Perspectives

AI AND TIGHT LABOR MARKETS FUEL ECONOMIC TRANSFORMATION

GW&K GLOBAL PERSPECTIVES | December 2024

Highlights:

• US productivity growth has surged to 2.4% annually over the past two years, with potential to accelerate further to match the 3% pace of the 1990s tech boom — a shift that could add $7 trillion to GDP by 2034.
• Manufacturing investment has doubled recently, driven by semiconductor and battery production, while generative AI is being adopted twice as fast as previous technological revolutions like PCs and the internet.
• Persistent labor shortages are forcing companies to invest in automation and technology, with historical patterns suggesting this could sustain productivity growth at 2.7% annually over the next five years.
• Policy decisions on trade and immigration could significantly impact this productivity trajectory, particularly given the importance of global supply chains and high-skilled STEM workers for technological innovation.

LABOR PRODUCTIVITY HAS SURGED

American productivity growth has quietly staged a remarkable comeback. After years of sluggish gains that puzzled economists and frustrated policymakers, US worker output is now expanding at its fastest pace since the dotcom boom, setting the stage for what could become a transformative period for the world’s largest economy.

Labor productivity has surged at a 2.4% annual rate over the past two years, according to the Bureau of Labor Statistics, with the potential to soon match the powerful gains seen during the internet revolution of the late 1990s (Figure 1). This renaissance comes at a crucial moment, as businesses grapple with persistent worker shortages and rapidly advancing artificial intelligence technologies.

The resurgence marks a sharp departure from the past decade, when productivity growth averaged just 1.2% annually — less than half the pace seen during the transformative 1995 – 2005 period that reshaped the American economy. The acceleration has profound implications for everything from inflation and wages to corporate profits and economic growth.

MANUFACTURING’S HIGH-TECH MAKEOVER

Behind the numbers lies a dramatic shift in business investment patterns. Manufacturing investment has doubled recently, with spending concentrated on electronics and electrical equipment production (Figure 2). Much of this surge has been catalyzed by federal legislation like the CHIPS Act and Inflation Reduction Act, which have incentivized domestic semiconductor and battery production.¹

This investment boom has proven remarkably resilient even in the face of the Federal Reserve’s aggressive interest rate hikes, helping to offset weakness in the housing market. The focus on high-tech manufacturing suggests companies are betting big on automation and advanced technologies to boost output.

LABOR SHORTAGES DRIVE INNOVATION

The tight US labor market, reflected in historically high prime-age workforce participation, has become an unexpected catalyst for productivity gains (Figure 3). With workers scarce and wages rising, companies are increasingly turning to labor-saving technologies and processes.

History suggests this could be the beginning of a sustained productivity boom. Previous periods of labor market tightness have typically been followed by robust productivity growth. Current conditions would be consistent with productivity growth averaging 2.7% over the next five years if historical patterns continue (Figure 4).

THE AI ACCELERANT

While traditional investment and labor market dynamics are important, the rapid emergence of artificial intelligence technologies could supercharge productivity gains in ways previous technological revolutions haven’t.

According to research from the Federal Reserve Bank of St. Louis, generative AI has achieved an adoption rate of nearly 40% within just two years of ChatGPT’s introduction — far outpacing the adoption rates for revolutionary technologies like personal computers and the internet, which took years longer to reach similar penetration (Figure 5).²

Goldman Sachs estimates that widespread AI adoption could boost productivity growth in developed markets by about 1.5 percentage points, with measurable effects on GDP beginning to appear by 2027 (Figure 6).³ Their analysis suggests AI could ultimately automate about 25% of labor tasks in advanced economies.

KEY RISKS TO THE PRODUCTIVITY RENAISSANCE

While the convergence of technological advancement and economic conditions has created fertile ground for a productivity boom, two significant policy risks could impede this transformation: trade restrictions and immigration constraints.

TRADE POLICY RISKS

Proposals for broad-based tariffs of 10% to 20% on America’s trading partners, with higher rates for China, could significantly impact productivity growth. Economic research suggests that trade barriers often impede the reallocation of resources to more productive uses — a crucial mechanism for productivity growth.⁴ While targeted tariffs might have limited effects, widespread trade restrictions could disrupt the supply chains that support technological advancement and manufacturing investment.

IMMIGRATION AND INNOVATION

Immigration policy presents perhaps an even more direct challenge to productivity growth. Research indicates that high-skilled foreign workers, particularly in science, technology, engineering, and mathematics (STEM) fields, have been crucial drivers of US productivity gains. Studies show that foreign STEM workers accounted for 30% to 50% of aggregate US productivity growth between 1990 and 2010.⁵ Historical precedent from the 1920s immigration restrictions demonstrates how reduced immigration can constrain both labor and capital growth, ultimately dampening productivity gains.⁶

Particularly concerning would be policies affecting high-skilled immigration channels like H-1B visas, which have historically supported innovation in key technology sectors. While labor shortages might accelerate automation in some sectors, the net effect of severely restricted immigration could be negative for overall productivity growth.

ECONOMIC IMPLICATIONS

The interplay between these risks and opportunities will likely define the trajectory of US productivity growth. Under optimal conditions — with continued technological adoption and measured policy approaches — productivity growth could match the 3% rate seen during the last tech boom. This would generate profound economic benefits:

1. US GDP could approach $50 trillion by 2034, approximately $7 trillion above current projections (Figure 7).
2. Higher productivity growth could help reconcile robust wage gains with controlled inflation, promoting a lengthy business cycle expansion (Figure 8).
3. Increased tax revenues could help address fiscal sustainability concerns.
4. Market valuations could be supported by higher expected corporate profits.

Financial markets may play a stabilizing role in policy formation, as significant market reactions to restrictive trade or immigration policies could encourage more moderate approaches. However, the ultimate outcome will depend on how policymakers balance competing priorities.

High stock market valuations have historically preceded periods of accelerated productivity growth (Figures 9 and 10). This relationship suggests that market valuations may serve as a leading indicator of productivity trends — and conversely, that policies which dampen market valuations could foreshadow weaker productivity growth. This historical pattern reinforces the potential feedback loop between policy decisions and economic outcomes.

CONCLUSION

The current productivity renaissance represents a rare confluence of technological advancement, business investment, and economic conditions. While potential policy headwinds exist, the fundamental drivers — particularly AI adoption and manufacturing modernization — remain powerful. The key to sustaining this productivity boom will likely lie in maintaining an economic environment that supports innovation while managing policy transitions carefully to preserve productivity-enhancing forces.

1 Skanda Amarnath, “Breaking Out of Stagnation: US Productivity Growth Is Clearly Beating Pre-Pandemic Trends Right Now”, Employ America Blog, October 30, 2024
2 Alexander Bick, Adam Blandin, and David Deming, “The Rapid Adoption of Generative AI,” On the Economy Blog, Federal Reserve Bank of St. Louis, September 23, 2024.
3 Goldman Sachs Research, “AI Is Showing ‘Very Positive’ Signs of Eventually Boosting GDP and Productivity,” Goldman Sachs Insights, May 13, 2024.
4 Era Dabla-Norris and Romain Duval, “How Lowering Trade Barriers Can Revive Global Productivity and Growth,” IMF Blog, June 20, 2016.
5 Giovanni Peri, Kevin Shih, and Chad Sparber, “ STEM Workers, H-1B Visas, and Productivity in US Cities,” Journal of Labor Economics, Vol. 33, July 2015.
6 Ran Abramitzky, et al, “The Effects of Immigration on the Economy: Lessons from the 1920s Border Closure,” National Bureau of Economic Research, Working Paper 26536, December 2019.