It's the demand, stupid! The role of weak demand on productivity growth

I couldn't resist the title.

Last week I was invited to give a short talk on what I thought was the most pressing policy issue facing the world economy today.

So I presented the findings from a very interesting paper entitled "Explaining Slower Productivity Growth: The Role of Weak Demand Growth" by Someshwar Rao and Jiang Li.

The paper examines the link between demand and productivity growth in both Canada and OECD countries. This issue has been an interest of mine ever since I read these lines in a book by Alan Blinder several years ago:

Economic slack...discourages business investment because companies that cannot sell their wares see little reason to expand their capacity. In consequence, the nation gradually acquires a smaller, older, and less efficient capital stock. 

[A]lthough the state of the national is far from the only factor, who doubts that a booming economy provides a better atmosphere for inventiveness, innovation, and entrepreneurs than a stagnant one? As the cliché says, a rising tide raises all boats...From 1962 to 1973, our generally healthy economy experienced only one mild recession, an average unemployment rate of 4.7 percent, and productivity growth that averaged a brisk 2.6 percent per annum. [Between 1974 and the mid-1980s] the economy [was] frequently...out of sorts. We...suffered through two long recessions and one short one, with an average unemployment rate of 7.3 percent and a paltry average productivity growth rate of 1 percent. This association of high unemployment with low productivity growth is no coincidence. 

Surveying these concomitants of high unemployment -- lack of upward mobility for workers, sluggish investment, lackluster productivity growth -- suggests an ironic conclusion: the best way to practice supply-side economics may be to run the economy at peak levels of demand. (1986:36).

This still makes lots of sense to me.

Verdoorn's Law

During my talk I described the paper as lending support to the well-known findings of economist Petrus J. Verdoorn, who several decades ago published research showing a positive relationship between labour productivity growth and real output growth.

In retrospect, I probably shouldn't have discussed this since it led to a number of questions on Verdoorn and his research, which shifted the focus away from the paper and the real purpose of my talk, which was to drive home the point that there is considerable evidence that productivity growth shouldn't be viewed as solely a supply-side phenomenon.

Specifically, the paper supports the -- in my opinion, common sense -- view that a slowdown in domestic and external demand is detrimental to growth in labour productivity, real incomes and economic activity because of the negative impact of weaker demand on scale and scope of economies, formation of physical and human capital, innovation and entrepreneurial activity.

Here are the paper's main findings:

Our major findings is that 93 percent of the fall in average labour productivity growth between 1981-2000 and 2000-2012 can be attributed to the drop in real GDP growth between the two periods...In addition, our new empirical research shows that a slowdown in growth of domestic and external demand also impacts negatively some of the key drivers of productivity growth, such as, gross fixed capital formation, M&E investment (including ICTs) and R&D spending, thus leading to lower trend labour productivity. (2013:14)

I concluded my presentation by discussing some of the policy implications outlined by the paper's authors. At this point, I was hoping my comments would get the attention of the government policy analysts and economists in the audience.

First, I suggested that it would be prudent for governments to ensure that deficit and debt reduction measures are gradual in nature so that their negative impact on domestic demand would not be excessive.

Then, I explained that it's always a good idea for governments to spend on productivity-enhancing public investment, even during a period of economic slowdown, as it contributes to both today's demand as well as future productivity growth.

References

Blinder, A., Hard Heads, Soft Hearts, (Mass: Perseus Books)

Rao, Someshwar and Jiang Li, "Explaining Slower Productivity Growth: The Role of Weak Demand Growth", International Productivity Monitor, Spring 2013.