After the crisis – why the slowdown in productivity?

Since the start of the global financial crisis, economists have been puzzled by the apparent disconnect between the historical patterns relating to traditional post-recessionary recoveries and the current period of sluggish and uneven post-crisis stabilization. Although the modern economic analysis does show that financial crises, especially those involving real assets busts, result in much slower periods of recovery, even by historical measures, the current post-2011 recovery has been disappointing.

One of the key aspects of the present economic dynamic that differentiates it from previous recoveries has been a marked slowdown in the rate of labor productivity growth. In a normal recession, increases in unemployment at the early stages of the recession are traditionally associated with rising labor productivity, as employers cut back on employing marginal workers. Subsequent to the employment slack attrition, capital expenditures provide an additional boost to labor productivity. After the recovery sets in, rapid jobs creation and falling unemployment reverse the process of rapid productivity growth. Thus, in general, exits from the past recessions have been associated with, first accelerating labor productivity growth, followed by a gradual tapering in both labor and broader productivity expansions.

Labour productivity growth, 1950 - 2015. Average annual growth rate in labor productivity per hour, percent
Labour productivity growth, 1950 – 2015. Average annual growth rate in labor productivity per hour, percent

However, the most recent global financial crisis and the Great Recession that followed have disrupted this historical pattern. Instead of acceleration in labor productivity growth, we are witnessing a deepening slowdown in the rates of output expansion per worker. This trend has now been present both at the times when labor availability was plentiful, and today, when labor markets slack has tightened somewhat, at least in official figures.

The reality of the productivity growth collapse has been not only noticeable, but in fact striking.

Since 2008, every advanced economy around the world has posted large declines in total productivity and, more specifically, labor productivity growth. Based on data from the BlackRock Investment Institute, during 1950-2007 average labor productivity growth was 4 percent in Germany, 3.5 percent in France, 2 percent in the U.S., 4.6 percent in Japan and 2.5 percent in the U.K. During the period of 2011 to 2015, German labor productivity growth fell to 0.8 percent marking a 5-fold fall, French productivity growth shrunk 7-fold, U.S. productivity growth is down 4-fold. In Japan, labor productivity growth fell more than 11-fold to just 0.4 percent. In the U.K. and Italy productivity growth rates shrunk to zero. Out of G7 largest advanced economies in the world, none have managed to post average labor productivity growth above 1 percent over the last five years.

Absent uplift in labor productivity, it is virtually impossible for the global economy to reach a structurally stronger economic growth performance. Slow growth in labor productivity not only reduces growth in household incomes, thus depressing investment and consumption, but also contributes to companies becoming more risk averse in undertaking capital investment. Lower expansion rates in output per worker cap competitive improvements in global prices for goods and services, reducing potential demand and trade volumes.

These effects are compounded for the sectors where labor skills are complementary to technological and physical capital – the very sectors either already hard-hit by the crises (such as manufacturing) or suffering from financial over-investment (such as tech, pharma and advanced services, e.g. finance and healthcare, education and communications). Not surprisingly, after almost a decade and a half of overheating, tech sector investments are starting to dry out in both Silicon Valley and across Europe. The latest data from CB Insights suggests that European and U.S. early stage funding investments in tech sector have been declining over the last three to four months and anecdotal evidence from both markets suggests that companies’ valuations are suffering as well.

The key question, from both policymakers and investors point of view is whether the current slowdown in labor productivity is cyclical or structural.

After years of debates, the economics profession is only now coming to the realization that both factors are at play in driving down productive capacity of the global workforce. Which, of course, presents an unprecedented challenge to policymakers and investors betting on supply side-driven recovery.

On the cyclical side, as recent research from the Bank for International Settlement highlights, current financial cycle is weighing heavily on labor’s productive capacity. Before the on-set of the financial crisis, most job creation took place in sectors with low labor productivity growth and limited skills transferability: construction, real estate and related financial services, hospitality and basic services. As a result, stripping out effects of employment level changes, actual labor productivity growth was in secular decline in the U.S. from the early 2000s through 2007, and into 2011-2015. Virtually identical dynamics, although with lags, were present in the European Union.

Worse, based on the data from the U.S. Bureau of Labor Statistics, in the period 2010 to 2014 overall productivity growth rates have plummeted in the U.S. from the post-crisis peak of around 2.4 percent to about 0.7 percent per annum. Key drivers for this decline were reduced capital expenditures and declining quality of labor. However, contrary to the myth of booming productivity growth in the tech sector, over the same period of time, total factor productivity – a metric that captures returns on managerial, technological, strategic and financial innovations – also fell from around 2.4 percent in 2009 to around 0.9 percent in 2014.

Outside the U.S., in Europe and Japan, total factor productivity growth has now turned negative, while capital deepening (capital expenditure) has also fallen off the cliff. As overall productivity growth peaked in Europe at around 1.1 percent in 1994-1996, current growth rates are languishing at around -0.3 percent and have been in the negative territory for about eight years now. Japan is in even worse shape.

