Productivity growth is almost everything in the post-Covid recovery

In the post-Covid recovery, productivity growth is almost everything.

The writer is a senior fellow at Harvard Kennedy School

The great inflation debate — is it sustained or transitory? — is missing a piece: productivity growth. The ability to produce more with the same or fewer inputs “isn’t everything”, Nobel Prize-winning economist Paul Krugman says, “but in the long-run it is almost everything”. It is likely that productivity growth has accelerated during the pandemic, which should take upward pressure off prices. It could also raise the long-run neutral interest rate for the world’s largest economies, giving their central banks more room to manoeuvre than we appreciate.

Most economists will tell you it is virtually impossible to have sustained price increases without spiralling wage growth. As Pantheon Macroeconomics highlighted in a recent client note, the single best indicator of consumer price inflation is unit labour costs. They have two inputs: wages and productivity. Because productivity growth tends to be stable, most economists look at wages as a rough measure of unit labour cost growth.

Wage growth has clearly accelerated during the pandemic, though this data has been distorted by compositional effects (as lower-wage hourly service workers lost jobs, aggregate wages rose). Nevertheless, with job openings surging and unemployment still higher than before the pandemic, firms are offering higher wages to fill roles. Production and non-supervisory workers in the US saw average hourly earnings grow almost 5 per cent year-on-year in July and August.

If productivity also accelerates, however, unit labour costs should remain stable and so should prices. After averaging around 1 per cent annual growth from 2013-18 in the US, eurozone and UK, labour productivity growth in those regions has roughly doubled in recent years. In the US, it grew an average of 3 per cent in the first half of 2021. Unit labour costs fell 0.8 per cent during the same period.

While a productivity bump is a standard feature of early stage recoveries, there are signs this one will last. A McKinsey Global Economic Conditions survey of executives at the end of 2020 showed just over half of respondents in North America and Europe said they had increased investment in new technologies over the year and about 75 per cent said they expected investment in new technologies to accelerate in 2020-24. Companies digitised activities 20-25 times faster than they had previous thought possible.

New orders for US-manufactured durable goods, a forward-looking gauge of investment, have risen in 15 of the past 16 months. There are many reasons to believe firms will continue to invest: they are sitting on a mound of cash as a result of stimulus programmes and cheap credit, earnings growth has soared, labour is no longer such a cheap substitute for capital expenditure and firms have to catch up after weak investment in the previous cycle.

The shift to working from home during the pandemic also may have yielded efficiency gains. According to a forthcoming survey of over 375 firms and $21tn in market capitalisation, by World50, 65 per cent of respondents felt remote working had been good for productivity. The jury is still out on this: bosses may see higher output without appreciating the expanded number of hours employees are putting in at home.

Higher productivity growth allows the economy to maintain stable prices even in the face of higher wages. Reopening the global economy has created supply shortages that have lifted inflation. As output rises, with productivity higher, those costs should fall. Companies will be able to afford higher wages without compressing margins.

Governments are embracing the concept that productivity growth is a good thing. The Biden administration is trying to pass $3.5tn in spending on infrastructure and investment in human capital. Deployed over the next decade, this would underpin continued US productivity growth over the long term. The eurozone’s €806bn Next Generation EU Fund requires a significant percentage to be spent on digitisation, research and innovation.

That should boost potential growth, and therefore the long-run interest rate that maximises growth without triggering inflation will be higher. The Federal Reserve’s latest projections estimate this rate to be 2.5 per cent. If productivity continues to rise, this rate will as well. Markets may balk at higher potential rates, but the central bank will have more flexibility to continue its efforts to drive unemployment lower. To boost growth, minimise inflation and maximise welfare, productivity is indeed almost everything.

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