An excerpt from Graeme Leach’s article, ‘The Future of Productivity’.
“As modern economies grow, production and consumption shift towards economic value that resides in bits and bytes and away from that embedded in atoms and molecule” - Danny Quah
The Nobel Laureate in economics, Paul Krugman, once stated that: “Productivity growth isn’t everything, but in the long run it’s almost everything”. Another economics Nobel Laureate, Robert Lucas, speaking about long-term economic growth and productivity, famously said that: “The consequences for human welfare are simply staggering once one starts to think about them, it is hard to think about anything else”. At the time, the humorous response was to say that both economists needed to get out more. The more serious response is to say that they were both making a point every CEO would recognise. Differences in productivity growth, compounded over time, make a huge difference to the bottom line of a company and the economic prosperity of a country.
Productivity growth is fundamental because it is the primary driver of real income growth. Figure 1 shows that household real income growth weakened considerably in the 2010s. This shouldn’t surprise us, because the UK experienced its lowest productivity growth in 120 years in the decade to 2019. The productivity slowdown has not been confined to the UK. It has been experienced across the G7 economies. As a result, there is much talk of ‘secular stagnation’ and the fear that the weak growth of the past decade will translate into continued slow growth in the 2020s and 2030s. Consensus opinion is repeating the mantra “We’re doomed, we’re doomed”, by the wild-eyed Scottish undertaker Private Frazer, in the BBC television series Dad’s Army. This paper argues that we’re not doomed, far from it. The second half of the 2020s is very likely to see a sharp upward acceleration in productivity growth due to the technological revolution now underway. Kingsgate calls this future acceleration in productivity growth: ‘The Great Inflection’.
Productivity Growth Really Matters
The wealthiest large economy in the world is the United States, where per capita GDP is over 200 times that found in the world’s poorest country, Burundi. For 90 percent of human history, over the past 2,000 years, the standard of living for the general population across the globe didn’t improve at all.3 From Roman Times until the Industrial Revolution, the average rate of global economic growth was a paltry, derisory 0.01 percent per annum. At this rate of growth, it takes over 7,000 years for an economy to double in size! In stark contrast, early in the 21st century, when the Chinese economy was growing at 10 percent per annum, it was doubling in size every 7 years.
Emerging economies tend to grow by increasing the inputs of capital investment and labour – so called ‘perspiration’ led-growth. Advanced economies tend to grow by increasing productivity – so called ‘inspiration’ led growth, around technology and innovation. We really need more inspiration. If the pre-2008 trend of 2 percent per annum productivity growth in the UK had continued, per capita GDP in 20194 would have been nearly £7,000 higher than it actually turned out to be. That innocuous word, productivity, really makes a difference to lives and lifestyles. If US productivity growth hadn’t slowed since 2005, US GDP would now be roughly $3+ trillion larger and household income would be $25,000 higher and GDP per capita $10,000 greater. Or viewed from a slightly different perspective. If US productivity growth since 1970 had been as rapid as in the preceding 50 years back to 1920, then real GDP per person in the US would now be double its current value. In other words, on average, people would have twice the income they currently have. These figures illustrate just how significant a sustained acceleration or deceleration in productivity growth can be.
The Solow Paradox and Redux
Perhaps the number one question in economics pre Covid-19 was why is productivity growth so slow when technological change is so fast? US total factor productivity (TFP) growth averaged 2.1 percent per annum over the years of the halcyon post-war economic boom from 1947 to 1973. TFP growth then fell back to 0.5 percent per annum over the 1974 to 1995 period, accelerating to 1.5 percent per annum growth over the 1995 to 2007 period, before decelerating to 0.5 percent per annum average growth thereafter.
Rewind to 1987 and the economics Nobel Laureate, Robert Solow, quipped that in the US economy, “we can see the computer age everywhere but in the productivity statistics”. This became known as the Solow Paradox. In response to Solow, the economist Paul David said, “Just wait”. David was vindicated in the sense that US productivity growth accelerated from the mid-1990s to the mid-2000s. Subsequently it has weakened sharply and there now appears to be a Solow Redux, with the digital economy seen everywhere but in the productivity statistics. The McKinsey Global Institute has stated: “We may be seeing a renewal of the Solow Paradox of the 1980s with the digital age around us but not yet in the productivity statistics”.
Professor Eric Brynjolfsson, head of the Digital Economy Lab at Stanford University, has written that: “On the one hand there are astonishing examples of potentially transformative new technologies which could greatly increase productivity and economic welfare … at the same time measured productivity growth over the past decade has slowed significantly … throughout the OECD and among many large emerging economies as well. We thus appear to be facing a redux of the Solow Paradox: we see transformative new technologies everywhere but in the productivity statistics”.
