Chasing Sustainable Growth: Understanding the Impact of Productivity of Economies

Sustainability is a contemporary conundrum that is likely going to grow in importance with each passing generation. Increasingly, Millennials and Generation Z are looking back at history to avoid the mistakes that their parents or grandparents committed. Examples include over-reliance on fossil fuels and rapid consumption of natural resources. They are learning the importance of creating a world with a less deleterious footprint on the environment than the one their predecessors created. At the same time, the quality of their lives is a function of sustainable economic growth. Unless an economy grows, it is very hard for lives to improve.

Economic growth is a function of many factors. These factors include natural resources, human capital, technology, the legal system, and infrastructure. Economic growth is a function of human capital and other resources and the productivity of those resources. Increasing the quantity of resources or getting the same resources to do more can lead to higher growth. If a country has a lack of natural resources say rare earth minerals, it can import it. The same logic applies to labor. A country with an aging workforce can design an immigration policy to make up the shortfall of labor or it can deploy technology to make its existing population to produce.

Productivity is a ratio of the output to the input. For example, if 10 workers produce 100 widgets, the productivity, in this case, is 10 widgets per worker and the output is 100 widgets. Let us assume that the 100 widgets represent the entire output of Country A. Once we multiply the widget with the selling price per widget, we get the Gross Domestic Product (GDP) of that country. Let us say we sell each widget for $10, the GDP of that economy is $1,000. Now, let us assume that the same 10 workers use advanced technology (machines) and can now make 20 widgets, the GDP rises to $2,000. In this case, the economic growth is 100 percent because of the increased productivity of the workers, which has also increased 100 percent. However, if the same 10 workers produce only 10 widgets and the output of a 100 widgets now sold at $20, the GDP still rises to $2,000 but there has been no improvement in the output or productivity. Therefore, the economy has grown only in ‘nominal’ terms not in ‘real’ terms. Real GDP thus strips out inflation to give a more real picture of economic growth.

The economic output of a country also increases by increasing the working population. In our example above, if country A imports 10 high skilled workers from country B, it now has 20 workers. If each worker maintains its earlier productivity, we now have 20 workers making 200 widgets. Selling these widgets at $10 per widget gets us an output of $2,000. Thus, economic growth is a function of resources and their productivity.

It is apparent from our discussion above that the segment of population we use to measure GDP growth is the working age population which typically belongs to the traditional working ages 20-64 years. As per the United Nations, there were seven working age people for each older person aged 65 years or above in the world in 2015. By 2030, that ratio will be 3.5 older person to one working person. All major regions except Africa are expected to have support rations of 3.2 or lower. In short, the world faces a demographic time bomb in the form of a shrinking working age population. A shrinking workforce also means lesser contributions to social security and imperils the retirement funds of the older non-working population. If this scenario plays out, productivity can only proceed along the technology frontier. This global megatrend also explains China doing away with the one child policy. Among many other reasons, this demographic time bomb explains the rise of robotics and Artificial Intelligence. As per the International Federation of Robotics (IFR), the top 10 most automated countries in the world are South Korea, Singapore, Germany, Japan, Sweden, Denmark, USA, Italy, Belgium, and Taiwan. These countries also happen to have a rapidly ageing workforce.

The issue with relying on technology to drive productivity gains leads to a contradiction called the “the productivity paradox.” The most frequently used measure of productivity is total factor productivity (TFP). TFP is a residual value. It explains the part of economic growth, which cannot be explained by changes in labor and capital. In other words, if labor and capital inputs remain unchanged between two periods, the change in output is squarely because of MFP. For most of the 21st century, TFP has been risen very slowly. In the case of some countries, it has declined. The productivity paradox is stagnant or declining TFP despite the rapid growth of technology. Some people explain the paradox by saying we do not know how to measure the impact of innovation. Others say the technologies were not as impressive as they were thought to be.

The reality is that the determinants of productivity are varied and many. There is a need to understand productivity better. For example, the management of a company is an important determinant of productivity. Secondly, technologies such as AI have a very long horizon to play out but will likely have a massive impact of the kind general purpose technologies such as electricity had. Thirdly, the work of U.S. economist Robert Solow who was awarded the 1987 Nobel Prize in economics showed that advances in the rate of technological progress is more important than labor and capital increases.

To cut a long story short, it is very tempting to think like a pessimist today. It is easy to think the world is heading towards ‘secular stagnation’ where global growth slows down considerably, and it becomes harder to sustain economies working at their full potential. As has been proven in the past, it is foolhardy to draw an early conclusion. Many developing countries are playing catch-up with their developed counterparts along the technology frontier. In addition, if every unit in an economy does its own bit to maximize its productivity and drive profitability, we might see good results. Lastly, AI could grow in fits and bursts rather than following a linear path. However, the impact of AI can be truly transformative. In the future, the next generation may look back at us and use Charles Dicken’s words from the book A Tale of Two Cities to describe the world we lived in—“it was the best of times, it was the worst of times.” For now, we live in interesting times indeed.