Saturday, August 4, 2018

It's weak investment that’s crimping productivity and prospects

US President Donald Trump said his big cut in company tax would do wonders for the economy. It’s certainly done wonders for company share buybacks. Which may be a clue to why America’s rate of improvement in productivity is so pathetic.

The continuing puzzle for the rich world’s economists is explaining the unusually weak rate of productivity improvement throughout the advanced economies. In Oz we’re not doing so badly, though we used to do a lot better.

Productivity measures the quantity of the economy’s (or just a particular business’s) output of goods and services relative to its inputs of raw materials, labour and capital equipment.

Productivity improves when a given quantity of inputs to the production process is able to produce a greater quantity of goods and services than before. It’s most commonly measured by reference to just one of the inputs, labour. So it’s output per unit of labour, usually per hour worked.

You still see people assuming that some politician or business person saying we need to increase our productivity is really saying we should work harder.

Wrong. The main way to make workers more productive is to give them more or better machines and structures to work with. That is, to invest in more physical capital.

Increasing workers’ education and training – “human capital” – also makes them more productive: better able to work with more sophisticated machines, to think of ways to make machines do better tricks, and think of more efficient ways to organise the work that’s done in a mine, farm, factory, office or shop.

Often, what the better machines and ways of organising things are intended to do is further exploit economies of scale.

Point is, it’s the almost continuous improvement in productivity, year after year, that does most to explain why we are so much more prosperous than our ancestors.

Hence economists’ consternation over the rich world’s unusually weak rate of productivity improvement for the past decade or so, and their search for explanations.

The most popular explanation among them, advanced by Professor Bob Gordon, of Northwestern University in Illinois, is one the rest of us would find hard to credit.

It’s that the present information and communication technology revolution isn’t transforming the economy to the extent that earlier general-purpose technologies – such as electricity, the internal combustion engine, the automated production line, and even running water and indoor toilets – did.

A different, but probably only partial, explanation is that much of the benefits coming from the digital revolution are going unrecognised by a system of national accounts (gross domestic product) designed to measure the industrial economy.

A month ago, I argued that another partial explanation was that the innovations of too many of our brightest and best brains were being used for nothing more productive than finding new ways to get around inconvenient laws and taxes.

Then there’s the notion of “secular stagnation” from Professor Lawrence Summers, of Harvard. Among other things, it says that the ageing of the population and very slow population growth in the rich countries (though not in Australia) means they face a future of weaker growth in consumer spending, thus diminishing the incentive for firms to invest in expansion.

Which links to the much more straightforward – and thus persuasive – explanation offered by former senior econocrat Dr Michael Keating and Professor Stephen Bell, of the University of Queensland, in their book Fair Share.

They argue that the key to productivity improvement is investment – particularly investment by businesses – and the spur to business investment is economic growth and the expectation it will continue.

Innovation is fine, but the main way some new technology is “diffused” throughout the economy is by firms replacing their old machines and structures with new ones that incorporate the latest advances.

Investment is also an essential part of the continuous process of change in the industry structure of the economy, where changes in consumers’ preferences and other developments cause some industries to contract while others expand and new industries emerge.

If firms are reluctant to invest, you don’t get enough expansion to offset the contraction.

What is businesses’ main motive for investing? Their expectations of increased demand for whatever they’re selling, Keating and Bell say.

But this is where the global financial crisis and the Great Recession come in. It was by far the deepest recession the developed world has suffered since the 1930s. The crisis was 10 years ago next month, and the recovery has been particularly weak.

Things in America may look pretty good today – unemployment is very low, profits are high and the economy grew at an annualised rate of 4.1 per cent in the June quarter.

But all is not as it seems. The latest amazing growth is the product of fiscal stimulus from Trump's income tax cuts and won’t last.

Low unemployment conceals a marked fall in the proportion of the population (particularly less-skilled middle-aged men) participating in the labour force.

Many people who lost their job during the recession have given up looking for another one. Their skills have “atrophied” – wasted away – and are a loss of human capital to the US economy.

Keating and Bell show that business investment fell more in this recession than previous ones and has been remarkably slow to recover.

Seeing no great reason to expand, US businesses have been using their profits not to reinvest but to pay big dividends and to buy back their shares on the stockmarket, hoping to boost their price. Trump’s company tax cut has pushed buybacks to record levels.

Get it? Weak economic growth in the advanced economies is discouraging businesses from investing. Weak investment means weak productivity improvement and skills atrophy. But weak productivity means more weak growth.

The authors note that business investment in physical capital, and growth in human capital, are key drivers of the economy’s “potential” growth rate in future years. Neglect them and the economy loses its ability to speed up.

The Organisation for Economic Co-operation and Development calls this a “low-growth trap”. Not an encouraging thought.