Roger W Ferguson, Jr: Lessons from past productivity booms
Speech by Mr Roger W Ferguson, Jr, Vice-Chairman of the Board of Governors of the US Federal
Reserve System, at the meetings of the American Economic Association, San Diego, 4 January 2004.
The references for the speech can be found on the Board of Governors of the Federal Reserve System's website.
* * *
As we are all well aware, the United States has been enjoying significantly faster productivity growth
for the past eight years or so than it did over the preceding two decades. Since 1995, labor
productivity has risen at an average annual rate of about 3 percent, up from an average annual rate of
around 1-1/2 percent between 1973 and 1995. And in the past two years alone, output per hour has
increased more than 5 percent per year.
The significance of the improvement since 1995 can hardly be overstated, even after taking into
account the cyclical component of the most recent quarters. If productivity were to continue to improve
at an average annual rate of 3 percent, the standard of living in the United States would double
roughly every twenty-four years. If, on the other hand, productivity growth were to revert to an average
annual pace of 1-1/2 percent, a doubling in the standard of living would occur only every forty-seven
years. Many observers-including some economists-argue that the present era of robust trend
productivity growth will soon come to an end. Others are more optimistic and argue that the potential
gains to productivity from the technological advances associated with the computer revolution are far
from complete.1 Because productivity growth is critical to economic welfare, assessing the likelihood of
these alternative outcomes is of considerable interest.
In thinking about this issue, it is worth recognizing that periods of strong trend productivity growth,
although perhaps novel to many of us, are not new to the U.S. economy. In fact, three earlier periods
seem to stand out from the historical record as especially worthy of further scrutiny for the lessons
they may offer regarding the current episode: a period in the late 1800s from roughly the end of the
Civil War to around 1890; the decade or so between the end of World War I and the onset of the Great
Depression; and the period from about 1950 to the early 1970s.2
Of particular note is that in at least two of the earlier episodes, heightened productivity growth lasted
for an extended period - roughly twenty years or so. Thus, one objective in examining these previous
productivity booms is to see whether we can glean any insights into the best ways to sustain the
current episode of strong productivity growth. To be sure, each period mentioned can be associated
with particular advances in technology, implying that technological progress is a necessary component
of trend productivity growth. But significant technological advances were also evident in periods when
productivity growth was less robust. Thus, a natural question to ask is whether other complementary
factors - including aspects of the labor market, of the business environment, or of government policies
- combine to render technological change especially potent or help to foster the transmission of
technological change into real gains in the efficiency of the production process.
Similarly, examining the historical record may shed light on the sustainability of the current boom. Do
productivity booms simply run out of steam and die natural deaths? Or are they cut short by economic
imbalances, exogenous shocks, or detrimental government policies? And, if the latter, are these
cessations inevitable?
At the outset, I should note that this lecture is co-authored with William Wascher, who is a member of
the staff at the Board of Governors. To provide a roadmap of where we intend to go, I want to start by
setting out some basic facts about previous periods of strong productivity growth in the United States. I
will, of course, begin with some numbers. But I also want to discuss some of the technological
innovations that contributed to these productivity booms and about the supportive roles played by
changes in the organization of American businesses and the structure of financial markets, and by the
U.S. education system. Finally, I will spend some time on the lessons that we think can be learned
from what, in many ways, are striking similarities across the three previous episodes and the current
one.
Identifying previous productivity booms
I should also note at this point that even the basic facts about economic growth, not to mention the
interpretation of those facts, are sometimes subject to considerable debate. Some of these
disagreements undoubtedly result from the lack of consistent information on U.S. productivity before
data from the Bureau of Labor Statistics (BLS) became available in 1948. For this earlier period, we
use data developed in the early 1960s by John Kendrick, who constructed estimates of GDP
consistent with the prevailing definitions in the National Income and Product Accounts going back to
the 1870s (which had as their basis estimates made by Simon Kuznets in the 1940s).3 These
estimates are often cited as the best available measure of U.S output and productivity growth for that
period. Although subsequent researchers - notably Balke and Gordon (1989) and Romer (1989) -
have refined these estimates in different ways, the additional refinements focus primarily on the
cyclical properties of output and do not significantly alter the qualitative statements about long-run
growth made here. A number of economic historians - most notably Robert Gallman - have estimated
U.S. GDP for the period before the Civil War.4 However, given that their estimates are surely less
reliable than those for the later, more industrialized period, we have elected to limit the focus of this
lecture to the post-Civil War period.
