Eliminating the Productivity Drag
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- Authors: NAN LI, DIAA NOURELDIN
- Published: September 3, 2024
Overview and key projection
- Global growth could stagnate at just 2.8 percent by the end of the decade without timely policy interventions or breakthroughs in technology and its adoption.
- This would be a drop of 1 percentage point from prepandemic levels.
- The United States leads the world among the sample countries in allocative efficiency.
- If less efficient countries narrow their gap with the United States by 15 percent, this would:
- boost productivity and stimulate investment, adding about 1.2 percentage points to annual global growth.
- Structural reforms addressing regulatory barriers, labor market rigidity, and access to financing are highlighted as key to achieving these gains.
Recent productivity trends (exact figures preserved)
- Productivity growth has markedly decelerated and accounts for more than half of the decline in global growth.
- Advanced economies: annual productivity growth fell from 1.4 percent during 1995–2000 to 0.4 percent after the pandemic.
- Emerging market economies: fell from 2.5 percent during 2001–07 to 0.8 percent.
- Low-income countries: fell from 2 percent during 2001–07 to nearly zero after the pandemic.
Drivers of productivity
- Two main factors drive productivity growth:
- Within-firm improvements (technology, management practices, innovation).
- Economy-wide allocative efficiency (how well capital and labor flow to most productive firms).
- Diminishing returns on R&D investment are noted (example: semiconductor industry requiring more researchers to double chip density), implying limits to relying only on within-firm advances.
- Allocative efficiency analogy: resources should flow to the most innovative and efficient companies so the best businesses thrive and less efficient ones exit.
Misallocation: scale, causes, and impact
- Misallocation of capital and labor across companies within sectors has increased.
- Misallocation has been dragging down productivity growth by an average of 0.6 percentage point annually.
- Without the increase in misallocation, productivity growth could have been 50 percent higher.
- Two-thirds of the observed misallocation is attributable to persistent structural issues.
- Primary structural frictions associated with higher misallocation include:
- Regulatory barriers
- Rigid labor markets
- Financing constraints
- Lack of trade openness
Policy approaches to address misallocation (recommendations)
- Reduce barriers to market entry and increase competition (example: India’s 1991 deregulation and removal of compulsory industrial licensing).
- Liberalize financial markets to improve firms’ access to funding and allow high-potential firms to grow.
- Reduce labor market rigidities to facilitate worker mobility and formal-sector employment (example: Brazil’s past stringent regulations contributing to large informal sector).
- Address institutional barriers: tackle corruption and weak property rights via governance and institutional reforms.
- Improve regulatory frameworks and ensure transparent, fair market practices.
- Foster an innovation and adoption ecosystem that supports creativity and minimizes frictions in reallocation of research resources to accelerate technological adoption.
Role of emerging technologies
- Emerging technologies with potential to lift productivity include:
- Artificial intelligence
- Supercomputer chips
- Biotechnology
- Green technologies
- Examples of productivity gains from AI: optimizing supply chains, reducing operational costs, improving customer service, AI-driven diagnostics and personalized medicine in health care, AI-powered automation in manufacturing.
- Governments should foster ecosystems that support innovation and reduce reallocation frictions for research resources.
Thought experiment and policy payoff
- If every country closed policy gaps with the best-performing economy in labor market flexibility, financial market liberalization, trade liberalization, and certain product market regulations:
- Narrowing policy gaps with the United States by 15 percent could eliminate the drag on annual productivity growth from allocative inefficiency, reversing the decline in productivity and boosting growth.
- Historical reforms demonstrate such targets can be ambitious yet achievable.
Country vignettes (selected findings)
- Brazil:
- Worker productivity increased after a 2017 labor reform (decline in litigation and associated costs).
- A 2023 value-added tax reform is expected to improve resource allocation, particularly in manufacturing, boost investment, and increase formal-sector activities, raising economic growth by 0.3-0.5 percentage points per year.
- Greater hydrocarbon output and investment in green growth opportunities could further lift economic potential.
- China:
- Rapid transformation historically drove exceptional performance, but growth has slowed and is projected to decelerate further amid an aging population and declining productivity growth.
- Allocative efficiency worsened in the service sector (which accounts for more than half of value added): less productive services firms hold large market shares while more productive firms remain small due to difficulty attracting capital and labor.
- Priorities: reform state-owned enterprises, remove protectionist barriers, and open up international trade in services.
- Euro Area:
- Productivity growth has lagged the United States since the 1990s; companies have not matched US innovative success.
- Lack of a truly integrated market for goods, services, labor, and capital limits economies of scale and growth, notably for disruptive start-ups.
- Inefficient insolvency frameworks slow exit of unproductive firms and hinder reallocation and technology adoption.
- Aging population and skills mismatches discourage necessary job churn for productivity growth.
- A stronger single market would improve competition and allocative efficiency.
- Japan:
- Total factor productivity growth recovered in the 2010s due to investments in software and digitalization but then slowed again.
- Despite high R&D spending as a share of GDP, insufficient technological breakthroughs have prevented restoration of historical productivity levels.
- A widening gap between high- and low-productivity companies reduces allocative efficiency; poor-performing companies persist and delay exit, dragging on economy-wide productivity growth.
Source: NAN LI and DIAA NOURELDIN; F&D Magazine, September 2024.
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- Eliminating the Productivity Drag