Productivity: Why does it matter?

As everybody seems to be talking about productivity, we decided to examine the subject for our latest Performance and Reward Centre (PARC) report – Productivity: puzzle or pandemic?

It seems that barely a week goes by without a headline about the UK’s productivity puzzle. Usually the news is bad. And even when it’s good, it’s often revised to bad a few months later. Earlier this week, the British Chambers of Commerce downgraded their economic forecast, citing weak productivity growth as one of their reasons for pessimism. The day after the Spring Statement, Paul Johnson, Director of the Institute for Fiscal Studies, remarked:

“Dismal productivity growth, dismal earnings growth and dismal economic growth are not just part of the history of the last decade, they appear to be the new normal.”

But why all the fuss? Why is productivity so important?

As American economist Paul Krugman famously said:

“Productivity isn’t everything, but in the long run it is almost everything. A country’s ability to improve its standard of living over time depends almost entirely on its ability to raise its output per worker.”

In a speech last month, Bank of England Chief Economist, Andy Haldane, produced a chart explaining how productivity growth changed our world. He pointed out that there was barely any economic growth before 1700. Improvements in per capita GDP and the living standards of all but the richest were glacially slow. Then the industrial revolution happened and with it came growth in productivity. Slowly at first but gathering pace over the 19th century, wages and living standards improved.

UK productivity real wages and gGDP per head chart
What is also clear from this chart is the rapid growth in productivity, GDP and wages after the Second World War and the sudden halt after the financial crisis. The period after 1948 might be called the lucky half century because it was an extraordinary time within an extraordinary time. Per capita GDP growth was a phenomenon of the last 250 years. Per capita GDP growth of 2.5 percent was a phenomenon of the last 60.

As Mr Haldane’s Bank of England colleague Silvana Tenreyro said earlier this year, productivity brings a lot of other good things with it:

“Higher productivity is associated, almost mechanically, with higher GDP and consumption per person. Labour productivity is 25 times higher than in 1831. That has enabled a 12-fold increase in the level of GDP per person and a 9-fold increase in consumption per person. Those increases come despite spending less of our lives working. Leisure time, crudely measured as hours not in work, has increased from less than 20 hours a week in the 1830s to 50 hours a week today.”

We have more but do less work for it than our forebears did. Along with that has come other benefits like better health, longer lives, improved education and falling crime rates. All developed economies show a similar pattern. Productivity means we produce more for less effort and therefore live better lives in almost every way than people did 100 years ago.

So what happens if productivity growth stops? Do we just bank the astonishing advances of the last half century and say that was great while it lasted? Would that it were that simple. We have built an entire society on the assumption that productivity will continue to grow. The almost continuous high growth between 1948 and 2007 shaped our beliefs about standards of living, pay and leisure time. It also defined our expectations of the state and of public service and welfare provision. We expect continuously improving services, longer and healthier lives and, until recently, we assumed that each generation would be materially better off than the previous one.

The consequences of a productivity slowdown could be severe. It has occurred just at the point where an ageing population is likely to put more pressure on public spending both through pensions and healthcare costs. Without a significant increase in productivity, these higher costs will have to be paid for by increasing the tax on stagnating incomes, borrowing more or cutting other services. With public debt still relatively high from the last recession and public services already coping with significant budget cuts, the prospect of weak wage growth delivering weak tax revenues leaves the chancellor with a headache. It’s little wonder that the government is concerned about productivity.

Most developed economies have experienced a productivity slowdown since the recession but the UK’s has been particularly severe and comes on top of a productivity performance that was already lagging behind many other countries before the crash. Economists are baffled by the reasons for this. As Andy Haldane said, the productivity puzzle has shown just how little we know about productivity:

“Saying that productivity matters is not the same as saying we understand its determinants. The past few years have served to underscore just how partial economists’ understanding of productivity remains.”

Some of the cause of the UK’s problem almost certainly lies in a chronic unwillingness to invest. The UK has been bottom of the OECD investment league for the last two decades years. More specifically, investment in R&D and the deployment of industrial robots are astonishingly low by international standards.

gross fixed capital formation chart
There is something else too, though. It’s not enough just to invest in clever new technology. We need organisations that can deploy that technology and develop the people, processes and systems that ensure it can be exploited to it’s greatest effect. As Cambridge economist Ha-Joon Chang explained, it is the ability to organise that determines the prosperity of nations:

“If effective entrepreneurship ever was a purely individual thing, it has stopped being so at least for the last century. The collective ability to build and manage effective organizations and institutions is now far more important than the drives or even the talents of a nation’s individual members in determining its prosperity.”

A report in February by the McKinsey Global Institute pointed out that during the 1990s, not everyone that invested in ICT realised the productivity gains:

“Productivity gains were not automatic and did not occur in all industries that invested heavily in ICT. Instead, real productivity gains required significant changes in business process, as well as managerial and technical innovation.”

Those that succeeded not only developed the technological capabilities but also the organisational capabilities to support them.

In his recent speech, during which he emphasised the importance of human capital, Andy Haldane too declared himself converted to the importance of institutions to economic growth:

“I thought I understood the story of economic growth, its drivers and determinants. But recently I have changed my mind. I have a new story of growth. I think this story carries important implications for understanding the future challenges of technology and for devising the future policies and institutions necessary to meet them.

“The story of growth is a story with two “i”s – ideas and institutions.”

Or as Wharton’s Ethan Mollick put it, when it comes to getting new ideas off the ground, the suits are as important as the innovators. The creative people have may have the ideas but it’s the organisations that make them happen.

Yet one of the things that surprised us when researching the productivity puzzle for our PARC report was how little it seems to register in the priorities of most businesses. Economists, business journalists and, somewhat belatedly, politicians have been sounding the alarm about the UK’s productivity for some years now but in most companies it is not identified as a must-win battle. It is, after all, possible to increase profits without increasing profitability, especially in markets where labour is plentiful, flexible and relatively cheap.

Not only does this show a lack of ambition, it could also leave companies vulnerable to sudden changes in the market. New competitors or more expensive labour could threaten less productive companies. Increasing a firm’s productivity therefore acts as an insurance policy against short-term headwinds. Higher productivity firms are also those that are more likely to increase revenues and market share over time.

Just as there are many different explanations for low productivity, there is no silver bullet that will cure it. What does seem clear from the available evidence, though, is that good management has a big part to play. Well-managed firms are more productive. While that might seem like an obvious thing to say it is not always obvious enough to persuade firms to invest in promoting, developing, training and encouraging their managers. Without a base of well-managed organisations, the big investments by government and the clever ideas of our creative people will go nowhere.

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