These caveats aside, average growth rates of productivity over various periods are presented in the
table. We will focus on labor productivity (the first column) because that measure is the best indicator
of improvement in the nation's standard of living. For the entire period from 1870 to 2003, labor
productivity has risen at an average rate of around 2 percent per year. However, productivity growth
has not proceeded in a steady fashion. We have chosen time periods for our analysis that smooth
through the business cycle, which is a significant source of shorter-term changes in rates of
productivity growth. More important for this discussion is the variation in labor productivity growth that
has occurred over longer stretches of time, with periods of robust growth interspersed with periods of
more modest productivity gains.
Using the Kendrick data as a guide and recognizing that the choice of any particular period is
somewhat subjective, we take as the first episode of strong productivity growth - or productivity boom,
if you will - roughly the period from 1873 to 1890. During this period, labor productivity rose more than
2-1/2 percent per year, a rate thought to be considerably higher than the average growth experienced
over the first 100 years of the United States.5 An important element of the analysis of this and other
periods is the decomposition of output per hour into its underlying sources, including the contributions
of multifactor productivity, capital deepening, and labor quality. In this regard, Kendrick's
decomposition suggests that labor productivity growth in the late 1800s was fueled importantly by
capital investment.6
During the next three decades, from 1890 to 1917, the growth rate of labor productivity slowed to an
average pace of only 1-1/2 percent per year, with modest rates of growth both in the capital stock and
in multifactor productivity. The United States then enjoyed a relatively brief spurt in productivity until
about 1927, with labor productivity rising about 3-3/4 percent per year and multifactor productivity up
around 2 3/4 percent per year. This productivity boom was led by the expansion of the automobile
industry and robust productivity gains in manufacturing more generally. Productivity growth was
markedly slower through the Great Depression and World War II, largely reflecting a lack of capital
deepening. Multifactor productivity rose at a relatively solid pace - albeit not as fast as earlier in the
century - despite the weak economy during much of that period.
Productivity growth since World War II is more familiar to us and is based on more reliable data - those
constructed as part of the multifactor productivity program at the BLS. According to these data, labor
productivity rose at an annual rate of close to 3 percent from 1948 to 1973 - a period sometimes
referred to as the golden age of productivity growth. During this period, productivity accelerated across
a broad range of industries, and both capital deepening and gains in multifactor productivity
contributed to the strong pace of growth. The productivity slowdown of the 1970s and 1980s is also
well known to us, and its possible causes have been the subject of much research. Labor productivity
growth slowed to an average pace of 1.4 percent per year over this period, while multifactor
productivity growth fell to a pace of 0.4 percent, the slowest pace of any of the periods shown on the
table. Finally, labor productivity growth has averaged about 3 percent at an annual rate since 1995,
with higher rates of both capital deepening and multifactor productivity growth contributing to the
pickup.
Sources of past productivity booms: technological change
Although the productivity booms of the past century and a quarter obviously differed in many respects,
each episode can readily be associated with the introduction of one or more new technologies. The
boom after the Civil War, for instance, appears to have had its genesis in technological improvements
that increased the flexibility of production and reduced transportation costs, which allowed firms to
take advantage of economies of scale in production and distribution.
