If productivity is then answer, then why are we not pursuing it harder?

Sailing Under Uncertain Skies

Australia’s economy sails under uncertain skies. To tame inflation, interest rates have been increased. This has hurt households and a recession lurks. Globally, the lingering economic impact of the pandemic and an on-going geopolitical recalibration create headwinds. Confidence, the life blood of any economy, ebbs.

In the foreground sit Australia’s economic managers, tending our macroeconomic cauldron. Like the witches of Macbeth, round they go with fillets of fenny snake (interest rates), eyes of newt (fiscal policy) in hand. Outside influences, both positive (concert of Tay Tay) and negative (global uncertainty and China), complicate the brew.

Comparing macroeconomic management to witchcraft is obviously, but not entirely, unfair. For one thing, Macbeth’s witches had a larder full of ingredients from which to choose. Bits of frogs, bats, dogs, owls and lizards went into the cauldron, all before the third Witch made some particularly horrible additions. Our economic managers have fewer ingredients to call on. One they would like – higher productivity growth – is proving hard to find.

Productivity is both an ingredient in, and emergent property of, the economic cauldron. It is a key source of growth and, in the long term, drives higher wages. Productivity also creates choice; allowing individuals and government to look beyond the ‘purely’ economic to other things, like more leisure.

Demand for productivity flows fundamentally from what sociologist Hugh McKay calls our desire for ‘more’. Economist Adam Smith sees it as a biological desire for ‘better’ which “comes with us from the womb and never leaves us till we go to the grave”. For both, wanting more/better is an innate and unchanging part of the human condition. History is on their side.

Our desire for more/better is in conflict with finite global resources and dwindling environmental capacity. Add a growing global population and the lure of creating more using less – productivity – becomes clear. It is little wonder economists are in its thrall.

Productivity is considered so important that Australia has a whole Commission to look after it. Every five years, the Productivity Commission examines ways of increasing Australian productivity. Its most recent report runs to nine volumes and 71 recommendations. This followed an earlier report with 28 (albeit more encompassing) recommendations and 16 supporting papers. Someone in the PC is presumably calculating which was most productive.

Australia’s recent record of low productivity is not for want of potential policy responses. Yet many of the PC’s 99 recommendations sit idle. Those that have been implemented do not, as yet anyway, seem to have made much difference. 

Australia is not alone in this. Low productivity is a feature of most so-called advanced economies. Despite its apparent desirability, productivity is more talked about than acted on across the globe. It’s all a bit odd.

Is politics the problem?

For some, the main problem is politics. Policy answers exist but political short-termism stands in the way. This argument has merit. The benefits of higher productivity are diffuse and primarily realised in the long term, while getting them often involves short term pain with clear winners and losers. It is a temporal mismatch that democracies struggle with world-wide.

Is there less productivity out there?

Another possibility is that achieving productivity growth has become more difficult. The problem is less that we are not trying and more that there is less productivity out there.

Imagine extracting liquid (production) from a wet sponge (economic potential). To increase the flow of liquid (productivity) you have two options: squeeze harder or increase the size of the sponge. Now imagine that the sponge has wetter spots and drier spots. Finally, imagine the sponge sitting in the sun drying out.

In its most recent report, the PC describes three barriers to faster productivity growth. The first involves the increasing importance of services to our economy. The second is the need to decarbonise our economy. The third involves shifts in the global economy, including a return to protectionism across the world.

Historically, services productivity has grown more slowly than that of agriculture or manufacturing (it is also harder to measure). Productivity growth for government-controlled services (health care, childcare or aged care etc) has been even slower. While gains are to be made, the PC accepts they may be structurally smaller than we have seen in the past. In relative terms, the drier spots in our sponge are getting larger and wetter spots smaller.

The PC’s focus on decarbonisation is understandable. It is, by far, the biggest environmental game in town.  How we manage the transition will be critical to our future. But it is only part of our growing understanding that global and local environmental capacity is less than previously assumed. This too could mean a drier sponge and, as a consequence, less scope for productivity.

Shifts in the global economy are working in a similar direction. After a period of liberalisation, constraints on trade are emerging. Pandemic induced shortages are also causing firms (and nations) to rethink supply chain strategies that were initially pursued in the name of productivity. These shifts further dry our sponge, reducing productivity potential.

Squeezing the sponge harder (what economists call static efficiency) or increasing its size (dynamic efficiency) may also have become more difficult.

