IT productivity and the U.S. economy

The secret behind the New Economy isn't information technology but old-fashioned competition and managerial innovation.

6 min read
As companies attempt to cope with an economic downturn and the United States fights a war on terrorism, many wonder whether the long-term health of the U.S. economy will be undermined.

The answer depends on what happens to the productivity growth rate--the main determinant of how fast the economy can grow. At issue is whether the near doubling of U.S. productivity growth rates during the late 1990s, from 1.4 percent (1972 to 1995) to 2.5 percent (1995 to 2000), can continue.

Our yearlong research indicates that many of the product, service, and process innovations underlying the productivity acceleration of the late 1990s will continue to generate productivity growth rates above the 1972-1995 trend for the next several years, although probably not as high as those of 1995 to 1999. Higher productivity, in turn, will boost economic growth.

Surprisingly, the primary source of the productivity gains of 1995 to 1999 was not increased demand resulting from the stock market bubble, as some economists have claimed. Nor was information technology the source, though companies accelerated the pace of their IT investments during those years. Rather, managerial and technological innovations in only six highly competitive industries--wholesale trade, retail trade, securities, semiconductors, computer manufacturing, and telecommunications--were the most important causes. The other 70 percent of the economy contributed a mix of small productivity gains and losses that offset each other. In addition, cyclical demand factors were important in some parts of the economy.

It is not unusual, we found, for only a small number of sectors to experience a productivity jump during any four-year period. But in the late 1990s, these six sectors, departing from the norm, either enjoyed extremely large leaps in productivity (for instance, semiconductors and computer manufacturing) or accounted for a large share of employment (retail and wholesale).

At the national level, the relationship between IT spending and productivity is unclear. Many sectors other than the six jumping ones increased their pace of IT investment but experienced stagnant or even slower productivity growth. We found an inconclusive correlation between the acceleration of IT investments and changes in productivity growth. In fact, taken as a group, the other 53 economic sectors had almost no productivity growth.

The challenge, then, was to understand what caused the productivity acceleration in the six key sectors. We did a detailed study of these sectors, as well as three others that invested heavily in IT but failed to boost productivity--hotels, long-distance data telephony, and retail banking.

Within the six jumping sectors, the most important cause of the productivity acceleration after 1995 was fundamental changes in the way companies deliver products and services. Sometimes these innovations were aided by technology (whether new or old), sometimes not. In all six sectors, high or increasing competitive intensity was essential to the spread of innovation. And in two sectors, regulatory changes played an important role in raising that intensity. Cyclical demand factors and a shift in consumer purchasing patterns toward higher-value goods were important in explaining the acceleration of productivity in retail, wholesale and securities.

Competition and innovation
The bulk of the acceleration in productivity after 1995 can be traced to managerial and technological innovations that improved the basic operations of companies. These innovations were structural and are likely to persist. Sometimes, the catalyst was a dominant player with a superior business model; other times, it was managers using new technology to redesign core operations.

At the national level, the relationship between IT spending and productivity is unclear. In general-merchandise retailing, productivity growth more than tripled after 1995 because competitors started more rapidly adopting Wal-Mart's innovations--including the large-scale ("big-box") format, "everyday low prices," economies of scale in warehouse logistics and purchasing, and electronic data interchange (EDI) with suppliers. As a result, Wal-Mart's competitors increased their productivity by 28 percent from 1995 to 1999, while Wal-Mart itself raised the bar further by increasing its own productivity by an additional 22 percent. Although e-commerce grew rapidly during this period, its penetration (0.9 percent of retail sales in 2000) was too low to make a difference in overall retail productivity. We estimate that Internet commerce contributed less than 0.01 percentage points to the 1.33 percent jump in economywide productivity growth.

The operations of wholesalers underwent similarly dramatic changes during the middle of the 1990s as new warehouse-management systems were adopted. Pharmaceuticals wholesalers, for instance, responded to increasing price pressure from large retailers by automating distribution centers. Because each center keeps an inventory of tens of thousands of different items, stocking, picking and shipping have traditionally been highly labor-intensive. The combination of pre-1995 hardware--bar codes, scanners, picking machines--and software for tracking and controlling inventory allowed wholesalers to automate their flow of goods partially and to increase their labor productivity greatly.

In computer manufacturing, nearly all of the productivity acceleration was due to innovations outside the sector itself. Technological improvements in microprocessors and other components (memory, storage devices), as well as the integration of new components (CD-ROMs, DVDs), caused an acceleration in the value of computers produced. At the same time, the popularization of the Internet and the accelerating processing requirements of Microsoft's Windows operating systems caused a spike in demand for more powerful personal computers. These two factors further contributed to the high productivity growth in the manufacture of computers and semiconductors.

Productivity growth in the semiconductor industry accelerated mainly because the performance of the average chip did. Largely in response to competitive pressure from Advanced Micro Devices, Intel took less time to bring out new and better chips than it had done previously. The securities industry was the only sector we studied in which the Internet materially boosted productivity. At the end of 1999, roughly 40 percent of retail securities trades were being conducted online, up from virtually zero in 1995, and a given number of frontline employees can now broker ten times as many trades as they could then. Competition from online discount brokers, such as E*Trade and Charles Schwab, was critical to the rapid diffusion of these innovations in the traditional brokerage houses.

Regulatory changes increased competition and had a significant effect on productivity in some cases. In the securities industry, the U.S. Securities and Exchange Commission's order-handling and 16th rules sharply reduced transaction costs, allowing institutional investors to take advantage of increasingly small price anomalies and boosting trading volumes.

In the telecommunications sector, the licensing of new spectrum for mobile telephony heightened competition and sparked faster price decreases, lifting both penetration and usage. In both the securities industry and the telecommunications sector, larger volumes allowed industry players to leverage fixed costs.

Cyclical demand factor
Some of the acceleration in productivity after 1995 was due to demand factors that may not be sustainable. In the securities industry, the soaring stock market led to productivity advances in three different ways. First, lofty index values--particularly the Nasdaq's--fueled a surge in online retail trading. Second, they also increased the value of assets under management, boosting the productivity of money managers. Finally, they increased the number and value of initial public offerings and of mergers. These factors explain half of the productivity jump observed in the securities industry.

In computer manufacturing, nearly all of the productivity acceleration was due to innovations outside the sector itself. In general-merchandise retailing, and most likely in the rest of retail and in wholesale, almost half of the measurable productivity jump reflected the higher value of the goods that consumers increasingly favored. Retailing experts believe that the shift was mainly the result of growing confidence, income, and wealth rather than a marked improvement in the retailers' techniques of enticement.

The role of IT
Contrary to conventional wisdom, the widespread adoption of information and communications technology was not the most important cause of the acceleration in productivity after 1995. Our nine sector case studies clearly show that the relationship between IT and labor productivity is extremely variable.

In rare cases, IT can deliver truly extraordinary productivity improvements, expanding labor capacity by an order of magnitude. As mentioned above, online securities trading requires only a fraction of the frontline labor employed in traditional channels. In mobile telecommunications, cellular equipment employing new digital standards made better use of the available spectrum, spurring rapid price declines and a spike in usage. In both cases, the product or service itself, being intangible information that could easily be digitized, was highly susceptible to such improvements.

In most cases, however, IT was just one of many tools that creative managers used to redesign core business processes, products, or services. A significant portion of Wal-Mart's business innovations--such as the big-box format--was independent of IT. Where IT did play a role, it was a necessary but not a sufficient enabler of productivity gains. To reap the full productivity benefits of inventory-management systems or EDI, for instance, a business must implement operational-process changes. The same is true of the automation of warehouse and distribution centers in the wholesale sector.