowth of several disparate but connected sources. In our August 2022 report we identified three such contributing sources. One was a passive government. Second was sound fiscal policy. The third was a burst of productivity brought on by technological changes. Focusing on productivity, we noted petroleum-based fuels replaced coal and animals as energy sources without government prodding. Tractors, powered by fossil fuel, replaced horse drawn plows without government prodding and this significantly boosted agricultural production. Electric powered tools increased efficiency in manufacturing and construction. And radio broadcasts went from sporadic to a miniscule audience, to transmission to 40% of the population by the end of the decade.

In that same August 2022 report, we noted that from the business cycle trough in 1921, real economic growth averaged 4.2% yearly in the decade of the 1920s, and the economy was free of recession. Over the course of the decade productivity was estimated to have increased by an average of 5.4% yearly.

Productivity may increase dramatically when capital is substituted for labor because of technological advances, especially when they occur in synergistic multiples. For example, the internal combustion engine, the development of the rotary drill for oil and gas drilling, and the catalytic cracking technique for refining gasoline allowed for widespread use of automobiles, aircraft, trucks and all sorts of power tools and equipment.

The substitution of capital for labor may also be the result of an increase in the cost of labor, resulting from a relative reduction in labor supply. Certainly the 1918 flu pandemic and the deaths of millions of healthy men in World War I reduced the labor supply and contributed to the substitution of capital for labor in the 1920s.

Technological advances may also negatively impact the demand for labor. Indeed, workers have been fighting the replacement of labor with machines since the industrial revolution. The Luddites revolted in response to the introduction of the Jacquard loom in 1801. It was a system of punched cards that controlled the pattern of the loom and reduced the demand for skilled workers. The new looms produced textiles faster and cheaper because they were operated by less-skilled, low wage laborers. An agricultural variant of Luddism occurred during the Swing Riots of 1830 in southern and eastern England, centering on breaking threshing machines. In some cases, many people may be replaced by machines in one fell swoop. In Austria there is a plant that produces 500k tons of steel wire per year using just 14 employees versus as many as one thousand in a mill with similar capacity built in the 1960s.

The United Auto Workers is very concerned with the extent that replacing internal combustion engines with electric motors will significantly reduce employment in vehicle manufacturing. A larger but less well organized group, whose employment is threatened by electrification are those who maintain and repair internal combustion engines, as electric vehicles require much less maintenance.

Most recently the potential productivity creating benefits of artificial intelligence (AI) has burst upon the scene. Concerns are already arising about the labor-saving effects of this technology. The Writers Guild of America has been striking since early May of this year. A major issue is the fear by writers that they will be made obsolete by AI. IBM recently announced a hiring freeze in those divisions where AI applications would be useful and in doing so it estimated about 40K positions could be eliminated within five years.

Attempts by organized labor and others to save jobs by prohibiting or destroying technology have generally been unsuccessful. As with the internet, potentially spectacular benefits of AI will be accompanied by significant opportunities for abuse. Indeed, much of the current focus of legislators calling for regulation and prohibitions on AI is focused on abuses it could engender. On May 17, 2023, Senator Richard Blumenthal commenced a hearing on the dangers of AI, featuring testimony from OPENAI CEO Sam Altman. Blumenthal's opening remarks were recorded, but he said those were not his words or even his voice. The entire speech had been written and vocalized by an AI audio application. Blumenthal then emphasized that it was impossible to determine if he had really said or wrote any of the text.

AI has gone from obscurity to the headlines in literally record time. In our report Productivity Prospects in the 2020s dated October 5, 2022, the term artificial intelligence appeared only three times. In that article we noted that robots and automation could be very important in boosting the efficiency of the service sector and the entire economy. Of course, predicting the path of productivity improvement is difficult, particularly because it is about the future. However, there is a growing list of anecdotal evidence that is encouraging. In late August 2022 CNBC published a report titled Panera Bread tests AI technology using voice ordering technology that interacts with customers. Similarly, McDonald's (MCD) announced it is working to automate its drive-thru lane in coordination with IBM. In this same vein, on May 17, 2023, Wendy's (WEN) announced a new partnership with Pipedream, a hyper logistics company, to pilot its underground autonomous robot system with the goal of delivering digital food orders from the kitchen to designated parking spots.

In that same report we noted that a significant productivity improvement could result from the introduction of autonomous or self-driving vehicles. Our feeling is that this technology would first be deployed on commercial vehicles that tend to follow prescribed routes. The ability of AI to allow autonomous vehicles to learn routes and road conditions, in the way that human drivers do, could be the breakthrough technology that allows autonomous vehicles to replace many human drivers sooner than many think.

