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Productivity Growth in the Developed EconomiesDavid BartlettEconomic Advisor, RSM

Productivity Growth in the Developed Economies

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March 2013

Productivity and Economic Growth

Economists have long recognised the pivotal role of productivity in national economic growth. The neoclassical model of Robert Solow hypothesizes economic growth as a function of productive inputs (capital and labour) and technological progress (measured as total factor productivity). According to this model, growth slows as capital investments yield diminishing returns and demographic factors limit expansion of the labour supply. Sustained growth in mature economies thus hinges on advances in technology to raise productivity.

A recent, highly controversial article by the American economist Robert Gordon, argues that the advanced industrialised countries have exhausted their potential for productivity-led growth (“Is U.S. Economic Growth Over? Faltering Innovation Confronts the Six Headwinds”, Center for Economic Policy Research, September 2012).

According to Gordon, the historical trajectory of economic growth is the product of three industrial revolutions. The First Industrial Revolution (1750-1830) created disruptive technologies (steam engines, cotton spinning, railroads) that catalysed early industrialisation. The Second Industrial Revolution (1870-1900) produced even greater technological breakthroughs (electricity, indoor plumbing, internal combustion engines) that spurred the economic transformations of the 20th century. The slowing of growth in the Western economies in the 1970s reflected the diminishing productivity gains from earlier technological innovations. By that juncture, the global industries

that resulted from the First and Second Industrial Revolutions (motor vehicles, home appliances, etc.) had reached maturation in the developed economies.

The resumption of economic growth in the 1980s-1990s reflected the impact of the Third Industrial Revolution, which featured advances in Information Technology (personal computers, Internet, mobile phones, etc.) While these IT innovations are clearly important, Gordon maintains they are not nearly as transformative as the technological breakthroughs of the previous industrial revolutions. While hand-held smart phones represent a major advance over land line sets, their economic impact does not approach that of the automobile (which eliminated dependence on waste-producing horses) or indoor plumbing (which removed the need to carry water by hand). In contrast to the First and Second Revolutions (whose productivity gains lasted well into the 20th century), the productivity spillover of the IT Revolution has already dissipated. The developed countries thus face a combination of declining returns to technological innovation and powerful economic headwinds (high debt, aging population, rising inequality, etc.) that foreshadow slow growth for decades to come.

Productivity Trends in the Developed Economies

Trend line data on productivity growth in the advanced industrialised countries generally support Gordon’s argument.

Introduction

RSM’s Prospects for the World Economy (Talking Points, January 2013) offers a sober forecast for GDP growth in the advanced industrialised countries. The overhang of public/private debt and the imperative of fiscal consolidation raise the threat of long-term stagnation in the developed economies, whose GDP growth prospects are far weaker than those of emerging markets.

Exhibit 1 reports changes in manufacturing productivity in selected developed countries between 1979 and 2011. Productivity growth stagnated in a number of developed economies (Australia, Spain, United Kingdom) between 1979 and 2000, then rose in the early/mid 2000s as the benefits of the IT Revolution took hold. The United States and Germany show a different pattern; the productivity boom in the US began in the 1990s, reflecting that country’s status as a first mover in computer and Internet-related technologies. Germany enjoyed robust productivity growth from 1979 until 2007, illustrating efficiency gains in that country’s world-class manufacturing sector. France and Italy display weak productivity performance throughout the period, indicating persistent structural rigidities in those economies.

Manufacturing productivity growth declined in most developed countries after 2007, demonstrating the impact of the global downturn that precipitated a sharp contraction of industrial output. Current data indicates a productivity rebound in 2010, 2011, and 2012 as the economic recovery gained traction and Western companies launched capital investments

Productivity Growth in the Developed Economies

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March 2013

deferred during the recession. But productivity growth in the advanced industrialised countries has still not returned to levels prevailing in the late 1990s and early/mid 2000s, validating Gordon’s argument that the spillover of the IT Revolution has dissipated.

