Productivity paradoxes in the West
The list of potential contributors to Western economies’ failure to sustain productivity gains over the past generation is long.
In a nutshell
- Advancing technology has not produced the expected productivity gains
- A variety of labor market trends could be behind this disappointment in Europe
- A swelling public sector and poor policy choices are aggravating the problem
Labor productivity growth has mostly been on the decline in the developed Western economies, especially in Europe, for at least a generation. Given the central role productivity gains have played in economic and social development, the trend raises concerns. Just this spring, several studies were published on the topic, while the former governor of the European Central Bank, Mario Draghi, is due to publish a report on productivity in the European Union later this summer. Recent research has tried to track more precisely the causes of the slowdown. It may turn out, however, that other aspects, less examined than productivity, could prove significant as well.
Productivity matters
Broadly defined, productivity is measured by comparing output (production) with the inputs used to produce it. One important input (or factor) is of course labor, and labor productivity is the focus of recent studies. Productivity gains are registered when workers produce more during the same number of working hours, for example, or when more is produced by the same number of workers. Total output – in other words, the economy – grows faster. Logically, higher productivity affects companies by creating more value that can be distributed to employees in the form of higher wages, to owners or shareholders through higher profits, or to consumers via lower prices, which also improve market competitiveness.
Trends in productivity, together with trends in production factors (labor, capital), determine “potential growth” – the maximum economic growth achievable without generating inflationary tensions. Increasing potential growth is, in turn, essential for an economy to achieve higher income per capita and improve living standards. It is also a determining variable in measuring the structural deficit of public finances, a key gauge of fiscal sustainability in indebted countries.
For all its central importance, productivity has proved surprisingly difficult for economists to calculate. Traditional caveats on “mismeasurement” potential refer to difficulties in assessing productivity in services, especially new digital services, adjusting for quality improvements, and – more recently – imputing inflation rates. A striking example is the free availability of many digital services (such as Google Maps), which generate productivity that, by definition, evades accounting through market prices. This highlights productivity gains that could be missing from the official figures.
Technological progress
Technological progress is one way to increase labor productivity, by equipping workers with better tools to produce more and/or better.
Economist Robert Gordon made the case a decade ago that the effects of disruptive, productivity-enhancing innovations such as computers and the internet have plateaued, with new products bringing marginal improvements rather than any radical technological change. Others such as Gilbert Cette recalled that innovation takes time to infuse throughout the economy. After all, the Nobel economist Robert Solow famously observed in 1987 that “you can see the computer age everywhere but in the productivity statistics.”
Yet, as one study notes, technological progress itself is highly dependent on research and development (R&D) activity. While R&D expenditure has increased both in the U.S. and the EU, it has been much slower in the latter. The result has been a widening gap that saw the U.S. spend $700 billion in 2021 versus the EU’s $400 million. European technology patents have remained flat over the past 15 years at an annual total of about 45,000, while U.S. patents increased to around 55,000. Moreover, the gap is even bigger in complex and critical technologies (less than 8,000 patents in the EU vs. almost 17,000 in the EU in 2021).
Some technological progress can yield ambiguous outcomes, however, with a prominent example being social media. Their use can greatly contribute to communication, information sharing and coordination in the workplace, thus generating productivity gains. However, without effective controls on their use, social media can also destroy value by distracting employees and wasting their time, making them less productive through disrupted workflows and focus. Moreover, social media usage outside the workplace can have a negative spillover effect on productivity by depriving employees of sleep and shortening their attention spans.
Declining investment
Several studies stress a decline in “capital deepening” (investment) – mostly in industries unrelated to Information and Communication Technologies (ICT), but also in ICT sectors themselves (including R&D, digital, and intellectual property) and in the more generalized “intangibles” (skills or management practices) that directly affect them. One explanation could be the aftereffects of the global financial crisis of 2008-2009: Financial cycles affect investment through financing constraints and lower demand, incentivizing businesses to cut investment disproportionately. Over the subsequent decade and a half, governments mostly focused on short-term stimulus while piling up debt, allowing productive investment (including in basic infrastructure) to decrease in proportion.
Measurably lower numbers for business formation and failure (indicating rising barriers to entry and exit) have weakened competitive pressures on markets and thus reduced the efficiency of allocation processes. Scarce resources are not being smoothly directed toward the most productive companies, while “zombie” firms can maintain themselves, dragging productivity figures down.
Globalization has also played a variable role. Increased offshoring of physical investment (factories, production lines etc.) and subsequent deindustrialization have straightforwardly translated into productivity declines in Western countries doing the “outsourcing” (some of these capital movements can also be explained by corporate taxation). At the same time, the EU has proved much less successful than the U.S. in attracting foreign direct investment, which could account for part of its productivity lag. Others stress that the global economy has already reaped most of the productivity gains from a dramatic expansion in global trade, while the demand shock caused by the Great Recession generated an additional slowdown, aggravated by a rise in protectionist measures.
Labor market shifts
Slowing productivity gains could also be the outcome of a growing mismatch between the supply and demand of skilled labor. For economies to reap the full benefit of technological change, there must be corresponding improvement in complementary human skills. Workers with an average education cannot keep up with the demands of high value-added industries and find themselves relegated to less productive tasks. On the other hand, new digital applications have reduced the information and transaction costs of matching vacancies and skills.
Demography also plays a role through the effects of aging populations on developed economies, acting through three channels. First, older workers may have more difficulty adapting to technological change, though this linkage is very indirect and still disputed. Second, people tend to consume more personal services and less goods as they grow older, reallocating labor markets toward lower-productivity jobs (here again, however, there is no consensus on the causal link). Finally, older people are said to consume less and save more, depressing aggregate demand and reducing investment (this argument also has its detractors, who counter that shrinking working-age populations have encouraged countries like Japan to invest in highly productive automated systems).