Static efficiency was an especially influential driver of public policy across the 80s and 90s. Competition policy, deregulation and marketisation were all seen as ways of better squeezing the economic sponge. More recently, however, the approach has fallen out of favour and bears the pejorative: neo-liberalism.

Ideology aside, potential reasons exist for the declining emphasis on static efficiency. One is that the flow of additional benefits from these efforts was always limited, and fewer gains are now available as the easy things have been done. Another is that these policies came with larger costs than expected. Both ring at least somewhat true.

A third explanation is that our policy paradigm needs updating to suit modern times. James Plunkett certainly thinks so. Plunkett argues that today’s digital and platform-based economy requires a major shift in the way government see its role and operates. Others - such as Kate Raworth - agree, albeit for differing reasons and with different solutions.

Separating static and dynamic efficiency is easier in words than in policy design. In the real world the concepts interweave, with policies designed for one having an impact on the other. That said, improving dynamic efficiency leans more into what the PC calls the ‘determinants of market growth’: innovation, human capital and investment.

Innovation is seen, in particular, as the holy grail of long-term growth. Without innovation, the argument goes, economies will ultimately stagnate no matter how statically efficient or institutionally sound they are. While this remains the general view, the ongoing power of innovation to improve productivity is subject to a surprising amount of debate. 

US economist Robert Gordon is a self-styled prophet of pessimism. He argues the great bursts of productivity we have seen in the past are less likely in the future. One reason is that innovations which allowed the creation of large cities (such as sewerage) have been exhausted. Another is that an undesirable driver of innovation, war, occurs less often.

Gordon’s view is that technology advances such as the internet are important but are unlikely to result in big increases in productivity. His message to young people is don’t expect the same improvement in living standards enjoyed by your parents or grandparents. As if increasing interest rates, the high cost of living and getting Tay Tay tickets aren’t problems enough.

Other economists are much more positive. One, Joel Mokyr, hails from the same university as Gordon. Mokyr describes Gordon as ‘misguided’ (their corridor chats must be quite something) and highlights the importance of the culture of innovation created in western society. He is a techno-optimist and puts the lack of improvement in productivity partly down to measurement problems.

Beneath the debate lie some other potential dynamics. For example, rather than accruing to ‘mature’ economies, the benefits of innovation may be flowing primarily to emerging economies. Some of this is a natural result of globalisation. But countries – notably China – also stand accused of stealing technical advances made by other nations, disrupting the connection between inventive effort and productive benefit. Those familiar with global colonial history may see a slight irony here.

The extent of this and other issues affecting the domestic innovation process are hard to judge. For one thing, as the PC points out, most Australian productivity comes from the adoption of innovations created overseas rather those created at home.

Spice Girls to the Rescue?

In presenting its latest report, the PC did not explore why past recommendations to improve productivity have had such a lukewarm reception. This is understandable. The Commission’s role is to put forward a positive program of change, reflecting its charter and relevant terms of reference.

While understandable, it leaves a hole in our understanding. It also leaves the managers of our economic cauldron short a key ingredient. Political short-termism, while a factor, is not compelling as a full answer. Nor is the growing challenge of extracting productivity from a potentially drier economic sponge.

At the end of the day, productivity is not an end itself. It is a means for meeting the desire of our citizens for more/better in a resource constrained world. The assumption is that the way we measure productivity aligns, borrowing from the Spice Girls, with what we “really, really want”. It is an assumption worth testing.

The Power of a Single Number

Australia’s productivity growth languishes. For the last two decades, growth in productivity has sat well below its 60-year average. In the 2010s, growth was half that of the 1990s.

Australia is in good company. More than 80 per cent of advanced economies have been recording productivity growth below long run averages. For emerging market and developing economies, the figure is less than 50 per cent. For low-income countries, it is roughly 30 per cent. 

Productivity has become so last century - for advanced economies anyway.

These dynamics have an upside. Incomes in advanced economies are much higher than in the rest of the world. Better productivity performance is helping poorer nations catch up, lowering global poverty along the way. But even here, there is a cloud. Productivity in emerging economies may also be slowing.

For economists, falling productivity growth is a massive concern. Long term, less productivity means lower income growth. This is leading some to warn future generations not to expect the same growth in living standards as their parents or grandparents.

The Australian Government seems to agree. It has reduced its expected long-term rate of productivity growth from 1.5 to 1.2 per cent a year. If realised, this will see incomes 20 per cent lower in 40 years than they would otherwise be. Good luck affording tickets to Tay Tay’s farewell tour.

