There are reasons why productivity is slowing and they’re not all bad

Everyone is hoping that the productivity fairy sprinkles pixie-dust on our economic problems – inflation, slow growth and income inequality. Remember Paul Krugman’s maxim: “Productivity isn’t everything, but in the long run it is almost everything.”

But there is more to this challenge than just squeezing inefficiencies out of work practices.

The Krugman quote goes on to remind us that the objective is “improving a country’s standard of living”.

This might not be the same as raising measured GDP per worker. To see why, let’s note a couple of reasons why productivity growth, as currently measured, has slowed.

As incomes rise, we want more services of the type which do not lend themselves to rapid technological progress and economies of scale. We want more health, education, entertainment and recreation. Productivity improvements are possible in service industries, but the opportunities are intrinsically more limited.

In some cases, technology has been marvellous (as in health), but it has encouraged us to consume more of the product, and this benefit is not well measured as ­productivity.

Over time, regulation of workplace safety has tightened, at some cost to productivity. The building industry is an example.

A third example: the current hot economy has brought some marginal workers into the labour force. This is excellent and should be applauded. But it does mean we are now “batting the whole of the team”, so the average score will be less than if only the top-order batters came to the crease.

Let’s ask ourselves: in any of these cases, would we want to reverse these factors dampening productivity? For most of us, the answer would be no.

The biggest opportunities for higher living standards come not from squeezing more out of labour, but from shifting resources into production with higher social value.

Looking historically, the dramatic rises in incomes came from shifting workers out of agriculture (half the population used to work on the land), into industry and services. Technology made this possible, but the shift in resources was the key to the benefit and may not happen without some prompting.

Where are the opportunities now?

In some cases the key to unlocking these shifts is competition. Resources don’t shift even when technology enables additional production – a higher level of service is provided instead, even when it is not highly valued. The legal industry has reaped huge benefits from computers, but do we have fewer lawyers?

Where industries hold an essential role as intermediaries, they can use this position – supplying a small but vital element of a much larger transaction – to have a high degree of control over their industry price.

The finance industry may show some of these characteristics. Its share of profits has increased fourfold since financial deregulation in the early 1980s. Sure, the payments system is providing a much-improved product compared with 30 years ago.

But is the finance sector doing a better job of steering savings into the highest-value investment?

Much of the effort seems to be in trading and churning (eg high-frequency trading, active management for small pension portfolios), providing second-by-second pricing which adds nothing to social value, financial engineering designed to raise leverage, or facilitating mergers and acquisitions which the record shows fail more often than they succeed.

Adair Turner identified a neat example of the market’s failure to reflect social value, which has much wider application. He cites the divorce lawyer. The division of family assets is a zero-sum transaction – or less than zero after the lawyers have taken their cut. But both parties can see the personal benefit of hiring the best lawyer: so top divorce lawyers can command fabulous fees. Suppose cases were settled by a non-adversarial system: those super-smart divorce lawyers could, instead, do something which added to net social value.

Or take advertising. As industry insiders say: “we know that half of advertising expenditure is wasted; we just don’t know which half”. To the extent that advertising just shifts demand between similar products (where advertising is purely defensive, required to preserve market share), then it adds nothing to social value. The link between social media and advertising adds to the disconnect between resources used and social value.

Such a large proportion of the economy operates largely outside the strict discipline of market competition that the opportunities for productivity gains through shifting resources are not ­identified.

One example: we plan to build our nuclear submarines at home. We will take our very best engineers and set them to a task for which they lack many of the relevant skills, where production will be far below efficient scale, with no prospect of an export market and where government ownership removes the profit discipline. We could buy overseas for a fraction of the price. It would be hard to find an example of a project which misallocates national resources so comprehensively. Yet many will see this as a boost to productivity, with relatively few workers producing something with a very high price. But we could do something far more valuable socially, and enhance our security more, if our industrial policy was directed towards our comparative advantage.