In particular, the widespread introduction of steam engines and machinery driven by new sources of
energy enabled firms to move away from sources of waterpower and closer to areas where inputs -
including labor and raw materials - were more readily available. The Midwest - where sources of
waterpower were less abundant but coal was more abundant - benefited greatly from this
development, and indeed within a few decades became known as the "industrial heartland" of the
United States. This regional shift in economic activity is illustrated by a sharp rise in the share of
personal income generated in the Midwest between 1840 and 1880 (from 20 percent to 35 percent),
and the commensurate decline in the share of income generated in the Northeast (from 43 percent to
31 percent).7
The increase in the importance of railroad transportation also helped raise productivity growth in the
second half of the nineteenth century.8 Improved methods of steel production - notably, the Bessemer
process, and later, Siemens's open hearth method - enabled railroads to lay longer-lasting steel track
rather than iron track. And the growth of telegraphy enabled railroads to better coordinate the
movement of trains over a wider area. As a result, railroads expanded their geographic coverage
significantly after the Civil War: From 1860 to 1890, the number of main track miles operated by
railroad companies more than quintupled, from 31,000 miles to 167,000 miles, while the number of
freight cars in operation jumped from 185,000 to more than 1 million.9
The expansion of the railroads drove transportation costs sharply lower and allowed a significant
increase in market size. Whereas, in 1830, the transportation of goods from New York to Chicago had
required three weeks even during the warmer months of the year, by 1870, it could be accomplished in
three days any time of the year.10 In addition, the construction of new rail lines in western states
opened those markets to a wide range of East Coast and Midwest manufacturers. Moreover, some of
the benefits of the productivity improvements in the railroad industry were passed on to producers in
the form of lower costs of transporting goods. Freight rates fell from 2-1/4 cents per ton-mile in 1860 to
less than 1 cent per ton-mile by 1890. As a result, the quantity of goods transported by rail increased
sharply, from about 12 billion ton-miles in 1870 to 80 billion ton-miles in 1890.11
Another major technological advance in the mid-1800s was the telegraph. Besides aiding the
expansion of railroads by improving the coordination of rail traffic, the telegraph sharply reduced the
costs of communicating in many other industries. And judging from the rapid growth in its use - the
number of messages handled rose from about 9 million in 1870 to nearly 56 million in 1890 - the
telegraph undoubtedly contributed to better decisionmaking and higher productivity throughout the
economy.12
Agriculture also was increasingly mechanized in the decades immediately after the Civil War, though
the change was not as impressive as in the industrial sector. The abundance of land in western states
limited the interest among farmers in raising land productivity. However, labor services were more
difficult to obtain, so farmers were quite willing to invest in labor-saving machinery. As a result, the
better plows, seed drills, reapers, and threshers developed by manufacturers were in high demand by
farmers, and the amount of labor required to farm an acre of land fell sharply for many crops.13
In the productivity boom of the early twentieth century, the chief technological innovation was most
likely the spread of electrification to the factory floor. As Paul David and others have extensively
documented, the use of electric motors in the production process increased substantially in the first
quarter of the century.14 In particular, the amount of mechanical energy derived from electric motors
rose from 475,000 horsepower in 1899 to nearly 34 million horsepower in 1929, and the fraction of
overall factory horsepower produced with electricity rose from less than 5 percent to more than
80 percent over that period.15
A major benefit of electric motors was that they enabled each machine in a factory to be powered by
its own motor. This allowed manufacturing plants to be organized in a way that maximized the efficient
movement of materials rather than the efficient transmission of power, and it facilitated the spread of
continuous processing techniques and the assembly lines made popular by Henry Ford. Indeed, as
electric power became less costly - aided by a steep reduction in regulated electricity rates after World
War I - its use increased sharply, and factory productivity rose significantly. By one estimate,
productivity growth in the manufacturing sector as a whole rose about 5-1/2 percent per year between
1919 and 1929.16
Of course, other technological innovations also contributed to productivity growth during this period.
Notable among them were the telephone - which by the 1920s had largely replaced the telegraph; the
internal combustion engine, the use of which in motorized vehicles led to sizable productivity gains in
the transportation and agriculture sectors; and a variety of technological advances in machine tools. In
addition, the early 1900s were characterized by the first wave of office automation equipment,
including the portable typewriter and adding and duplicating machines. These machines improved the
efficiency of a wide range of management and accounting tasks, and the demand for such equipment
rose quite sharply between 1900 and the late 1920s. Indeed, in real terms, business investment in
office equipment increased from about $50 million (in 1929 dollars) in 1899 to nearly $500 million in
1929, with a particularly large jump evident in the 1920s.17
The productivity gains of the 1950s and 1960s, in part, had their roots in the technological innovations
arising out of research sponsored by the military during World War II.18 For example, although
research advances in synthetic polymerization chemistry (most notably, the introduction of catalytic
cracking in the processing of crude oil) were made in the 1920s and 1930s, the synthetic rubber
program launched during the war led to mass production of the first synthetic polymer from
petroleumbased feedstocks. Similarly, production of polyethylene, a petrochemical-based plastic discovered in
the 1930s, jumped sharply in the 1940s because of its widespread use in military equipment. And, the
military's need for large stocks of penicillin led to a production process for it that turned out to have
applicability to a wide range of pharmaceuticals.