Productivity wouldn’t matter, at least not as much, but for an in-built human desire for more and better. This desire conflicts with our growing understanding of the environmental limitations of our planet. Logic suggests that doing more with less – the essence of productivity – should be becoming more valuable, not less. Yet ideas for doing better sit unloved on the policy cutting room floor.

Explanations compete for why this is happening occurring. Many contain at least a kernel of truth. But none, even when added together, seem provide a complete answer. Something is missing.

One possibility is that our measures of productivity do not align with the version of more and better we (really, really) want. For the measure to have policy meaning, the alignment does not need to be perfect. But it does need to be pretty good. It also needs to hold, with a reasonable degree of stability, over time.

Given the importance placed on productivity by policy makers and other decision makers, alignment is not simply a matter of abstract academic interest. It is, or at least it should be, a matter of national concern.

Measuring productivity

The formula for productivity is simple – outputs divided by the inputs used to create those outputs. The higher the number, the more productive you are. Productivity growth records how this ratio changes over time. It feels like measuring productivity should be easy. Only it isn’t.

Even for an individual organisation, translating the idea of productivity into meaningful data can be difficult. W Bruce Chew, for example, examines how to assess productivity at a manufacturing organisation. As he does, the conceptually simple becomes startlingly complicated.

What is challenging at a firm level is an order of magnitude more difficult at societal level. It is little wonder that a recent Productivity Commission report noted difficulties measuring productivity without pursuing them further.

The PC’s decision was both pragmatic and somewhat reasonable. Its most used measure of productivity does not seek to capture all inputs, just one – labour. Its preferred measure of output, Gross Domestic Product, is used world-wide. One advantage of these measures is that they allow for a consistent time series. Another is that they allow comparisons with other nations. Both advantages facilitate meaningful empirical analysis.

Most of the technical debate around measuring productivity tends to focus on the inputs side. Labour productivity (partly because of its connection to personal income) is used commonly. But so are other measures, like total factor productivity, which seek to capture a fuller range of inputs.

Less debate tends to occur on the output side. GDP stands pretty much alone as a measure of societal output. The assumption is that GDP provides a good sense of what we (really, really) want. But does it?

A brief history of GDP

The history of GDP is more interesting than it sounds. Honestly.  

The story begins with William Petty in 17th Century England at a time of ongoing civil war. Petty had what we would today call multiple careers. He was a cabin boy who was marooned after breaking his leg, private secretary to Thomas Hobbes, an optician’s assistant, an anatomist who apparently revived a corpse, and physician-general for Oliver Cromwell’s army. Finally, after a bite to eat and a lie down, he founded political arithmetic (now known as statistics).

Petty’s work included combining a mix of real and estimated data to value the lands under Cromwell’s control. This provided the empirical base for Cromwell to distribute land to his army in lieu of pay. As it happens, many did not want the land and the ever-helpful Petty bought it from them. He made a fortune. It seems that Sir William was, in addition to being the ‘most rational’ man in England, also a bit of a bounder. But his idea of measuring things to inform political decisions has caught on.

A hundred or so years later, Adam Smith entered the stage. Smith, aside from some stunning bouts of absent mindedness, led a much less exciting life than Petty. But it was infinitely more influential. One of Smith’s views was that humans had a biological desire to ‘better’ their condition and, as a consequence, governments should focus on producing ‘more’. It is a view that drives governments worldwide.

Smith’s conception of delivering ‘better’ focussed primarily on the increasing the production of goods and wealth. Later thinkers, like Alfred Marshall and Arthur Pigou, argued for a broader concept – welfare (more commonly understand today as wellbeing). The problem was that only some elements of welfare could be measured. This resulted in what Philipp Lepenies describes as paradoxes.

One key paradox, which remains today, is that the value of unpaid work was excluded from measurement efforts. Too hard apparently. As Arthur Pigou observed “if a man marries his housekeeper or his cook, the national dividend would be diminished”.  His example feels archaic today. But it was a different time, and the mountain climbing Pigou was a cloistered academic, so let’s forgive him.

Paradoxes aside, technical work on building a measure of ‘national income’ continued. However, in Britain it was not until 1940s that things really started to come together. War was again a driver and production, as opposed to welfare, was the key focus.

Across the Atlantic, Simon Kuznets had been taking knowledge gained from his home nation of Russia (then a leader in political arithmetic) and applying it to the US. Kuznets sought to include a subjective element into national income to capture life satisfaction. Quantification eluded him however, leaving a gap (in his mind at least) between what should be measured and what could be measured.

