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The productivity problem - We need to invest

Posted on April 21, 2017 by Tom McDonnell

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For most economists the sources of productivity, innovation and technological progress are almost co-extensive with the central question of economics - what is the source of the wealth of nations?

Unfortunately productivity growth has been on a generally downward in the advanced economies for close on 40 years. A recent blog on the Focus Economics website shows clearly this downward trend in productivity growth for each of the G7 countries. While some countries have been able to buck the trend for a while (e.g. Ireland in the 1990s) the overall downward trend is fairly evident. For some, such as Robert Gordon (see here and here), the era of productiuvity based growth has come to an end as we have plucked the low hanging fruit in terms of management efficiency and technological progress and we are now set to enter a period of stagnant growth and faltering innovation. The OECD have expressed concern at the slowdown in productivity growth and point to the breakdown of the technology diffusion engine as central to the phenomenon of falling productivity growth. Others such as Erik Brynjolfsson and Tyler Cowen are less pessimistic and it is certainly plausible that the productivity slowdown is a temporary phenomenon. For example, the neo-Schumpeterian growth models predict that innovation increases in waves with faster rates of innovation occuring in the wake of the invention and diffusion of General Purpose Technologies (think steam engine, electricity or microprocessor). Periods of low productivity growth are therefore to be expected.

But it would be a mistake to dismiss the concerns and even if one believes that the rate of innovation is cyclical (it almost certainly is) that doesn't mean we cant or shouldn't use policy to nudge it upwards in the long-run.

An interesting aspect of the policy debate on the Focus Economics website is the breadth of policy solutrions proposed. Even so there is some degree of consensus. Perhaps most notable is the regular identification of the low rate of capital investment (public and private) as a cause of declining productivity growth. Ageing populations and crisis related hysteresis (i.e. the post-crisis deterioration in human capital arising from long-term unemployment) are also regularly identified.

Economic forecasters have a difficult job for many reasons. One reason is the difficulty in forecasting productivity growth. The government's Stability Programme Update (SPU) assumes labour productivity growth of around 1.5% per year out to 2060 and then assesses the sustainability of public spending based on these assumptions. But if productivity growth systematically undershoots the conclusion vis-a-vis fiscal sustainability becomes radically different. We simply dont know what is going to happen with regard to labour productivity.

A small open economy like Ireland will always find itself roiled by external shocks. Brexit and Trump et al are certainly concerns but should never become excuses to take our eye of the ball in terms of environmentally sustainable and inclusive productivity based growth being the priority. Unfortunately our current fiscal policy mix is far from optimal if our goal is to encourage and drive innovation and productivity growth. Most obviously the low level of public capital spending can be generously described as shortsighted and unwise. This is a false economy that saves money in the short-run at the expense of the productive capacity of the economy. The SPU envisages public capital spending of less than 2% of GDP in 2017 and just 2.2% of GDP in 2021. Even allowing for the problems associated with GDP this is clearly insufficient. The weakness of private investment only magnifies the need for the public sector to strep into the breach and invest. There are other false economies - Ireland also underspends on public Research & Development (R&D) and on third level education relative to its Western European peer group.

You can find a more in-depth discussion of these issues in this NERI working paper (or just read the associated slides here). With just €500 million to €600 million available for new measures in Budget 2018 its important to prioritise. The most effective way the government can boost the productive capacity of the economy in the medium-term is to invest in the future - and this means more resources for capital spending, education and R&D. Failure to act appropriately will not be looked upon kindly by economic historians. 

 

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