Productivity - The Road Behind
Mind the gap! Figure 2 shows the output per hour measure of productivity for the UK economy over the past 25 years. The dotted line shows the level of productivity if the pre-financial crisis trend had continued. The other line shows the actual out-turn for productivity.
The scale of the gap between where we are and where we might have been is huge. A study by Nicholas Crafts and Terence Mills found that: “… the current productivity slowdown has resulted in productivity being 19.7% below the pre-2008 trend path (in 2018). This is nearly double the previous worst productivity shortfall 10 years after the start of a downturn”.
Table 1 above shows average growth rates for output per hour across the G7 economies.8 We can see that productivity growth declined across all the G7 economies – with the exception of Italy, which managed to achieve the lowest productivity growth in both decades! UK productivity growth was the second fastest in the G7 over the period 1997-2007. However, over the 2009-2019 period, the UK recorded the second slowest growth rate. There is a productivity problem across the G7, with all the economies displaying a productivity problem to a greater or lesser extent. Figure 3 compares the level of output per hour productivity growth across the G7 economies. The level of output per hour in the UK is less than France and the US, but greater than Canada and Japan. The level of output is calculated using alternative methodologies due to international differences in how hours worked are measured.
Alternative productivity measures, such as output per worker, show a similar story. Figure 4 shows that UK output per worker is higher than in Japan and Canada, but below that of the rest of the G7.
Finally, if we look at multi or total factor productivity measures before and after the financial crisis, the deterioration in multi or total factor productivity growth is apparent across all of the G7, but particularly so in the UK.
However, the UK’s productivity performance is more nuanced than it first appears. If one compares the level of TFP in manufacturing between the UK, US and EU5, then US TFP is well above that of the UK and EU5. The UK performs poorly on this measure. However, if one compares TFP in market services, the level of TFP in the US and UK is almost identical and the EU5 level is well below. In the UK, one sector of the economy stands out as a significant underperformer, the public sector. Figure 6 shows that public sector productivity has been flat for almost 25 years. It must also be acknowledged that measuring productivity in an environment where services are provided free of charge, makes public sector calculations very difficult.
From What Happened To Why
TFP is widely interpreted as being solely related to technology and innovation, but this would be an incorrect reading. TFP is the growth in output not accounted for by the growth in inputs. Kingsgate research suggests that one of the reasons for the depressed rate of TFP growth over recent decades could have been the growth effects of the public sector on the private sector. As we have seen, public sector productivity performance has been weak, but this is far from the end of the story. The disincentive effects of taxation and regulation (induced by the government) on the incentives to work, save and invest will almost certainly have depressed private sector productivity performance as well. Although this topic is beyond the scope of the paper, we mention it as one of the possible explanations for the dampened productivity growth of recent decades.
Another possible explanation as to why productivity growth generally has been weak, despite the scale of technological change, relates to Metcalfe’s Law. Metcalfe’s Law, that the usefulness of a network increases with the square of the number of users, may have a dark side.
According to one commentator, we are living through a “cultural crisis of attention” and are distracted nearly 50 per cent of our time. Persistently lower productivity could have been influenced by habitually distracted minds. Distracted moments can lead to distracted days, due to habit formation and the role of consumer technologies, which are designed to be as addictive as possible and as a result “hijack the mind”. A widely quoted study found that we checked our mobile phones around 150 times every day.
But regardless of the past, weak growth yesterday and today doesn’t beget the same again tomorrow. There is a very weak economic relationship between productivity growth in one decade and the next. Past productivity performance is no guide to the future, so slow growth today in no way precludes faster growth tomorrow. The empirical evidence clearly shows that:
Sharp reversals in productivity performance are not signalled in advance and this applied to all the major reversals of recent decades.
There is no correlation between adjacent 10-year periods of productivity performance.
Though it is beyond the scope of this paper, two other potential influences on productivity weakness over recent decades need to be considered. Firstly the growth in public debt. Second, the explosion in easy money (near zero interest rates prior to the monetary tightening in 2022-23). In the economics literature there are clear thresholds for the ratio of public debt to GDP, beyond which GDP growth is progressively undermined. The ratio of public debt to GDP reached 100% in 2023 - well above the 80-90% threshold at which significant negative effects are likely to take hold. With regard to easy money - excessively low interest rates over the 2010-2021 period - this may well have permitted many zombie companies to continue in existence when they would normally have failed. This may well have undermined the natural entry and exit of firms and thereby aggregate productivity growth. This means that in the future there is likely to be a widening spread between productivity laggards and frontier firms.
(Continued in PDF).
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See other articles from Kingsgate:
The Future of the UK Housing Market - Graeme Leach
The Future of the UK Commercial Property Market - Jonathan Gibson
The Future of Cyber Security - Rhys Gillespie
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