Labour productivity and growth

Published 15th February 2015

“For the fact is that the key both to long-term economic growth and to sustained differences in economic performance between countries seems to be the ability to get more for less — to have output grow faster than input.” Paul Krugman (International Affairs, 1995; 71(4): 717–732)

One of the things that I focus on most when making investment decisions is labour productivity — not only in different countries but also within the same sector globally.

Differences in labour productivity, the evidence suggests, largely explain differences in GDP per head between states. To illustrate this, take a look at this chart (from APO) which looks at GDP per head and labour productivity for a number of Asian states:

You can see that the variable that explains most of the difference in GDP with the USA is the difference in labour productivity even if it is true that for some countries — Bangladesh, Pakistan and Iran, there are importance differences in the employment rate but the overall conclusion is pretty clear.

Here is another chart which sets out the evidence on labour productivity in Asia. (This time Japan 2009 =1)

Now let’s not get confused about what these charts mean. They do not mean that that Asia needs more sweatshops to increase GDP relative to the USA. Nor do they mean that Asian wage levels need to be cut to increase Asian GDP per capita.
 Increases in labour productivity — that is the increased output that results from an hour of work — can result from two main sources: using more capital per head (“capital deepening”) to achieve higher output per hour — more tools rather than working by hand, mechanization in textile mills and computers. Capital deepening also occurs when roads, rail, infrastructure and other public goods are put in place in a way that makes it possible for people to produce more output per hours. Imagine the reduction in spoiled food that would come about through a better road system in India, let alone a network of food depots with refrigeration facilities. 
 Increasing labour productivity can also result from better quality inputs and better decision making (i.e. total factor productivity or TFP): education, training, more reliable tools, better management, a better financial services industry capable of making better capital allocation decisions, and improvements in a host of broader legal and political institutions.

Both are important and much of Asia needs both. Much of Asia’s growth in the past two decades has resulted from capital deepening rather than improvements in total factor productivity and this of course has been the case particularly in China where TFP levels remain low relative to the USA.

Global investors can help with capital — to help increase labour productivity through capital deepening — but gains in income per head that come from TFP hardly ever require capital and the gains accrue almost always to workers and consumers.

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