The commercialization of these wartime innovations sharply increased the number of products made
wholly or partly from newly developed plastic polymers and other synthetic materials. The use of
polyethylene, for example, grew sharply after the war, while additional technological advances isolated
new forms of synthetics and further reduced production costs for chemicals and pharmaceuticals.
Overall, production in the rubber and plastic products industry rose nearly 7 percent per year between
1947 and 1970, while the output of the chemical products industry rose more than 8 percent annually
over the same period.19
Two other notable technological advances during this period were the invention of the transistor in
1947 and the use of the jet engine in commercial aircraft. Commercial applications of the transistor,
initially in solid state consumer electronic products, were stimulated by improvements in the fabrication
process (in 1954) and by the introduction of the integrated circuit (in 1958). With the rise in demand,
semiconductor production jumped markedly, rising nearly 20 percent per year during the 1960s.20
Similarly, the introduction of the Boeing 707 in 1958 sharply reduced the time and cost of transporting
passengers and freight. In particular, according to estimates by Gordon (1992), productivity in the
commercial airline industry rose 7 percent per year during the 1960s, well above the rate of labor
productivity growth for the economy as a whole.21
For purposes of comparison, the technological origins of the more recent computer revolution also
bear a brief mention. Obviously, the invention of the transistor and the development of the mainframe
computer were precursors of the technological advances that contributed to the current productivity
boom. However, the real drivers of the productivity gains in the 1990s were the related high-tech
innovations of the 1970s and 1980s, including the personal computer, fiber optics, wireless
communications, and the Internet.
Many of the recent technological innovations have significantly altered how firms interact with their
customers, in ways that have raised the productivity of the economy. In the retail sector, the Internet
stores made popular by Amazon.com have been adopted by nearly all large retail chains; in banking, it
is now routine for customers to pay bills online; and for airlines, Internet reservations and e-tickets are
the norm. Moreover, throughout the goods economy, from manufacturing to retailing, innovations in
inventory management practices made possible by new technologies have substantially reduced
costs.
An important point about technological change is that, in most cases, the invention of the technologies
that stimulated the productivity growth in these boom periods took place well before the productivity
gains were realized. For example, the steam engine was invented in the 1700s, well before it had any
measurable effect on the production process in the United States. Similarly, railroads were being built
in the 1840s, and the first electric power plant was built in 1882. And as we all know, the absence of a
significant contribution to productivity growth from computers, which were first introduced in 1945, was
a puzzle to many economists as late as the mid-1990s.
What then facilitated the translation of these innovations into gains in productivity? At one level, the
delay reflected the challenges of developing commercial applications for the new technologies. The
lag from a new invention to a new product or process was sometimes quite long because of the
additional scientific research required to demonstrate its practicality. In addition, in many cases, new
technologies diffused into the capital stock relatively slowly. Replacing older machines with equipment
that embodied the new technologies was often not immediately profitable, and thus firms frequently
took some time before making the capital investments required to take full advantage of technological
progress.
Sources of past productivity booms: organizational change
A careful examination of past productivity booms also points to substantial changes in business
practices and in the organization of firms as a key factor enabling businesses to achieve the potential
productivity gains associated with new technologies.22 In many cases, these organizational changes
went hand in hand with the technological advances - the changes both being made possible by the
new technologies and being necessary to achieve the additional productivity associated with the use
of these technologies.
