May 8, 2008 | posted by Michael Baxter in US economy, productivity |

Critics of the US often forget about one key aspect of the economy:  productivity and what drives it.

The US is pumping money into the financial system at a time of rising prices – a recipe for inflation, argue many.  This is why, for example, the National Institute of Economic and Social Research recently forecast 4.3 per cent inflation for the US this year.

But, as has been said before, rising prices only lead to inflation if the price rises are sustained.  Inflation only becomes an issue in the longer-term if wages are rising too.

Remember, price is determined by demand and supply.  If demand is greater than supply, prices will rise until demand falls to the level that matches supply. In the longer-term, supply will rise too.  If, however, rising prices are met with rising wages, then demand will continue to exceed supply and prices will continue to go up.  That’s when inflation sets in.   

The fear is that all this money the Fed is pumping in will eventually feed future pay rises – leading to an inflationary spiral.

But on the other hand, if wages stay low, then it’s all quite affordable.

Yesterday came some real good news on that front.

Unit labour costs and productivity rose at exactly the same pace in the first quarter.  Both jumped at an annualised rate of 2.2 per cent.

This means that labour costs per hour rose by exactly the same amount as labour productivity per hour – in other words, any rise in wages came out of productivity, and will have had zero impact on inflation.

The good news does not stop there, either.  Over the last year, US productivity is now up by 3.2 per cent, a rate which Capital Economics said, “most other developed service-based economies can only dream of.”

For as long as productivity continues to enjoy such rapid growth, American workers should find themselves getting steadily better off.  In the long-term this could even turn the credit crunch into a good thing.  

US consumers have too much debt – in the past they reacted to rising wages by taking on even more debt – so that no matter how much more they were earning their exposure was too high.     With luck, the credit crunch is changing attitudes, so if productivity can continue to rise, and in its wake wages – total debt relative to incomes should fall to sustainable levels. 

The alternative was a route that seems to be leading to bankruptcy.

Ironically, the United States’ strength seems to be its weakness.  Attitudes to risk in the US have led to a too relaxed approach to debt – but at the same time have encouraged entrepreneurism, which surely lies behind the rises in productivity.