Kuznets’ calculations of US national income for 1929 to 1932 were nonetheless a major hit. They were referred to extensively in the 1936 US Presidential campaign by Franklin Delano Roosevelt. The subtext was clear: government performance could now be assessed via a single number.

Despite Kuznets’ efforts, notions of welfare were ultimately overtaken in the US by a stricter focus on national production. This, once again, partly reflected wartime priorities in the US. But measurement issues and a drive to produce standardised statistics that could be compared across nations also played a role. The end result was the birth of gross domestic product (GDP).

By the way, don’t feel too sorry for Kuznets. He won a Nobel prize and had a university named after him. You win some, you lose some.

The power of a single number

GDP is arguably the single most important piece of political arithmetic in the world today. Estimates of GDP growth headline government budgets across the globe. Thanks partly to FDR, the election prospects of democratic governments can rest on whether GDP growth is meeting public expectations. It is a number with real power.

GDP is also what gives measures of productivity meaning. If GDP does not align with what we really, really want, nor will productivity. It is here where some questions arise. The focus of GDP was influenced by national priorities at times of war. Empirical pragmatism has resulted in a preferencing of what can be measured over what cannot. Some things are measured more accurately than others.

Psychologist Daniel Kahneman might describe GDP as a heuristic. It is a short cut which allows us to make fast-thinking decisions about something which is, in fact, uncertain and complicated. Like all heuristic short-cuts, it is not free from bias and not immutably fit for purpose.

It is unreasonable to expect GDP to align perfectly to what we really, really want. But to deserve its power, the relationship needs to be strong, and it also needs to be reasonably stable over time. The big question is – is it?

From GDP to Well Being

Gross Domestic Production is not a term that rolls easily off the tongue. It sounds like what it is – a technical construct. Almost no one, including many in government, understands how GDP is derived. Yet it is arguably the most powerful piece of ‘political arithmetic’ in the world today.

The way we measure GDP was born, almost literally, in the fires of war. Necessity and pragmatism drove its design. A debate between those seeking a measure of ‘production’ and those seeking a broader measure of ‘welfare’ was won decisively by those on the side of production. The ramifications of this, both good and bad, echo through the entire globe.

Ultimately, the value of GDP lies in how well it represents what society (really, really) wants. GDP, and its efficiency focussed derivative, productivity, only have meaning if GDP captures this reasonably well.

No one pretends GDP is perfect. It is a short cut we use to measure something too complicated to calculate precisely. Even those involved in its establishment saw a gap between what can be measured and what should be measured. The size of this gap size and how it is changing is of real importance.

Where GDP gets it wrong

Throw a rock into a group of economists and philosophers (not that you should, no matter how tempted) and you have a high chance of hitting a critic of GDP. Joseph Stiglitz, Marianna Mazzucato, Kate Raworth and Michael Sandel – to name a few – have written compelling modern critiques. Even The Economist has got in on the act.

Defenders of GDP exist. Like Inigo Montoya from The Princess Bride, they say “you keep using that word. I do not think it means what you think it means”. The defence is based around what GDP does measure rather than what it does not. And what it does measure over time (albeit imperfectly) is whether society is producing more than before.

The problem is that our human desire for more is complicated. Hugh McKay describes it as only one of a suite of things that make us tick. Adam Smith’s concept of better involves more nuance than generally recognised. We do want more, but what we (really, really) want is more wellbeing. Production helps, but only when it involves producing the right things.

GDP has no view on what is right. Declaring war is a great way of boosting GDP. Production created from car accidents (hospital treatments, car repairs, taxi trips, phone calls to the insurance companies) has the same value as providing nutritious meals for people in aged care. Robodebt provided a much bigger boost to GDP (Royal Commissions involve a lot of production) than would have come from a well-designed and administered welfare compliance scheme.

GDP also misses things critical to wellbeing. A nurse holding the hand of a dying patient has the same GDP value as one who walks past to do other things. Arguably worse still, a parent staying home from work to support a child who had a bad day at school (if unpaid) reduces GDP. In a world where high quality care is more demanded, this matters.

Further wrinkles exist.

One is that GDP is agnostic about how the benefits of production are distributed. Admittedly, distribution is a difficult topic. Views on how societal production (or wellbeing) should be distributed vary widely and are debated fiercely. But, for most of us anyway, what happens to other people matters. To stretch Smith’s concept, better also needs be fair. 

