Inside the Market’s Mind: Productivity, Growth and In(ter)ventions

Productivity[1] is hot. As a topic that is. As a measure, however, it has cooled as Chart 1 below shows for both emerging and developed markets. In the US, the Bureau of Labor Statistics just reported the first sequential drop in productivity since 1993.

This is worrying for a number of reasons, but mainly because of the links between productivity, wages, and consumer spending. Specifically, higher productivity increases wages and leads to higher spending. So when George Osborne, reappointed UK Chancellor of the Exchequer, referred to productivity and warned that “Our future prosperity depends on it” he was not exaggerating. Moreover, there are demand and supply issues involved and I will argue that most are symptoms of a deeper underlying cause.

How Did We Get Here?

There was a time, not so long ago, when things were looking better. In the build-up to, as well as aftermath of the internet bubble labor productivity, particularly in the US, grew much faster than over the previous two decades. In one of his more memorable speeches Alan Greenspan, former Chairman of the Federal Reserve (Fed), even talked about the “productivity feast”.[2] That didn’t last:

So what went wrong? In February 2015, the Fed published a report[3] arguing that we are possibly witnessing “a pause in—if not the end of—exceptional productivity growth associated with information technology” mainly caused by “slower growth in innovation”. Going forward, a relatively slow productivity pace is their best guess. Andrew Smithers has a different take on it.[4] He argues that poor productivity is a consequence of low investment. The latter is caused by the corporate incentive structure, specifically paying executives large bonuses for short-term success. In addition, being rewarded in (options on) shares favors tactics to influence the share price, for example via buybacks. The bonus culture is detrimental to long-term investment and this is not only negatively impacting productivity, but is a problem for the entire economy and possibly society.

Why? Because of a related hot topic, namely inequality. If top management (representing those exclusive “1%-ers”) has largely benefited from delaying or diverting investments, a logical question is whether this also goes for average workers. This is relevant for the broader economy because final demand, i.e. consumption, by the ‘average worker’ is ultimately fueled by his or her income. A lively debate has followed early research, centered on graphs like Chart 3, which compares the growth in productivity to that in compensation:

Source: Federal Reserve Bank of St. Louis. From 1 January 1960 to 1 January 2013. Indexed at 100 at start date.

The flat lining of the real value of family income since the internet peak is among the standard bearers of the ‘demise of the middle class’ argument.[5] It counters the general assumption that faster productivity growth leads to higher real wages and improved living standards. If this has shown to be elusive when productivity was still ‘okay’, then we should indeed worry when productivity drops even further, particularly in those developed markets experiencing demographic pressures.

Demand and Supply

Productivity clearly matters to the private sector. Depending on the broader ‘demand’ outlook, a company hires employees on the expectation that they can improve its productivity. By hiring the firm believes it can optimize the balance between its investment in capital (plants, machinery, etc.) and that in humans, allowing its workforce to work its capital harder so to speak. It hopes that this will lead to cheaper production of better goods which, in turn, should lead to higher demand. But when productivity slows while employment costs increase (see Chart 4 below), pressure starts to build on margins. Soon a vicious circle can develop where hiring stalls, unemployment increases, consumer spending is cut, and final demand drops.

Source: Federal Reserve Bank of St. Louis. 1 January 2001 to 1 January 2015.

Acknowledging the limits of stimulating demand, globally a number of initiatives are being undertaken to improve the supply side:

  • Restructuring the economy more broadly (e.g. the so-called ‘third arrow’ of Abenomics in Japan);
  • Investing in infrastructure (e.g. China’s new Silk Road); and
  • Boosting trade (e.g. the Transatlantic/Transpacific trade-agreements).

These measures aim to increase competition and raise productivity thereby lifting the potential growth rate of the global economy. However, the fact that all these are ‘pending’ shows that progress is slow, at best.

A related issue in light of the debt overhang is whether the financing of supply initiatives is actually prudent for countries that have ample fiscal space. Surprisingly, the IMF[6] has argued it is, suggesting that reducing debt in such cases is undesirable because the costs involved (such as potentially jeopardizing an early recovery) can be larger than the benefits. Their pro-stimulus stance further weakens the austerity camp.

In summary, both global economic growth and productivity have been disappointing. Various fiscal and monetary policies (e.g. zero/negative interest rates, quantitative easing) have attempted―but so far failed―to boost demand. Still, there is a risk that any uptick in demand against much diminished supply leads to inflationary pressures, including higher wages, which in turn are going to negatively impact profit margins and interest rates. For this, and other reasons, demand initiatives are now being supported by attempts to strengthen supply. It remains to be seen if these are more successful.

Longer term I’m skeptical. What both have in common is the misbelief that the economy is mechanical whereby these two key economic forces can somehow be engineered and controlled. The implications of this negatively impact both the demand and supply side of growth in general and productivity in particular. Nowhere is this clearer than in the creative processes that ultimately underlie innovation.

Innovation and the Lack of Discovery

Returning to the role of innovation as a driving force for growth through renewal, apart from the Fed a number of other experts[7] have voiced concerns that this is diminishing. I believe there is more than a grain of truth to this but that this should be viewed in the broader framework of discovery. The context for this is my thesis that the dynamics in the economy mirror those of the collective mind of the individual economic agents. These dynamics are complex rather than mechanical. In short, even though innovation often involves technology, the economy in general, and capital markets in particular, should not be treated as a machine.

Innovation implies novelty, new ways to use our resources, be they natural or human. As Nobel laureate Edmund Phelps stated: “Innovators are taking a leap into the unknown.”[8] By definition, the unknown is virgin territory that needs to be explored. It’s the space where discoveries take place. Crucially, growth in the economy is generated by ‘physical’ discoveries, i.e. technological gadgets, manufacturing breakthroughs, etc. that allow us to adapt to our environment and improve our lives. These are then valued by way of the ‘psychic’ discovery of prices in the capital markets. Prices contain highly concentrated information and are the numerical symbols that provide meaning relevant into decision making. Ultimately both originate with individuals who require the freedom to make these discoveries.

The premise of the current dominant approaches, however, leads to centrally determined policies (e.g. via ‘central’ banks) to engineer demand and/or supply. This dominance has grown over the past decades and manifests itself in a number of negative consequences. Banks that are too big to fail, for example, or tech giants that monopolize (e.g. searches for) data. A related consequence is the flattening in the number of small company formations in both the US and the UK, diminishing the healthy threat of creative destruction.[9] Perhaps most worryingly, it forces people into a ‘required’ behavior, like chasing yield rather than discovering value. In the final analysis a mechanical worldview that justifies centralized manipulation chokes the individual creativity that underlies innovation. No wonder productivity slows.

As I’ve written elsewhere, this deeper underlying cause is a truly hard problem. Worse, modern economics and the policies they produce are in denial, not facing up to it. In my follow-up article I will discuss how all this relates to bonds and why and when we should consider selling them.


[1] Generally, productivity is measured as total (real) GDP divided by either total number of employees or total number of hours worked

[2] It became known as his “(internet) productivity miracle” speech. In it he also referred to a “productivity famine”.



[5] However, it is also a contentious issue. A number of economists have argued that it requires adjustment and that hourly compensation has actually tracked productivity over the past 65 years. As far as US consumption is concerned, the IMF has argued that it is actually the rich who are now the “marginal buyer” of goods and services and, via their savings rate, have contributed most to the recent consumption boom-bust.

[6] Also, please read my earlier reflections on “Debt, Growth, and Politics”.

[7] Including the economist Robert Gordon (e.g. here) and Peter Thiel, an early backer of Facebook.



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