Productivity: The elephant in the room?

  • Written by 

    David Motsonelidze, CFA, December 2014 / January 2015

  • 24/12/2014

Productivity is a key component of GDP. But recently it has declined. Should we be concerned?

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Residents of the United States, please read this important information before proceeding

Before the financial crisis, productivity growth (measured by total factor productivity [TFP]1) was the second-highest contributor to world GDP growth after non-IT capital spending.2 (Figure 1)

However, in the years since the crisis, productivity growth has slowed significantly. For example, in 2013, US total factor productivity was just half the level seen before the financial crisis, standing at 0.4% versus 0.8% during the 1997-2006 period. (Figure 2)

In this piece, we seek to answer two key questions:

  • What is the current state of productivity globally?

  • What are the prospects of global productivity?

Broadly speaking, TFP is a function of government policies, new technologies, human capital (education and health), infrastructure, competition and financial development.3 For low-income countries, unlocking productivity growth relies on reducing trade barriers and reforming the agricultural and banking sectors. But for high-income countries, the more significant drivers of productivity growth are investing in research and development and new technologies.4

FIGURE 1: Productivity Before the financial crisis (1997-2006): the importance of world productivity growth to GDP growth  FIGURE 2: Global productivity trends from 1997 to 2013

What is productivity?

Productivity is often defined as the interaction of new technology with the learning curve: simply put, learning by doing. Like any other economic statistic, productivity does not travel in a straight line. (Figure 3) It is very difficult to measure accurately because of unreliable statistics on output growth and labour market hours worked. Both productivity and innovation can appear anywhere; no nation or society has the sole ability to fashion new products or breakthroughs. However, the economies that tend to excel in implementing fresh innovations tend to be those with higher levels of creative destruction (such as the US). To allocate capital and labour where it will be most productively used, the market must be free, and this combination of situations is obviously in constant flux.

FIGURE 3: Productivity growth changes over time

Productivity is notoriously difficult to measure, particularly in the service sector. For example, in the US, economists focus on output per hour worked for private sector non-farm businesses. Changes in this gauge of productivity often reflect changes in labour demand rather than increased efficiency. 

Total factor productivity (TFP) is a useful measure of productivity because it values the efficiency of both labour and capital relative to changes in output. Productivity increases if GDP expands more than the sum of the number of working hours and spending on equipment and machinery.5 

What has driven productivity levels globally?

Over the past few years, the world has seen a productivity slowdown, which has been more pronounced in the emerging markets.6 (Figure 2) China’s slowdown in productivity is not surprising to us. After increasing as a result of urbanisation and infrastructure building, the economy is now transitioning to a more mature market while its GDP growth approaches a more sustainable level of 7%.6 Typically productivity tends to moderate as the market starts to mature, and the service sector begins to represent a higher percentage of the economy. As a result, companies come to play a more pivotal role in innovation, which naturally means assuming more risk. 

Latin America has also experienced a slowdown in total productivity growth. According to the Conference Board, both Brazil and Mexico have experienced negative productivity growth, due to the following factors: lack of investment in new machinery and equipment, a weak infrastructure, unfriendly tax regimes, and inadequate management abilities and worker skills.7 The Inter-American Development Bank (IADB) has reached similar conclusions; since 1960, even though Latin America has increased its capital stock and labour force at a faster rate than the US, the shortfall in per-person GDP performance was due to a significant relative decline in total factor productivity. Unless one sees improvements in policies that relate to tax and infrastructure, it is unlikely that TFP will increase from current levels.8

Among developed economies, the US stands out in terms of its relative TFP. (Figure 2) The relatively strong performance was triggered by the US service sector, a major part of the economy enjoying productivity growth. However, the US manufacturing sector has slowed somewhat, largely attributed to the deceleration of world demand. This is unlikely to continue as manufacturing is now showing signs of a solid recovery, suggesting an increase in world GDP growth. (Figure 4)

FIGURE 4: US manufacturing leads world GDP growth

In 2013, even though Japan’s productivity grew at a rate higher than that of the US and Europe, its absolute level is well below that of the US and lower than Europe‘s. This is in part a result of declining aggregate working hours as the working-age population shrinks. The decline of productivity can also be attributed to labour market inflexibility, stagnation of commerce and the service industries, and practices that discourage foreign competition. Policies that counteract these factors could accelerate Japan’s productivity growth.7

Europe has seen negative TFP growth, which is unlikely to change unless regional capital spending increases and funds are allocated efficiently.7 These are more likely to happen if the European recovery project is successful and Europe introduces more coordinated banking rules and offers greater opportunities to migrate within the region, so that the pertinent people skills are matched with relevant job opportunities. Another reason for declining productivity is a lack of capital investment in information and technologies, which has been negatively affected by regulation within product, land markets and labour.9

All in all, there are wide discrepancies among regions for productivity. Unsurprisingly, productivity levels in emerging market economies are lower than those in the developed world. Asian economies typically have a lower amount of assets than Latin America.10 Different regions have dissimilar reasons for their trajectory of total factor productivity growth; as a result, the policies that are needed for boosting productivity vary according to individual countries or regions.

