Solving the productivity puzzle

3 Jun 14
The UK came out of recession with more people in work, producing less than in 2008. On the other side of the world, New Zealand also has stagnating productivity. But nobody’s quite sure why. So are fears of a global low-growth trap justified?

By Patrick Nolan | 3 June 2014

The UK came out of recession with more people in work, producing less than in 2008. On the other side of the world, New Zealand also has stagnating productivity. But nobody’s quite sure why. So are fears of a global low-growth trap justified?

While the worst of the global financial crisis and its aftermath appears to have passed, the risk remains that, as International Monetary Fund managing director Christine Lagarde has noted, ‘the world could fall into a medium-term low-growth trap’. Effort needs to shift from coping with the crisis to improving the fundamental drivers of growth. And this, in turn, requires an increased focus on lifting productivity.

In the long run, productivity is probably the single most important factor in determining a country’s wealth and wellbeing. Labour productivity shows the output produced from each hour of work. Increasing labour productivity – along with increased hours in work – can lead to more output per person. More output per person – along with higher world prices for what is produced – leads to higher per capita incomes. And higher per capita incomes allow a country to enjoy better living standards, including by providing more resources for public services.

Yet for several years the UK has had weak productivity growth. This preceded the global financial crisis and raises practical questions. At the Bank of England, governor Mark Carney has bet on productivity growth returning. He is gambling on the ability of companies to increase output through productivity gains rather than the more inflationary route of bidding up prices and wages. Lower productivity growth also means Chancellor George Osborne needs to make deeper spending cuts – or increase taxes further – to hit his deficit and public debt targets.

The UK is not the only country with stagnating productivity. Take New Zealand. While these two economies have obvious differences, they are also both experiencing reasonable levels of economic growth, reflecting the rebound from the global financial crisis and, in New Zealand’s case, the rebuild after the Christchurch earthquakes. Yet in both countries productivity growth since the beginning of this century has been weak.

Indeed, statistics from the Organisation for Economic Co-operation and Development on labour productivity show that in 2012 the UK needed to lift GDP per hour worked by 19% to reach the average labour productivity for the G7 (see table). New Zealand’s labour productivity is even weaker, with its productivity (in terms of the UK’s performance) being, in turn, 19% lower.

Like the UK, it has been said that New Zealand presents a productivity puzzle. But its challenges are different. In the UK the puzzle reflects a ‘jobs-rich recession’, where the slump in output has not been matched in the labour market. As the Institute for Fiscal Studies has shown, compared to the start of 2008, more people are working but they are producing 2.6% less output on average. The challenge is to explain this decline in productivity, as the standard explanations of firms hoarding labour and changes in the composition of the economy and workforce (such as more part-time workers) cannot adequately explain the fall.

While New Zealand faces different challenges, its experience can throw light on the UK’s situation. OECD research recently published by the New Zealand Productivity Commission has shown that the country has good resources – investment in physical capital and average years of schooling are broadly consistent with other countries – and policy settings. It is one of the easiest countries in the world in which to set up a business and its tax and regulation regimes are often seen as world class. 

Indeed, the OECD estimates that New Zealand should have GDP per capita 20% above the OECD average. But its productivity performance means it is 20% below. In short, New Zealand poses a real challenge for standard prescriptions for what countries should do to lift their productivity performance.

Internationally, there has been debate on whether the productivity slowdown is a temporary blip or a sign of things to come. In the pessimistic camp, US economist Robert Gordon argues that the slowdown is permanent. His view is that the innovations of the first half of the 20th century, such as electrification and the internal combustion engine, are more significant than information and communications technology or other recent innovations. 

Optimists argue that the ICT revolution still has a long way to run and the underlying rate of technological progress has not slowed. In any case, there appears to be plenty of scope for countries and firms to lift their performance to the technological frontier, irrespective of how fast this frontier is growing.

This debate points to the importance of knowledge-based capital encompassing a range of assets including product design, inter-firm networks, research and development, and organisational know-how. Productivity not only reflects capital intensity – how much physical and financial capital workers have at their disposal – but multi-factor productivity. This is a proxy for broad technological advances and includes improvements in management and production processes, increased scale, skill accumulation and improvements in the effectiveness with which labour is combined with capital. 

New Zealand’s experience suggests that knowledge-based capital is a critical if often overlooked factor in driving productivity performance.