For example, before the Civil War, most businesses were either sole proprietorships or partnerships
serving local markets and consisted of small shops employing skilled workers involved in each aspect
of the production process. At the same time that the spread of railroads lowered transportation costs
and increased the size and number of potential markets, the greater availability of steam power
enabled manufacturers to set up factories to take advantage of economies of scale in production. As a
result, the optimal firm size rose substantially in many industries. In the cotton industry, for example,
the median firm size (measured as the annual value of gross production in 1860 dollars) rose from
$31,000 in 1850 to nearly $100,000 in 1870; similarly, in the iron industry, median firm size rose from
$24,000 in 1850 to more than $200,000 in 1870.23 In addition, large wholesalers (and later, retailers)
emerged to take advantage of increased distributional efficiencies to sharply reduce the costs of
moving commodities and manufactured goods from the farm or factory to retailers' shelves.
These larger enterprises typically had to confront communications challenges not faced by smaller
businesses. In particular, effective internal information flows were often crucial to the success of firms
producing or distributing large volumes of inputs and outputs. The telegraph and the railroad-based
postal service made prompt communication over great distances possible. But firms also had to set up
hierarchical management systems to control the production process and to coordinate the flow of
goods across the distribution system in order to take advantage of the economies of scale presented
by technological change.
Advances in production processes in the early 1900s led to new challenges and opportunities for
business organization. As noted above, the diffusion of the electric motor throughout the factory
increased the use of continuous-process methods and the assembly line and thus accelerated the
trend toward mass production. In addition, as early as the 1880s, manufacturers had begun to
integrate forward into distribution; one noteworthy example was the meatpacking industry, in which
firms purchased refrigerated rail cars that allowed shipment of beef from centralized slaughterhouses
to branch houses that served local markets. The advances in mass production techniques and the
increasing complexity of many manufactured products led firms in other industries to integrate forward
not only into distribution but also into retailing; this vertical integration reduced transactions costs even
more and further increased the optimal size of firms. Indeed, many of the large corporations that arose
at this time - Ford, General Motors, and General Electric, for example - are still with us today.
The vertical integration of these large corporations, in turn, led to a greater emphasis on
nonproduction activities.24 To compete in retail markets, firms needed to understand what products
consumers wanted and to enable consumers to associate specific products with a particular firm; in
addition, firms needed to establish accounting systems to keep track of a wider range of activities. As
a result, marketing and advertising departments arose within large corporations, as did accounting
departments. Also, with large corporations now more sensitive to their market share and their cost
advantage over their competitors, they began to develop applied research departments to foster
innovations in their industries.
After World War II, changes in the organization of the firm took two forms. The first was an increasing
tendency by corporate managers to split the firms' operations into separate divisions, each with its
own manufacturing and marketing departments. This multidivisional approach was well suited to the
technological changes of the 1940s and 1950s, as many innovations during that period led to the
manufacturing of diverse product lines by a single company, DuPont and Monsanto being key
examples.25
This multidivisional structure also turned out to be an effective method of handling corporate
operations in different geographic areas; and indeed, the second major organizational innovation
during this period was the rise of the multinational corporation. After World War II, new trade
agreements and efforts to revitalize Europe and Japan allowed American firms to make significant
inroads into foreign markets. To handle these long-distance operations more easily, corporations often
set up foreign subsidiaries that could adapt quickly to changing circumstances in the host country's
marketplace. By one estimate, such multinational corporations accounted for nearly 35 percent of total
U.S. corporate assets by 1966.26
Organizational structure during the productivity boom of the late 1990s has, in some respects, shifted
away from the large corporations that dominated the U.S. economy during much of the twentieth
century. To be sure, the marketplace in many industries is still dominated by large, well-established
firms. And in some industries - the financial services sector comes to mind - recent technological
innovations have, if anything, increased the scale of business. But in other industries, intense global
competition has motivated many corporations to narrow their focus to core production-related activities
and to outsource other functions. Increasingly, these supporting firms are providing their services from
overseas, taking advantage both of lower labor costs there and of the revolution in communications.
