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.

Robert Gordon on the death of innovation and end of growth

This TED talk by Robert Gordon (Northwestern) is a must-see (do it, it's only 12 minutes long). You may recall that a paper by Gordon created quite a stir in the news a few months ago because of the bleak outlook it gives regarding future economic growth in the US.

In the talk, Gordon counters the commonly-held idea that economic growth is a continuous process. He makes the case that the rapid growth experienced during the last two and half centuries may have been an anomaly rather than the start of a new, everlasting historical trend.

According to Gordon, economic growth in the coming decades will slow as a result of six headwinds that will reduce future productivity and income growth. In the end, the impact of these six headwinds will leave long-term growth at half or less of the (near) 2 percent annual rate experienced between the mid-1800s and today.

The six negative headwinds that make up Gordon's "exercise in subtraction" are demography, education, inequality, globalization, energy and debt (for more, see Gordon, 2013).

My take on this issue is that I'm generally optimistic about the prospect of continued future growth but becoming somewhat pessimistic about the ability of governments to take the appropriate steps to encourage the type of innovation and technological advancements that promote robust long-term economic growth.*

As I've mentioned before, the current preoccupation of politicians and policymakers with slashing spending and reducing public debt levels is likely going to be detrimental to long-term growth. I doubt there are many growth theorists out there who would argue that trillions of dollars in lost output (as witnessed by the huge amount of idle resources, including unemployed workers) and cuts to public investment are beneficial to a nation's long-term growth prospects.

A few years ago, (the great) economist Albert Wojnilower summed up the problem that's emerged in the US with respect to government support for innovation in a 2011 interview as follows:

Gail Foster: What about the long term? There are many, maybe even a majority, who believe that we are possibly in a temporary innovation funk — maybe not so temporary. In other words, while it may be possible to be encouraged about the short term, we are just getting back to where we were before the recession, and there is not much that is economically exciting to look forward to. Would you agree?

Albert Wojnilower: I wouldn’t sell the future short. There is no lack of new business opportunities (cell phones, Facebook, electric cars, energy innovation, services that cater to aging societies). The question is, where will they be invented, used and exploited? And to whom will the benefits be distributed? The United States has traditionally been a leader in this important growth process; now it is a laggard. The shift in the U.S.’s relative position is a matter of ideology, not economics.

GF: What do you mean by ideology?

AW: The United States has adopted a free-market, small-government ideology, ostensibly copying what we did in the distant past. The difference today is that there is no frontier. Most opportunities tread on someone else’s toes (as in property rights). There is less space for greenfield experimentation. The small-government mentality means that there is no effective arbitrator of the trade-offs to break the log jam. Many of our newest “innovations” have occurred outside the traditional economic sectors — for example, creating a new sector that today we refer to as technology. Major inventions have been made by civil servants, at little personal benefit. The United States has usually been pragmatic on these matters, but now it appears to be headed in a much more dogmatic direction...

GF: Would it be fair to say that you are an optimist with respect to human ingenuity but not human nature?

AW: Yes, indeed.

* For a more optimistic view, see Baily et al, the TED talk by Eric Brynjolffson and this debate between Robert Gordon and Eric Brynjolffson
 
References

Gordon, Robert, US Productivity Growth: The slowdown has returned after a temporary revival, International Productivity Monitor, Spring 2013.

Baily, Martin.N. James Manyika and Shalabh Gupta, US Productivity Growth: An optimistic perspective, International Productivity Monitor,  Spring 2013.

Fosler, Gail and Albert Wojnilower, Interview: Are we out of the woods yet, Gail Foster Group LLC. February 9, 2011.