Productivity Pinch

Because of the nature of the services they provide, states and localities find it difficult to increase productivity.
September 2003
John E. Petersen
By John E. Petersen  |  Columnist
John E. Petersen was GOVERNING's Public Finance columnist. He was a Professor of Public Policy and Finance at the George Mason School of Public Policy.

A few weeks ago, the National Bureau of Economic Research announced that the U.S. recession had officially ended in November of 2001. This certainly came as news to the states, which are hobbling along with revenues that continue to fall behind expenditures and which, after two years of dodging the bullets with short-term fixes, are now earnestly cutting spending and jobs.

According to the lore of public finance, state finances are supposed to recover 18 months after the uptick in the rest of the economy. It's been a year and a half since November 2001. So, where is the rebound?

Well, it isn't here. This is the situation for many sectors, including state and local government, because history has an ornery way of not always repeating itself. This recession, which in terms of unemployment is still very much a continuing fact, is different. Jobs are down, prices are flat, profits are suspect, and there are nagging deflationary concerns. Take business investment. Despite the NBER announcement, a recovery in job-producing investments by business has not occurred. Capacity was built up so much during the last half of the 1990s that there are excesses all over the place. Furthermore, manufacturing and--to an increasing (and unnerving) extent--services are finding less expensive places to operate. For example, service jobs that can be done off-site, ranging from computer support to accounting, are fleeing to lower-cost foreign shores.

What this all comes down to is that economists are now talking about very long business cycles replacing the shorter, sharper ones: Several years of prosperity followed by years of lingering blahs.

The public sector is right in the midst of these changes. In fact, it is facing some especially difficult adjustment problems. Contrary to what is the recently received wisdom, governments did not load up on expensive employees during the good times. It is the increase in transfers, especially Medicaid, and the growth of high-service populations (children and convicts) that have done them in. But governments are major employers, and as such they face peculiar hurdles. It's very difficult to become more productive because of the nature of the services they provide.

Some 35 years ago, the economist William Baumol identified the service-intensive nature of government as a long-term problem. Capital could be combined with technology to increase productivity in many areas and effectively replace labor, something we have seen in manufacturing, agriculture and many former service areas. That is called increased productivity. But most government services are not susceptible to these advances in productivity. Teachers, police, fire fighters and social workers are "hands-on" producers. The services they render are, to a great extent, the final product. This workforce needs to stay near at hand and be on the scene to deliver its output to its clients.

The rub is that this means time. It is extremely difficult to make workers more productive by increasing their caseloads. While a teacher with 40 pupils in the classroom might appear to be more productive than one with 20, most of us would expect the quality of instruction to suffer. The same might be said for playing a string quartet with two instruments: More productive, perhaps, but it's not the same thing.

There are implications arising from the disease of lagging productivity in public services. As wages go up in those sectors that enjoy the fruits of more productivity, the wages of those in the service-intensive sector also rise in order to retain qualified labor. According to work done by the National Bureau of Economic Research (the same outfit that is calling the business cycle), the average public-sector wage from 1960 to the late 1990s grew at about the same rate as private-sector wages. What changed, however, was what makes up the average. Public-sector wages are much more compacted around the average, without the extremes found in the private sector. Furthermore, the wage dispersion in public-sector jobs remained steady, while increasing in the private sector. Roughly translated, this means that lower-paid workers do relatively better in public- sector jobs and the higher paid do worse. Of course, aside from the thrill of serving the public, one of the attractions of a career in the public sector has been the job security and good benefits. But these enticements are now very much at risk as pink slips go out and benefits are scaled back.

So there you have it. Governments have two built-in problems to deal with. They are service-oriented (where increased productivity is hard to come by), and they cannot compete effectively for higher-paid, more skilled talent. The rough justice in all this has been that public employees have been relatively secure from the big ups and downs. But in a service-heavy sector plagued by Dr. Baumol's productivity disease, they may no longer be safe from an ever-constricting budget.