Thus, although the underlying causes of the productivity slowdown vary across regions, three factors remain stubbornly identical across all of the advanced economies:

  • Firstly, a recent dip in capital expenditures per employee has both contributed to and was co-caused by the collapse in labor productivity growth;
  • Secondly, with technological innovation largely yielding only marginal gains in total factor productivity, technology deepening has been exhausted as a source for productivity growth; and
  • Thirdly, legacy of the financial crises, especially legacies of corporate and household debt overhangs, exacerbated by fiscal policies that shifted the burden of post crisis adjustments heavily onto higher taxation of ordinary workers’ incomes, have contributed to lower growth in both capital and labor productivity through suppressed demand and investment. One standout example of direct and indirect tax burden increases acting to reduce real incomes is the Euro area. However, based on the IMF data, for general government revenues as a share of GDP, 26 out of 37 advanced economies experienced increases in overall burden of taxation over the period of 2013-2015, compared to 2008.

It is worth adding to the above that the adverse impact of labor productivity slump on incomes can also be traced not only to the actual levels of income earned, but to income volatility. A recent research note by JPMorgan-Chase showed that in the U.S. in 2015, more than half of household income volatility was accounted for by labor income volatility. Worse, yet, a typical U.S. worker experienced dips in labor income 43 percent of the time and spikes in income 33 percent of the time.

A general counter-argument to the thesis of slower total factor and general productivity growth is the view held by some economists that impacts of innovation are generally incorrectly measured. In July 2015 report, Goldman Sachs estimated that mis-measured tech-related productivity gains accounted for roughly 0.7 percent of the U.S. GDP over the period of five years. Not a pittance, but hardly enough to correct for the aggregate productivity growth slump. Or put differently, even allowing for the errors in measurement of productivity, technological innovation has been disappointing in terms of enhancing value added across majority of sectors.

And investment markets are signaling the same. On the long-term time horizon, of all various capital management strategies, R&D (which includes non-technology innovation) is virtually on par in terms of profitability or total returns with shares buy-backs. Capex comes in a rather distant third. However, for short term investment projects, buy-backs dominate both R&D and capex in generating higher returns.

It appears that technological innovation currently produces high investment yields only across a relatively narrow range of firms, comprised of larger-scale technology leaders, like Apple and Tesla. Other tech and technology-intensive giants, for example IBM, Samsung, Alphabet and Amazon have actually struggled to derive serious value out of large scale R&D investments. The democratic ‘revolution’ of the tech sector appears to have stalled. Instead of a tech revolution, we are appearing to be heading into the Eugene Fama and Kenneth French world, where companies that under-invest relative to their peers tend to generate higher returns over longer horizons.

It remains to be seen, whether this is a sign of a secular decline or a temporary pause, but U.S. and European tech sectors are the 2016 candidates for a classic value trap, just as the U.S. dot.com firms were in 1999 to 2000, homebuilders were in 2006 and oil and gas companies were in 2011. And, given sky-high equity valuations achieved by a number of technology firms in recent years, a major correction – on par with 2000-2002 dot.com bust – is now overdue.

Concerns with falling labor productivity growth have recently prompted the IMF to devote several pages of its pre-G20 Summit briefing paper on the global economy to the topic. Even though the IMF has squarely missed the point concerning the key drivers of the new trend, the very fact of the Fund pre-occupation with it is significant. If between 2009 and 2014 the IMF put emphasis on fiscal consolidations and monetary policies as the key levers to support global recovery, today the organization is pushing micro- and markets structure proposals aimed at superficially boosting labor share in production and, thus, temporarily lifting labor productivity.

For example, in the case of the U.S., IMF has called for increased focus on boosting labor supply, productivity, and growth via simultaneously expanding the earned income tax credit, increasing the federal minimum wage, raising family benefits, and enacting a comprehensive, skills-based immigration reform, as well as enhanced infrastructure spending, innovation incentives, and vocational training. All along calling for the U.S. federal budget consolidation. While the majority of these policies proposals have nothing to do with improving labor productivity or indeed total productivity across the U.S. economy, the idea of dramatically raising federal government spending on such ‘reforms’ programs while simultaneously attempting to reduce fiscal deficits implies the IMF calling for increased taxation burden on the economy, and more specifically – on upper middle class incomes and capital – the two core drivers of productivity growth.

Technology stagnation or capex starvation, with labor productivity growth collapsing across the advanced economies, potential rates of economic growth are bound to stay depressed for some time to come. This is a more permanent and more potent factor that will be driving global economy in years to come. Beyond income, consumption and investment effects, slower labor productivity is also likely to end recent historical trends toward real deflation in consumer goods and services – deflation driven by improvements in production, supply chain management and retailing technologies. As a result, real incomes will decline faster and fiscal and monetary systems around the world will be feeling the pain of these adjustments. On a long enough time-horizon, a structural slowdown in productivity growth can end up lifting inflation at the same time as continuing to depress economic growth. Good luck getting out of that monetary and fiscal corner.

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