To these factors must be added the Covid-19 crisis, which prompted many companies to practice “labor hoarding,” even as demand and output fell, to retain experienced staff and avoid the training and administrative costs of re-hiring. In the short term, this trend had a purely mechanical effect of diminishing productivity. Other possible labor market contributors include the popularity in the U.S. of non-compete agreements, which prevent productive labor reallocation, and the prevalence of the gig economy, which in the UK has resulted in lower investment in skills and increased the role of unskilled labor. In France, on the other hand, the growing use of vocational trainees has lowered productivity while increasing the employment rate.
Less effort
Other potential explanations should not be discarded, either. For instance, analysts have expressed concern about many of the new generations arriving on the labor market. Mysteriously, their ability to use apps and other productivity-enhancing digital devices has not yet translated into higher labor productivity. Given a massive increase in the market share of graduates with higher education – in other words, possessors of “human capital” – one would expect a corresponding increase in productivity. One explanation could be a drastic decline in educational standards.
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Recent PISA surveys of 15-year-olds have shown falling levels of knowledge and skills in mathematics, reading and writing. Just as disturbing, however, is a visible deterioration in social or interactive skills (including simple manners) essential in the workplace for cooperating with others and coordinating teams. More broadly, observed declines in attention spans and the ability to focus have been attributed to excessive use of personal digital devices and changing pedagogical approaches in both public and private education, where a more egalitarian, consumer-oriented ethos downplays the hard work required to earn good grades. This fading “taste for effort” instills a preference among young people for quick and easy profit opportunities that require little long-term investment. Some economists also stress a financialization effect as companies focus on short-term results, putting less effort into investment and strategies such as buy-backs.
Facts & figures
The impact of minimum wages
Typically, a minimum wage is seen as increasing productivity, for at least four reasons. First, based on “efficient wage” theory, a minimum (i.e. higher than market) wage motivates workers to be more productive. Second, it reduces employee turnover, which often leads to higher levels of training and productivity. Third, a high minimum wage destroys jobs for the most unproductive workers as companies invest in technology to replace costly human labor, thus increasing productivity. Fourth, a minimum wage can force low-productivity companies out of business, acting as a market selection mechanism to help healthier companies thrive.
However, in countries with a high minimum wage and high payroll taxes, the outcome might be negative for productivity. France, where 17 percent of the workforce earned the minimum wage in 2023, is a recent example of this. To avoid a disincentive for employers to hire, governments can compensate for a high minimum wage by reducing payroll tax for minimum wage employees – thus keeping their perceived net wages intact. Unfortunately, this system gives employers incentives to keep workers at or just above the minimum wage – a good recipe for demotivated employees and stagnant productivity.
At the same time, stagnating wages have the same depressing effect on productivity. However, since this stagnation is itself caused by lagging productivity, afflicted economies find themselves trapped in a vicious circle. In keeping with “efficient wage theory,” the policy response of interventionist economists is to push for higher wages. Liberal economists reply that using regulation to force up wages, irrespective of productivity gains, violates economic fundamentals and ultimately proves counterproductive by preventing efficient allocation and quite possibly stoking inflation.
Corporate debt levels may certainly have something to do with the decline of investment. Some would add that the post-2009 monetary policies of zero or low interest rates have contributed to a present-oriented mentality detrimental to long-term investment and productivity gains. The “great resignation” and “quiet-quitting” movement in the post-Covid period also showed that the financial crisis and pandemic lockdowns have shifted perceptions of the work-leisure balance. Stress induced by economic pessimism may likewise have made people less productive.
Meaningless employment
Another phenomenon rarely mentioned in productivity studies is the multiplication of what anthropologist David Graeber described as “bullshit jobs” – for example, in bureaucracies of the private sector (especially in large companies that demand monitoring of line employees but less of the middle managers doing the monitoring) and in public administration (due to traditional bureaucratic inertia and lack of accountability, which encourages bloat). An inbuilt government preference for over-regulation (which can be likened to turning complexity into a business) encourages the creation of useless roles in both the private and public sector.
In the short term, a rise in meaningless employment will appear as a boost to output and economic aggregates, but the burden it actually represents will make itself felt over the longer haul. There is an opportunity cost to paying workers for unproductive activities. In the public sector, their “jobs” often restrict economic freedom, pile on debt and thus contribute to political instability, which all reduce the long-term incentive to invest. In countries with more employee protection, the detrimental impact of more corporatism and less competition will likely prove to be significant.
Scenarios
Less likely: Productivity begins to rise again
An optimistic, if ultimately less likely, forecast for French productivity is offered by Banque de France, which claims that recent declines are mostly cyclical. It argues that increases in vocational training and improving labor retention show “the dynamism of French employment” rather than any “decline of the potential for wealth creation.” It is indeed possible that new technologies have not yet had time to feed through into higher productivity figures. Artificial intelligence is still in its infancy and could soon generate a disruptive leap. Efforts to combat climate change could also, for example, lead to revolutionary progress on new energy sources, such as commercially viable nuclear fusion or hydrogen fuels.
More likely: Productivity declines
A more probable scenario would allow for the negative effect of EU over-regulation (especially in the AI and digital markets) on new investment and productivity. Stubbornly high levels of public spending and debt, swelled by mismanagement and enormous, unfunded government retirement schemes, will eventually depress both demand and supply through higher taxation, while fiscal pressures curb essential public investment in infrastructure. Such fiscal stress is usually accompanied by growing political instability, which is rarely conducive to long-term investment. The steady erosion in the quality of human capital and a cultural shift in favor of leisure will do the rest. In Europe, the recent increase in energy costs will likely not translate into new opportunities rapidly, but rather remain a burden.
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