SUMMARY
- In our May Secular Forum, we highlighted the rising potential for an innovation-driven productivity rebound in the coming years after a decade-long slump ‒ driven by a host of new technologies spreading throughout the global economy.
- In the post-crisis years, strong macro headwinds have stood in the way: excess capacity and large output gaps; high economic and policy uncertainty; weak capital investment; a worsening misallocation of capital across firms; and lingering credit market strains and corporate-sector financial vulnerabilities.
- What lies ahead? We see increasing potential for several key macro headwinds to fade. Although it is too soon to declare victory, recent macro trends are encouraging. But a productivity upswing, if it were to materialize, could prove disruptive to the markets.
In our latest Secular Outlook, we highlighted the rising potential for an innovation-driven productivity rebound in the coming years. We think productivity, after a decade-long slump, may be driven higher by a host of new technologies spreading throughout the economy. However, for microeconomic advances to unleash a productivity rebound economywide, the macroeconomics must cooperate: It takes two to tango. In recent years, several key macro headwinds – mostly demand-side factors and hangover effects from the 2008−2009 global financial crisis – have stood in the way. This may be about to change.
SLUMPING PRODUCTIVITY – WHY EVERYWHERE AT ONCE?
Like innovation, productivity booms have come in fits and starts. It has been considered normal for productivity, or output per hour worked, to jump in some geographies and industries while simultaneously slumping in others. So it is revealing that the ongoing global productivity slump has been abrupt, deep and highly synchronous across countries and sectors. As shown in Figure 1, productivity growth has converged across countries in recent years more than at any other time in the postwar period.
Divergences in productivity trends across countries used to be far wider, even during prior slumps. From an industry-level perspective, consider that in the post-crisis period, less than 5% of all sectors (by number) have enjoyed accelerating productivity growth relative to their long-term trend, versus half of all sectors in the years leading up to the crisis.
In a normal economic environment, productivity does not slump everywhere all at once. So what is going on?
MACRO FACTORS HOLDING PRODUCTIVITY BACK
Several macro factors – mostly on the demand side, including hangover effects from the crisis and the deep recession that followed it – may be to blame for the uncanny synchronicity in the latest productivity downturn. The crisis significantly depressed global aggregate demand, producing excess capacity (idle resources) and large output gaps (below-potential GDP growth) that have taken years to work through. And in the recovery period, companies steadily hired back the unemployed after deep layoffs during the crisis. The result has been consistently slow economic growth combined with accelerating growth in total hours worked – a sure recipe for a productivity slump.
Note, however, that during prior episodes of deep recession in developed economies, there were large declines in total factor productivity (TFP) even after adjusting for resource underutilization. Might there be more to the productivity downturn this time as well?
Weak capital investment
It is no secret that in the post-crisis years business investment has been weak. Most developed economies have had to work off high unemployment and labor market slack; the result, slow wage growth, has reduced the incentive for firms to substitute (productivity-enhancing) capital for labor.
A climate of uncertainty – economic, political and regulatory – also has played a role in the lack of capital investment. According to McKinsey & Company’s March 2017 quarterly corporate survey, nearly 40% of companies reported rising uncertainty and risk aversion as the key reasons for not investing in all attractive projects. Moreover, the largest post-crisis declines have occurred in capital investments that depend more on intermediate-term demand expectations (like structures and equipment) than on firms’ long-term strategic plans (notably, research and development).
As Dr. Olivier Blanchard, who spoke at a prior PIMCO Secular Forum, and his coauthors argue in a 2017 study, a feedback loop may also be at play: The sharp downturn in 2008−2009 depressed investment initially, which led to lower productivity growth at the time and to the expectation that economic growth would be weak in the future. This initial pessimism then led to weak investment and productivity growth in the next period, and alas on it went. The result has been persistently weak capital investment, which has stunted the “capital deepening” (growth in capital services per hour) component of total productivity.
FINANCIAL CRISIS “HANGOVER”
More subtle macro factors also appear to be at play in the ongoing global productivity slump – factors unique to periods of financial crisis.
“Negative economies of scale” shock. Positive economies of scale are achieved when companies increase production and spread out their fixed and quasi-fixed costs over a higher volume of output. Negative economies of scale represent the opposite: Production takes a big hit, but the cost base cannot fully adjust downward. And this is exactly what we observed during the crisis in hard-hit industries such as finance, where bank lending volumes sharply fell but banks could not fully offset these declines with staff cuts. The result for such industries was a negative productivity shock as output fell faster than hours worked.