To illustrate the importance of knowledge-based capital, consider what Claudia Goldin and Lawrence Katz describe as the ‘race between education and technology’. This race emphasises the need for workers’ skills to keep pace with changes in demand due to new technologies. This is an important issue for the UK, where there is scope for improving the degree to which the education system supplies skills that match firms’ needs. 

The OECD’s Pisa rankings for the performance of 15-year-olds indicate that the UK is failing to keep pace with the best countries in achieving education outcomes for maths, reading and science. Yet simply reforming the education system is not enough. Schools in New Zealand do relatively well in producing good quality labour but this is not reflected in productivity. Something goes wrong when students enter the labour market. 

As well as education, making the most of technological change also requires complementary investment in knowledge-based capital, such as improved management and production techniques, and research and development that helps firms absorb new technologies. Thus, as well as outcomes like years in schooling, factors such as managerial practices – particularly people management – are important too.

Managerial practices are one part of what the OECD calls organisational capital. This includes the allocation of decision rights, the design of incentive systems, and supplier and customer networks. This organisational capital often plays a complementary role to physical capital. Firms’ spending on ICT is a good example of this. ICT has been shown to make a strong contribution to labour productivity growth, yet it often requires investments in human capital and business process reorganisation to accompany it. In other words, spending on new technology will only be fully realised when firms move beyond simply ‘computerising’ or ‘web-enabling’ existing processes. They also need to adapt their business practices and train their workers. In general, firms in the US have been more effective at this than their European counterparts.

Improving the allocation of resources is another challenge. Ben Broadbent, of the Bank of England’s Monetary Policy Committee, has noted that it takes time for unproductive sectors and firms to shed labour and capital and for fast-growing new firms to mop up these resources. Improving this resource allocation would boost productivity. 

Indeed, Diego Restuccia, professor of economics at the University of Toronto, has shown that the systematic reallocation of employment and hours can explain many countries’ experiences of productivity catch-up, slowdown or stagnation. Yet there is concern that the UK economy has been poor at reallocation, with the global financial crisis seeing an increase in the number of ‘zombie firms’ making losses but not being shut down.

The New Zealand experience shows that the churn from dying firms being replaced by new firms is only one part of the story. It is important to not impede this turnover, as new firms are an important source of competitive pressure and can raise productivity in the medium term. But encouraging incumbent firms to lift their performance to that of frontier firms (convergence) is also a source of potential productivity growth.

One way to speed up convergence is to create an environment that helps spread good practice. Framework policy settings that support competition can play an important role. The risk of losing market share can concentrate the minds of company owners and managers.

The ‘innovation ecosystem’ can play an important role too. However, government actions to support innovation need to be thought out carefully. There has to be a strong case for intervention, and monitoring and evaluation is essential. There is a need to better understand not only who receives government assistance, but what difference this makes to the rate of innovation and productivity growth. The innovation system should encourage the diffusion of good practice, not protect incumbents and hold back reallocation.

Being open to the world can also help spread good practice. When countries turn inwards they lose the benefit of the insights and connections that migrants can bring. More migration can also help increase labour market density, raising competition in the labour market and firms’ access to the skills they need. There may be concern that groups of domestic workers could come under pressure when migration increases, but this reinforces the importance of improving their skills.

Global markets also provide important opportunities for domestic firms. This goes beyond the traditional ‘make, pack and export’ story to also include collaborating in global value chains – where production activities are spread across countries. Global value chains are becoming an increasingly important feature of international trade and are where the transfer of new technologies often now occurs.

The need to lift productivity becomes clearer when focus shifts to the future. Both the UK and New Zealand face many challenges: including demographic change, changes in distribution of incomes and wealth, and environmental pressures and constraints. The fiscal implications of these challenges, such as on pensions and health spending, have been widely canvassed. What has been less widely canvassed is their broader economic implications, including for productivity. The changing demographic outlook will, for example, impact on productivity by changing the composition of the workforce and environment for savings.

These changes will make lifting productivity more important, too. With a decreasing proportion of the population being of working age it will be harder to boost national incomes through increased labour force participation rates or hours of work. Success or failure will increasingly depend on productivity growth. 

Yet, the UK’s recent productivity performance raises more questions than answers. This is why insights from New Zealand can be valuable. This country’s recent experience provides important clues on how to solve the UK’s productivity puzzle.

 

Patrick Nolan is principal adviser for economics and research at the New Zealand Productivity Commission


This feature was first published in the June edition of Public Finance magazine

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