Another wrinkle is that GDP pays no inherent regard to environmental capacity. Activities which damage the environment have the same value as those they do not. Economists have sought to address this by designing systems to ‘price’ environmental impact. While conceptually neat, these systems have proved difficult to put effectively into practice. The translation of these efforts into GDP (with its focus on more) remains at best clumsy and at worst provide false comfort.

These wrinkles caused Kate Raworth to conceive the economy as a doughnut. It’s true. Perhaps it was morning teatime.

Raworth’s argues that economies need to operate in the space between two constraints – a distributional constraint which ensures everyone receives a fair share and an environmental constraint which ensures human activity remains within the carrying a capacity of our planet. The space between is the doughnut. It is (ahem) a sweet concept, even if it might not be Adam Smith’s cup of tea. That said, the absent-minded Smith once placed a slice of bread and butter into a brewing tea pot before drinking the result – so who knows.

A growing gap

GDP was largely conceptualised in a period from the Great Depression through to the aftermath of the second World War. At the time, economies were dominated by agriculture and manufacturing. Material comforts were hard to come by. Care was provided by families, not markets. Rachel Carson was only beginning to warn us of the harm environmental damage human activity can bring. Producing things mattered more than producing services, even in so-called advanced economies.

While imperfect, the GDP was very well suited to the time in which it was created. The tight focus it brought on economic growth (more) and production-based productivity (more using less) has enriched the lives of billions. It is no coincidence that standards of living have risen dramatically since GDP was first conceptualised.

An argument exists that these benefits came with large costs. The focus GDP brought, as the world’s most important number, has undoubtedly biased government decision making. It is interesting to imagine what our world might be like, for example, had the value of unpaid ‘production’ within the home had been recognised. Or if better distinctions were made between bad GDP (car accidents) and good GDP (well-designed welfare compliance systems). Or if environmental impact was properly considered.

Look forward and the future suitability of GDP seems far less certain. Advanced economies today are very different from those of the 1930s, 40s and 50s. People are richer and older. Government funded care services (the quality and value of which GDP captures poorly) increasingly dominate economic activity. Travel and entertainment are a bigger part of most people’s lives. Material comforts (housing aside) are easier for most people to come by, despite wildly increased expectations. The importance of remaining within the gooey space depicted by Kate Raworth’s doughnut is better understood.

As time goes, the gap that has always existed between what GDP does measure and what it should measure is growing larger. Franklin Delano Roosevelt, if he was around today, would be much less likely to point to GDP as the ultimate measure of government performance. He would be right not to do so.

New Beginnings – From a single statistic to a wellbeing dashboard

None of this is new. Attempts have and continue to be made to complement (if not replace) GDP as the primary way of assessing societal progress. Indeed, Australia was an early leader. Between 2002 and 2013 the ABS produced Measures of Australia’s Progress and The Treasury developed a wellbeing framework to guide its policy development. Both fell into disrepair.

New Zealand, Canada, Germany, and Bhutan all have wellbeing frameworks. Even the ACT government has one. The OECD has developed a Better Life Index which allows comparisons across countries. Australia has recently (re) joined the throng with the release of Measuring What Matters – Australia’s First Wellbeing Framework.

The focus of these wellbeing frameworks differ. Some emphasise individual wellbeing, while others (like Australia’s new framework) emphasise national wellbeing. New Zealand’s framework steps beyond measuring the past, to assessing future wellbeing. Scotland and the UN have leapt the measurement boundary by including targets as well as measures.

How well the 50 measures anointed by the Australian Treasurer describe what we (really, really) want remains to be seen. The framework is developmental in nature. Some chosen indicators are vague, and many are incomplete. Tensions exist between indicators and trade-offs between them are needed. Not every paradox with GDP has been solved.

Back to productivity

The weakening ability of GDP to describe what we (really, really) want provides another explanation for why governments seem so reluctant to pursue productivity-enhancing reforms. Government may well be short-sighted, and productivity may well be harder to find. But it may also be government has concluded (implicitly if not explicitly) that GDP-based measures of productivity are not telling us what we need to know.

The significance of this should not be underestimated. There is no serious sign that our human desire for more is waning, even in rich nations. For poorer people and nations, the desire to catch up is as strong as ever. This, combined with finite environmental capacity and a growing population, make the pursuit of productivity critical. The power of GDP may be eroding, but it still points to something important.

The real purpose of measuring productivity is to assess how efficiently we are creating what society (really, really) wants. If this is not GDP, then an updated approach to measuring productivity is also needed. Without it, the managers of our economic cauldron are in for a very tough time. Even worse, those hoping to have the income needed to see Tay Tay’s farewell tour might end up really disappointed.