Rising capital misallocation. There is evidence that the financial crisis and its aftereffects have distorted the allocation of capital across firms in advanced economies. One key to maximizing aggregate productivity is to enable capital to flow to its most productive uses. But we observe a worsening misallocation of capital in advanced economies during the post-crisis years, shown in the rising dispersion of firms’ marginal product of capital within each industry (see Figure 2). In an efficient economy, the dispersion in marginal returns to capital should be low and relatively stable over time.
Why has capital allocation become worse? Theories abound. Extraordinary post-crisis monetary stimulus (artificially low interest rates and quantitative easing) may be in part to blame. Another theory is that credit market frictions have impeded the growth of financially constrained firms that would have benefitted from capital investment (discussed below). Finally, poor incentives in some countries’ banking industries may have postponed the creative destruction that could have forced inefficient firms to improve or exit and freed up capital for more productive ventures (for example, banks in Europe “evergreening” loans to weak businesses to avoid or delay non-performing loan recognition). Whatever the causes, inefficient capital allocation in advanced economies has held back aggregate productivity growth.
Firm-level financial vulnerability. Balance sheet vulnerabilities stemming from the crisis have had a pernicious impact on corporate behavior, with crippling effects on firms’ productivity growth. Credit-constrained firms – especially those facing both leverage (debt overhang) and short-term funding risks – tend to cut investment, sell productive assets and prioritize capital projects that boost cash flow quickly over those that might enhance profits and productivity the most in the long run. As shown in Figure 3, firms with weaker balance sheets heading into the 2008–2009 crisis experienced larger TFP contractions than their stronger counterparts. Note that in milder downturns (for example, the early 2000s) we have not observed this disproportionate decline in TFP among financially weaker firms. As the International Monetary Fund concluded in a 2017 research note, “The global financial crisis was different.”
ARE THE MACRO HEADWINDS FADING?
In “Productivity: A Surprise Upside Risk to the Global Economy,” we argued that innovation is anything but dead, and we laid out a microeconomic case for a global productivity rebound. Yet in the post-crisis years, as we have argued here, several strong macro headwinds have stood in the way: excess capacity and large output gaps; high economic and policy uncertainty; weak capital investment; a worsening misallocation of capital across firms; and lingering credit market strains and corporate-sector financial vulnerabilities.
So what lies ahead? Around the world, excess capacity is being worked off; output gaps have closed (U.S.) or are closing (Europe); and the outlook for business investment finally may have turned the corner, at least in the U.S., as optimism nears record highs and capital planning gathers steam (looking beyond, for the moment, current trade war tremors). Also in the U.S., a tight labor market and the potential for rising wages could spark faster substitution of new productive capital for labor.
In credit markets, the external financing environment has improved; firms can turn both to (healthier) traditional bank lenders and, increasingly, to alternative providers of capital to meet their funding needs.
Finally, the gradual withdrawal of central banks’ ultra-accommodative monetary policies may encourage a more efficient capital allocation throughout the global economy by helping to jumpstart creative destruction – ultimately the key to boosting aggregate productivity.
Bottom line: Although it is too soon to declare victory, recent macro trends are encouraging. The music is finally playing, and productivity may be about to dance. But investors, be careful what you wish for; a productivity upswing, if it materializes, could prove disruptive to the markets.
REFERENCES
Adler, Gustavo, Romain Duval, Davide Furceri, Sinem Kiliç Çelik, Ksenia Koloskova and Marcos Poplawski-Ribeiro. 2017. “Gone with the Headwinds: Global Productivity,” IMF Staff Discussion Note, April 2017.
Barnett, Alina, Ben Broadbent, Adrian Chiu, Jeremy Franklin and Helen Miller. 2014. “Impaired Capital Reallocation and Productivity,” National Institute of Economic and Social Research, Volume 228, Issue 1, April 2014.
Blanchard, Olivier, Guido Lorenzoni and Jean-Paul L’Huillier. 2017. “Short-Run Effects of Lower Productivity Growth. A Twist on the Secular Stagnation Hypothesis,” NBER Working Paper No. 23160, February 2017.
Duval, Romain, Gee Hee Kong and Yannick Timmer. 2017. “Financial Frictions and the Great Productivity Slowdown,” IMF Working Paper 17/129, May 2017.
Furman, Jason and Peter Orszag. 2018. “Slower Productivity and Higher Inequality: Are They Related?” Peterson Institute for International Economics, Working Paper #18-4, June 2018.
Remes, Jaana, James Manyika, Jacques Bughin, Jonathan Woetzel, Jan Mischke and Mekala Krishnan. 2018. “Solving the Productivity Puzzle: The Role of Demand and the Promise of Digitization,” McKinsey Global Institute, February 2018.
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