The Productivity Conundrum

15/02/17: Some unexpected conclusions to an exploration of why productivity is apparently so poor

We place huge reliance on increased productivity to power growth in the economy. With such massive technological advances taking place over the last few years, why has productivity remained so static for the last decade?

Defining Productivity
Firstly, let’s define productivity. It is the increase in the quantity or quality of output from year to year, without an increase in the resources used to produce that output. Productivity can come from people working harder, or people working smarter, or organisations working together more efficiently, or breakthroughs in know-how. Actually, by far the largest cause of increased productivity is not individual breakthroughs such as the iPhone, but the cumulative effect of vast numbers of tiny improvements, such as tweaking the order of production, or rewording a sign, or finding more efficient sources of supply.

Generally, we are fairly good at measuring increases in the quantity of output relative to input. But we are woefully poor at measuring increases in the quality of output. So in reality, the figures we quote for productivity are, at best, only a partial reflection of changes in productivity.

Productivity Outcomes
During the financial crash of 2007–2012, there was a colossal restructuring of the productive economies. Many productive units went out of business, many more hunkered down to wait out the passing of the storm. Although employment did not crash in the way it had done in the 1929 depression, the quality of employment dived. It made employees anxious about their job security, meaning their relative bargaining power with employers was significantly weakened. The restructuring meant the capacity of many employees were significantly constrained, and the hunkering down resulted in a very inefficient structuring of productive resources. In the first few years of the crash, productivity took a huge hit, although strangely, it was not fully reflected in the GDP.

Once the storm had done its worst, the US, UK and European economies spluttered back to life. Just. During this time, some of the most profound advances in technology were introduced to the workplace. 3D printing, genetic engineering, artificial intelligence, robotics to name but a few. This released a soaring in productive capacity, yet the new capacity was not reflected in the anaemic GDP growth.

Was this a result of productive capacity failing to take advantage of the new technology?

I think the answer is no. All around, we see new technology being successfully adopted. It is arguable that the traditional areas economic production have been failing, cancelling out the growth in productivity in the high performing sectors of society. But it is unlikely, given the low base of productivity in the early 2010s. I believe there is another influence that has profound implications for governments and for society as a whole.

Imagine a very simple example of an organisation producing 10 units of output in the first year, and 11 units in the second. In both years, the organisation used exactly the same number of resources. The increase in output is a direct result of productivity gains. The gains can be distributed through the economy in one of two ways. The organisation can reduce its prices to its customers by exactly the increase in productive output. The company would be no better or worse off, with all the gains being enjoyed by its customers. In this case, GDP stays static, which means the increase in productivity is not reflected in growth. Or it could keep its prices exactly the same as before, meaning its customers are no better or worse off, leaving the producer to enjoy the increased profit exactly equal to the increase in production. In this case, the company’s output has increased by 10%, which is reflected both in in the GDP and in the growth figures.

This very simple example demonstrates that productivity gains do not necessarily reveal themselves in changes in GDP.

This has an important implication. If productivity gains are reflected in increased GDP, probably in higher wages and corporate profits, the government’s tax revenues increase. In the UK, the government is desperate for GDP growth to help pay off the staggering cost of having bailed out the collapsing banking system in 2008. This conundrum has significance.

Productivity and Measured Growth
So what determines whether productivity growth will result in measured increased GDP or unmeasured increased consumption? The answer lies in the judgement of employers.

As defined, increased productivity means an organisation will increase its output without increasing its costs. The producer has a choice — keep prices static to increase monetary output, or drop prices to ensure all items are sold. Core to this decision is how the producer evaluates the strength of the market for their product. To the extent that productivity gains result in monetary gains, there is a further decision to be made. How much should be paid to employees, and how much should be paid to the managers and owners? If the job market is buoyant, employees can find work elsewhere. More of the gains will be paid to employees. Conversely, in a weak jobs market, the employer can get away with keeping more, if not all, of the gain. The less money paid in wages, the less money will be available by consumers to buy the company’s products.

The frustrating conclusion is this. Productivity gains will not be reflected in GDP growth if either confidence is undermined, for example by an austerity drive, or if the monetary gains are not shared fairly with the people who will spend the money to keep the flow of demand aligned with supply, such as in a weak jobs market.

As an aside, it is interesting to delve a little deeper into the influences about how productivity gains will be shared between the various parties involved in production and consumption? The gains can be shared between the owner/senior leadership through retaining the gain, the employees through increased pay, the customers through increased quality or reduced prices, the suppliers through relaxed terms, or the community through corporate contribition to social cohesion and social action. How the gains are split between each group depends on their relative control within the whole and the social contribution the owner/senior leadership choose to make to society. If there is a shortage of employees, they are likely to enjoy a greater share of the gains. If there are laws, customs or prejudices that restrict employees ability to find work elsewhere, they are more likely to be short changed. If the employer has a social conscience, suppliers and customers are more likely to enjoy some of the productivity gains. Where the owner holds all the trump cards, and has negligible interest in the outcome for others, they will become enriched on the coat tails of productivity.

The Conundrum for Governments
For governments in particular, here is the conundrum.

Where productivity gains flow through to GDP, the perceived wealth (voter happiness) and tax receipts increase. Where it does not, confidence and government finances take a hit. When confidence is low, this creates a cycle of depression of measured GDP which can have very little bearing to the success of the economy. I believe the current state of GDP is being suppressed by the continuing talk of austerity, associated with a continual undermining of confidence in the future. I belive productivity is hugely understated at present, with some of the productivity gains being suppressed from the GDP, and the lions share of the remainder being eaten up by the more wealthy in society, suppressing demand and reinforcing the perception of doom. Unnecessarily.

The UK government has huge debt built up whilst paying for the mistakes of inadequate banking regulation prior to 2007. This failure of monetary measurement has implications for the level of infrastructure and social care the government is able to provide.

There is worse in store.

Much of the astounding advance in productivity is based around technology. When Google creates free mapping software, for example, the gains are enjoyed by billions of people around the world, with no change in GDP. (Of course, Google monetises most of its output through advertising, but this has a whole series of alternative consequences). It is one of the most profound social shifts taking place in the world, in plain sight and entirely unrecognised by aging measures of economic success. The issue is that the current basis of taxation is not able to cope with non-monetary gains that are circulated through the economy. The situation is going to get worse (from a tax perspective, or better from the perspective of sharing the gains of society more fairly).

The current tax system is regressive and incomplete, making it both unfair and inadequate to meet the needs of society. A forecast — in 20 years time, taxes will be widened with measures that are more in line with people’s changing methods of consumption, and new forms of tax will evolve that empower people to pay taxes in a non-monetary format to accommodate their increased proportion of non-monetary income.

Solving the Tax Conundrum
To me, it is clear we need to develop a fundamentally new way of understanding wealth creation and consumption, and to develop entirely tax systems that cope with the new era. At this stage, it is difficult to see where it will come from. But the stirrings of a new system might be found in any or all of (1) searching for a system of economic measurement that is closer aligned with human needs and aspirations, (2) developing a culture that is better suited to mutual support, (3) creating a feedback system that measures and collates individual experience more reliably, (4) exploring alternative systems of reward, such as based on status, to supplement existing monetary systems, and (5) creating a more fluid way for people to contribute to society’s coordinated output, especially by people whose capacity is underutilised.