Does Verdoorn’s law still hold? This question is key to whether economic recoveries – fuelled in the US by President Biden’s fiscal stimulus – will raise inflation much.
The law says that faster growth in output and demand are accompanied by faster productivity growth. To the extent that this is the case, efficiency gains will hold down costs and hence prices, meaning that expansions need not be inflationary.
One mechanism through which this happens is that demand growth – and expectations thereof – causes companies to invest more, thus creating more and better capacity. Another channel is learning by doing. In one study of a US steel mill, for example, Igal Hendel and Yossi Spiegel found that it doubled production over 12 years even with the same plant and workforce because every time the mill seemed to be at “full capacity” its managers found ways of tweaking production methods to eke out more output.
Verdoorn’s law has certainly worked in the past. Western economies enjoyed a 20-year boom after WWII without much inflation in part because demand growth fostered productivity gains.
Can we get a repeat of that?
You might think not, because economies today are based less upon manufacturing and more upon services, where productivity gains are harder to achieve. On the other hand, though, we also now have more intangibles-based companies where output is easily scalable: Google, Facebook and software and video game producers, for example, can raise production quickly at little cost if the demand is there.
Instead, I have other doubts about Verdoorn’s law, because I’m not sure that capital spending is as sensitive to aggregate demand now as it was in the 1950s and 1960s.
For one thing, we’ve much less assurance now that demand will stay strong. In the 1950s and 1960s policy-makers were genuinely committed to full employment (at least for men). Today they are not. The fear of a fiscal or monetary tightening might well therefore restrain capital spending.
Also, in the 1950s and 1960s there was a backlog of innovations in civilian production caused by the war (not to mention bombed-out plant) and so there was huge pent-up demand for new equipment. Today, there are fewer big monetisable innovations fuelling capital spending. Granted, there are perhaps many new technologies in the pipeline such as AI, driverless cars or green fuels. But these are reasons for companies not to invest: why invest today if better future technologies will make those investments unprofitable?
And then there are scarring effects. Memories of the tech bust, the financial crisis and 2020’s recession might well depress animal spirits even when demand recovers. Which won’t be irrational. The work of William Nordhaus has shown that the returns on innovation are often low, and Hendrik Bessembinder has shown that most listed companies perform so poorly that their shares actually underperform cash during their lifetimes. Knowing this, why would anyone invest?
Finally, there are brute numbers. In the US, returns on non-financial capital have halved since the 1950s. That alone depresses investment.
There are therefore strong reasons to think that stronger demand won’t boost productivity much. Yes, you can read this as a reason to fear inflation. But you can also see it as reason to think that the golden age of capitalism has gone for good.