While the US is the current productivity champion, it is hoped that the laggard regions of Latin America, China, Japan, and Europe will rebound as they have in the past, fuelled by a hunger to catch up with the US and inspired in part by the US success story. In a world economy in turmoil, we think it is likely that enlightened self-interest will cause these economies to recognize that enhanced productivity is the key to their economic recovery and health. Concerted government planning, applied technological innovation, and the other factors mentioned here will drive productivity in these economies.

Will productivity increase?

In the long term, the world is likely to see acceleration in productivity growth. This will be triggered by dramatic technological advances, and in the emerging markets, it will be propelled by the natural human urge to strive for a higher standard of living and comfort. In the long term, technology is likely to be a meaningful driver of productivity, but its beneficial effects will not necessarily be immediate. Mankind’s ability to invent and adjust to new challenges is evident in human history, and technology is directly linked to improvements in living standards. But because new technologies are not immediately put to use, their benefits are not instantly realized. It takes some time both for companies and humans to adapt and innovate based on prevailing social, economic and historical circumstances. For example, it took several decades for productivity gains to be realized by switching from steam to electric power.11

Currently, many remarkable discoveries are being made in robotics, artificial intelligence (IA) and genetic engineering, which could boost productivity in the future. In fact, China is already the second largest importer of robots.12

Setting innovation aside, productivity is also likely to emerge from countries like India, China, and Brazil.13 These economies are likely to catch up with Europe and the US in terms of technological advancement over generations, as they start to compete on a global level and adjust to current trends.

Productivity gains may result from other factors, such as foreign direct investment and falling trade barriers. For example, according to a McKinsey & Company study, in the 1990s, removing trade barriers led to significant gains in productivity for Brazil’s agriculture and Europe’s freight transport industries, as this encouraged competition.14 One of the current candidates for this kind of change is India’s protected retail industry.

How can investors benefit from this theme?

Social, economic and political flux opens opportunities for canny investors if they know where to seek windows of productivity growth. Overall, we see global prospects for productivity to increase, as economies and societies are propelled by enlightened self-interest and a desire to match the higher standard of living of highly visible neighbouring regions.

As the world economy gains further momentum and businesses become more confident about spending globally, they will start purchasing new technology to drive efficiency gains. The tech investment as a share of GDP in the US is near its historic low, suggesting that there is a significant pent-up demand for technology. Signs of demand firming in this area are already notable. Taiwanese export orders of electronic equipment is increasing at a meaningful 20% year-over-rate.15

In the developed world, capital stock has aged dramatically, necessitating an increase in capital expenditure, which will ultimately benefit industrials. Despite a lower potential capital expenditure budget for the Energy sector, other sectors that consume energy are likely to fill the gap as they increase their investments. The global Manufacturing Purchasing Managers Index (PMI) remains in expansionary mode. This measure is positively correlated for Industrials earnings, ultimately benefiting this sector.


We see world productivity strengthening as more economies become cognizant of its crucial power and take steps to nurture it with targeted government policies and programs of intensive technological innovation.

Government policies will continue to be an important driver for future total factor productivity growth. However, new technology in the developed markets and emerging markets catching up with the rest of the world are likely to unlock productivity gains and put upward pressure on world total factor productivity growth in the long term. Investors who want to benefit from this theme are advised to gain exposure to the technology and industrial sectors.

Bond and stock investing involves risk including loss of principal international investing involves a greater degree of risk and increased volatility.

1 For a brief discussion of productivity measures, please see on the next page, “What is productivity?”
2 The concept was developed by Nobel Prize winner Professor Robert Solow, who proposed that GDP growth does not stem solely from the accumulation of capital or an increase in labor, but also from total factor productivity growth, which encompasses technological progress and advances in management and organizational techniques.
3 Determinants of total factor productivity: a literature review, United Nations, July 2007.
4 Anchoring Growth: The Importance of Productivity-Enhancing Reforms in Emerging Market and Developing Economies, International Monetary Fund, December 31, 2013.
5 Charles Cobb and Paul Douglas quantified GDP growth as the product of the following three factors: capital input growth (the real value of all equipment and machinery), labor input growth (the total number working hours), total factor productivity growth (TFP).
6 Total Economy DatabaseTM, The Conference Board, as of January 31, 2014.
7 Total Economy DatabaseTM, The Conference Board, as of January 31 2014.
8 The Economist, as of March 31, 2014.
9 Source: The Information Technology & Innovation Foundation, June 30, 2014.
10 Source: Conference Board, as of January 31, 2014.
11 The New Yorker, as of April 1, 2013.
12 Financial Times, as of November 5, 2014.
13 Prospects for growth: An interview with Robert Solow, McKinsey Quarterly, September 30, 2014.
14 A productivity perspective on the future of growth, McKinsey Quarterly, September 30, 2014.
15 Source: Macro Research Board, as of October 31, 2014.