Prospects for Increased Productivity Growth

The experiences of the developed economies of East Asia provide valuable lessons on the prospects for boosting productivity growth in the West.

As shown in Exhibit 1, the leading productivity performers among the advanced industrialised countries are Singapore, Taiwan and South Korea. Those countries did not incur the asset appreciation and debt accumulation that afflicted Europe and North America during the pre-2008 period. This relieves the East Asian developed economies of the burden of fiscal consolidation and deleveraging that restrains economic growth in the West.

The East Asian countries also enjoy high savings rates and strong education systems that facilitate investments in productivity-enhancing technologies. With a population of 50 million (25th in the world), South Korea ranks 6th worldwide in spending on research and development. South Korea’s R&D spending/GDP ratio is 3.7 percent, surpassing levels in the West (U.S. 2.7 percent, Germany 2.3 percent, France 1.9 percent, UK 1.8 percent, Italy 1.1 percent). Taiwan (50th in population) ranks 10th in R&D spending. Singapore is noted for its commitment to science, technology and engineering to generate the productivity gains needed to compete with lower cost Asian economies like China, Thailand and Vietnam.

A range of factors (political, economic, social, culture) hinders emulation of the East Asian model in Europe and North America. Furthermore, high spending on research and development is not a

guarantor of sustained economic growth. Japan, which ranks second to the US in total R&D spending and boasts an R&D/GDP ratio matching South Korea’s, has been mired in economic stagnation since 1990. But comparative data clearly demonstrates the economic payoff of productivity-related investments, especially in high cost developed countries facing mounting competition from emerging markets.

Productivity Potential of New Technologies

Gordon’s work has prompted a debate over the productivity effects of new technologies. While these technologies do not have the disruptive potential of early innovations like electricity and automobiles, they do hold significant promise for increased productivity growth in the developed economies. Moreover, many emerging technologies are derived from previous advances in Information Technology, indicating that the productivity gains of the Third Industrial Revolution have yet fully to dissipate.

Advanced Manufacturing: While manufacturing represents a declining share of employment in developed economies, the manufacturing sector accounts for dominant shares of business expenditures on R & D in many countries: 90 percent in Germany, Japan and South Korea, 86 percent in France and 70 percent in the United States. Manufacturing-related productivity improvements also generate spillover to other sectors of the economy. Recent advances in manufacturing technology thus offer substantial potential for broad-based productivity growth. Examples include robotics, industrial automation, process controls and embedded sensors.

Biomedical Technology: The Information Technology Revolution created the foundation for the rapidly growing field of bioinformatics, driving advances in genetic mapping, high throughput DNA sequencing and related applications.

Prior innovations in IT also enabled the progression of telemedicine and remote diagnostics that is transforming health care delivery. These biomedical advances boost productivity by improving the health and vitality of the active labour force and extending the productive work span of citizens in developed economies with aging populations.

Energy: Renewable energy technologies (biofuels, geothermal, solar, wind) have yet to display the rapid progression of IT. But advances in enabling technologies (particularly materials science) raise hopes for breakthroughs in renewable energy that will speed the commercialisation of these alternatives to hydrocarbons. Parallel advances in conventional energy technologies also promise to accelerate productivity growth in the developed economies. Improvements in recovery techniques (hydraulic fracturing, horizontal drilling) have already transformed the natural gas industry in the United States and heightened the competitiveness of American manufacturers.

Conclusion: Human Capital in the Developed Economies

Full exploitation of the above-cited technological advances requires a highly educated, well trained and strongly motivated labour force. Increased productivity growth in the developed economies thus depends on investments in human capital.

This entails (1) increased access to higher education, whose rising costs exceed the financial means of a rising number of young people, (2) strengthening of technical/vocational training of new entrants in the labour force and mid-career individuals needing retooled skill sets and (3) expanded support of older workers displaced by the global recession, whose exit depressed already low labour force participation rates and whose re-entry demands improved work skills.

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