At the same time, much of the rapid technological innovation in this period has occurred outside the
large corporate sector, and the success of that innovation has boosted the pace at which new
ventures are being created. For example, more than 700,000 new businesses were incorporated each
year, on average, in the 1990s, about double the pace of the 1970s.27 Of course, as we know from the
dot-com experience, many of these firms failed. However, many others either grew or were bought by
larger firms better able to market and distribute the most promising innovations.
Sources of past productivity booms: financial market change
A third major ingredient in promoting the productivity gains associated with technological innovation
has been a complementary set of innovations in the financial sector that have changed the financial
landscape in ways that were especially appropriate to the predominate form of business organization
in each period.28
For example, before the Civil War, most nonfinancial business investment was financed internally with
retained earnings, with capital provided by family or friends, or through partnerships formed with other
proprietors. The chief exceptions were the canals and railroads, which were actively issuing stocks
and bonds in the 1850s.29 With the need for greater capital investments and the sharp increases in the
scale of operations of many firms after the Civil War, however, businesses in other industries also
began to look more toward external sources of financing.
The main sources of funding in the decades after the Civil War were debt and preferred stock.30 Debt
often took the form of secured loans, in large part because investors were concerned about the
informational asymmetries they faced in evaluating the bankruptcy risk of particular firms. In addition,
the owners of many firms often preferred financing with debt rather than common stock because they
did not want to see their equity diluted or their control of the enterprise diminished. Similarly, preferred
stock, which reduced bankruptcy risk but did not dilute the equity of the owners of the firm, was often
used when assets were insufficient to secure the loan. Thus, despite the prevalence of information
problems, financial intermediaries were able to provide firms with external sources of funds, making
possible the rapid buildup in the capital stock that took place in the late 1800s. For example, the total
value of bank loans rose from less than $1 billion in 1870 to more than $6 billion in the early 1890s, a
notable increase in nominal value during a time when, if anything, the aggregate price level was
falling.31
In contrast, the years after World War I were characterized by an increase in the importance of equity
markets. At the New York Stock Exchange alone, the volume of stock sales rose from 186 million
shares in 1917 to more than 1 billion shares in 1929.32 And, by one estimate, the number of individuals
holding stock increased from 500,000 in 1900 to 10 million by 1930.33
The rise in the public's interest in common stock occurred for several reasons. First, and probably
most importantly, the profitability of large corporations during the early 1900s was accompanied by an
expanding middle and upper class that wanted to take part in the economic gains associated with the
introduction of new technologies such as the internal combustion engine and the electric motor. As the
main way to share in these capital gains was to purchase some ownership in those corporations,
these individuals increasingly looked to invest their savings in the stock market.
At about the same time, the informational problems that had constrained interest in common stock
through the early 1900s were being reduced. Rising demand from investors in the late 1800s for
information about railroad companies had led to the proliferation of newsletters watching
developments in that industry, and similar publications soon sprang up to provide information on other
traded securities. These newsletters eventually evolved into ratings agencies covering a wide range of
individual corporations, with Moody's issuing the first bond ratings in 1909. Although these agencies'
ratings focused on corporate bond issues, many also provided economic forecasting services and
more detailed information about the relative risk of specific companies. In addition, with a greater
recognition of the need to address investors' concerns about risk, more public companies regularly
issued audited financial statements.34
Interest in common stock was also boosted by the tendency to imbue them with characteristics similar
to those associated with debt, with which investors were more familiar. For example, businesses
frequently attempted to establish steady dividend streams in order to boost investors' confidence
about the future profitability of the firm and encourage holdings of their securities. Finally, the
marketing of securities to the household sector became more aggressive in the 1920s, led by
investment trusts - which offered investors a means of diversifying individual portfolios - and retail
brokerage firms.
Given the relative prosperity of the post-World War II period, nonfinancial corporations were able to
generate significant increases in internal funds. Even so, the growth of investment spending over this
period noticeably outpaced the rise in retained earnings, and thus these corporations turned to the
capital markets to fill the widening gap. In response, both bond and equity issuance rose rapidly in
absolute terms, and the ratio of external financing to overall capital spending increased from an
average of around 30 percent in the late 1940s to more than 40 percent in the early 1970s.35
There were two specific developments in financial m