We may be at the tip of an iceberg in terms of productivity improvement and the major question is by how much could productivity be expected to improve in the decade ahead. Researching this report resulted in an interesting example and precursor of the potential. Before WWI many of the early owners of automobiles were taunted with the phrase "get a horse" by those passing by broken down cars. In addition to the 8.5 million military deaths in WWI, about 8 million horses were killed . These were largely requisitioned from the civilian population, which in turn then had a big incentive to adopt mechanization. Well, fifty years ago, trying to retrieve information on numbers of horses killed in WWI would likely have necessitated trips to libraries and reading through reams of microfiche. Five years ago, this task was facilitated by internet search engines. In our case we used ChatGPT open AI and in about five seconds it responded to our query. This does not bode well for those whose employment depends on tracking down obscure data.

Proponents of AI liken it to that of electricity over a century ago. That is, it is a general-purpose technology which is useful for many processes. Electricity had been in use since 1879 with the invention of the light bulb. During the 1920s this single purpose technology when combined with advances in vacuum tubes allowed for widespread use of radio and television. The electric refrigerator was invented by General Electric (GE) in 1927 and the Maytag Corporation, now owned by Whirlpool (WHR) invented the electric washing machine with an agitator. Washing machines and refrigerators reduced employment in hotels and restaurants, and this also enabled many women to enter the paid labor force, as less time was required for domestic chores.

Keeping all else equal, a change in productivity results in a commensurate change in output. Chart I attached shows the level and percent change in productivity from 1948 through 2022 with estimates from CBO extending through 2033. Over the current forecast period CBO is projecting that productivity will rise by an average of 1.9% per year. If productivity were alternatively to rise 0.5% higher in each year, i.e., 2.4% yearly, federal revenues would be higher by a cumulative $2,2 trillion. This would significantly dent future budget deficits and the amount of debt accumulation.

A step up in the nation's efficiency of 0.5% per year may be conservative. Currently about 67% of fourth graders nationwide are below proficient on reading tests and the results for math proficiency are even worse. The Khan Academy is working with generative AI to scale one on one teaching to the masses. With this technology Mr. Khan believes issues like classroom size and school choice would gradually fade as low cost twenty first century primers become available to all students. School boards and teachers’ unions may have an issue with this just as the UAW and the Writers Guild and yes, the Luddites seek to protect their respective bailiwicks. But if technology ultimately wins out as it always does, the impacts could be dramatic.

Education and training may be one of the biggest fields impacted by AI. As Senator Blumenthal demonstrated, voice synthesis and voice recognition technology are already well developed. Combining those existing technologies with AI, will allow everyone to essentially be tutored by the world's best teachers. Private tutoring is now mostly confined to the wealthy. That has always been the case. Following the publication of The Theory of Moral Sentiments, Adam Smith became so popular that many wealthy students left their schools in other countries to enroll at the University of Glasgow to learn under Smith. In 1764, Smith resigned from his professorship to take a tutoring position, at more than double what his salary had been, as a professor at the University of Glasgow. The extremely wealthy British chancellor of the Exchequer Charles Townshend hired Smith to tutor his stepson, Henry Scott, the young Duke of Buccleuch.

Earlier forms of AI are already in use in education. Colorado Technical University, a subsidiary of Perdoceo Education (PRDO), uses a personalized learning system called Intellipath®. This allows online students to receive course material based on their progress on multiple choice and fill-in-the blanks questions. The system creates a learning path for each student based on their answers and does all of the grading.

AI may eliminate many teaching positions. However, its impact on productivity may be even greater when people all over the world, from girls in Afghanistan, to poorer children in Sub-Sahara Africa have access to the type of education, via personal tutoring, that only the very wealthy could afford in 1764 and mostly now. This will put to the test the belief that the best path to productivity and thus economic growth, is through education and training.

Some attempts to quantify the potential impact of AI on productivity have been made. A recent headline Stanford and MIT study: A.I. boosted worker productivity by 14%—those who use it ‘will replace those who don't, was the result of an April 2023 National Bureau of Economic Research (NBER) working paper Generative AI at Work by Erik Brynjolfsson of Stanford and Lindsey Raymond of MIT. The NBER website shows 27 references to that working paper in major media outlets from CNBC to Forbes, in just the few weeks after its publication.

Chart I

Productivity (created by the author with data from FRED and CBO)

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