Economists are failing to understand the 21st century economy

When is a fact not a fact? When it is an economic statistic. Economists use  statistics like GDP, productivity or inflation, as if they were facts. And because economists set the terms of public policy debate, the rest of the world follows them. But they are abstract artefacts, designed to help us see the facts, but which conceal as much as they reveal. There may have been a time when this didn’t matter much. That is certainly not the case now. We are missing something very important.

Economists like to accuse others of the fallacy of composition. That is the assumption that the finances of a nation work on the same principles as that of the households that make it up. For example, the budget constraints in a household work in an entirely different way to those for state finances – which doesn’t stop politicians lecturing us about the absence “money trees”. But economists are the world’s worst at a very similar fallacy: assuming that national level statistics represent the truth for individual households and businesses.

This is very striking with discussions about productivity, such as on this morning’s Radio 4 Today. This is newsworthy here in Britain. Growth in productivity grew at about 2% a year in Britain until 2008, during the financial crisis. It then stopped growing – creating what is often called the “productivity puzzle”. This is happening, to a lesser extent, in other developed countries too. It is the news now because the Office for Budget Responsibility has admitted that its assumption that productivity growth would revert to historical norms has failed to materialise for yet another year. That matters because it affects forecast tax revenues, around which the Chancellor of the Exchequer must base his annual budget, due next month. It is also the explanation offered for the fact that rates of pay seem to have stagnated for many Britons.

What is productivity? It is output per worker per period worked (typically a day or an hour). If you work in a ball-bearing factory it is relatively easy to understand what this actually means. You count the number of ball-bearings produced in a month, say; you count the number of hours worked in that month; you divide one by the other. Because of this simplicity it is easy to imagine the national economy made up entirely of ball-bearing factories or close equivalents, so that if productivity rises, it means that more ball bearings are being produced for the same number of hours. And most of the discussion about productivity uses something like this mental picture. Economist speculate about businesses using cheap labour as a substitute for upgrading capital equipment, for example. This is like the butler in Kazuo Ishiguro’s The Remains of the Day who immerses himself in his familiar daily duties so as not to confront the realities of the changing world around him.

To understand this, consider two groups of problems. The first type of problem is how do you actually measure output? The more you consider this, the harder it gets. Start with some obvious problems: what is the output of a squadron of jet fighters? Then how do you compare organic carrots with carrots grown on a farm pumped with environment-degrading chemicals? Or an iPhone 6 with an iPhone 8? Or is a loss-making factory with few people and overpriced robots really more efficient that a profitable one with lots of labourers and primitive machinery? Economic statisticians wrestle with such questions, but largely hidden from view. Economics undergraduates are barely troubled with such issues, and are quickly ushered on to the certainties of supply and demand curves and medium term fiscal policy. The result is a series of estimates and fixes, but not enough discussion about what they all add up to. Occasionally a conservative politician will pop up to suggest that lower-paid workers should be much happier because improvements in technology aren’t properly reflected in inflation. But that’s about it.

The second group of problems is conceptually somewhat easier: it is variations in the composition of the economy. Overall productivity may be improving not because individual businesses, or even industries, are becoming more efficient, but because industries with a higher measured productivity are taking a larger share. In fact it turns out that this was largely the case in Britain before 2008, with the expansion of banking and professional services. Just how productive these industries were in reality was thrown sharply into question in the following year, when banking threw up eye-watering levels of losses, from which government finances have never recovered.

These difficulties have been known about for a long time, and professional economists are more aware of them than the public whom they lecture. But they are shrugged off, with the assumption that it all comes out in the wash. Policymakers should be doing something about productivity, they say. This needs some serious challenge. And the consequences of that challenge are profound.

My first challenge is known as the Baumol effect, or more usually known, revealingly, as “Baumol’s cost disease”, as if it was something to be eradicated rather than an ordinary physical constraint. Suppose a legal firm adopts a highly efficient artificial intelligence system and makes most of its workers redundant. And then those workers take up jobs such as being personal trainers or producing craft pottery. All the positive productivity effects of the firm’s investment in AI is neutralised by the displaced workers moving into low-productivity jobs. Perhaps we are at state where most productivity improvements are being statistically neutralised in this way? After all, the more efficient an industry becomes, the fewer jobs in that industry there are overall.

Now let’s get into territory that mediocre economists really want to avoid: human alienation. One way of looking at productivity is that it advances by two alternative means: cutting wastage and cutting human content. By and large nobody will argue with cutting wastage. Vacuum cleaners have liberated home-keepers; time spent in queues is good for nobody; and so on. But cutting human content, and human contact, is distinctly two-sided. This is the world of standardised products, specialisation and automatic interfaces that may reduce costs but leave workers and users alike cut off from their fellow human beings, and being forced to conform to somebody else’s idea of what they should be. That is alienation, an idea first made famous by none other than Karl Marx in the Communist Manifesto – a document of startling insight. Alienation can be to the good overall, but it often isn’t. And there are bad signs all around us, from the obesity epidemic, the poor mental health of teenagers (especially girls), to the breakdown of community activities in our cities. Now, to back to my example of the legal firm, what if one of those displaced admin assistants finds life much more fulfilling as a personal trainer, even if the pay is miserable? A conventional economist would fret that surely it is better for her clients to download a demo video from You-Tube so that the trainer can work in a soulless call-centre? Well it would for those aggregated statistics, but not necessarily for the state of the human condition. In fact many economists suffer from acute double-think. On the one hand they praise markets and the wisdom of freely made choices of individuals over bureaucratic planners. And yet when those freely made choices go to more leisure, low productivity work and locally-sourced vegetables, they moan like mad.

But there is one sense in which those economists are right. Those aggregate statistics have one useful purpose: in planning taxes. Taxes are based on the money economy, which is the foundation of those statistical measures. If the stagnation of productivity is a fact of life, and actually represents a struggle against human alienation, then tax revenues are going to stagnate unless the rates increase. And since demand for tax funded services is liable to keep rising, we are going to have to think very hard how we order people’s relationship to the state. We are surely heading for an era of higher taxes. But how to design these taxes?

Instead we just get useless calls for action to raise productivity. Time to move on.

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4 thoughts on “Economists are failing to understand the 21st century economy”

  1. Do the exhortations to improve productivity risk work being done poorly, necessitating retrospective repairs etc.?

    In which case shouldn’t the work of retrospective repairs count as negative productivity – on the grounds that the first time round the car or whatever wasn’t made fit for purpose?

    1. Well that can be an issue – environmental degradation is a similar problem too. And if we water down environmental standards on new buildings…

  2. It is easy to suggest that productivity doesn’t matter, but the figures show that UK productivity grew from at least 1971 up to the 2008 banking crisis and has remained flat since then. See the first figure in:
    researchbriefings.files.parliament.uk/documents/SN06492/SN06492.pdf
    Combine this with flat wage rates since 2008 and employers continuing to complain about skills shortages and it is obvious that there is something wrong.

    1. I’m not saying that there isn’t a problem – but it is not nearly as simple as the aggregate figures make it look. There was a very interesting article in the FT earlier this year, which showed that in the years before 2008 productivity growth was entirely in 5 sectors comprising just 11% of the economy. The main one was banking, and I would suggest that the later write-offs mean that this productivity growth was in fact spurious. The issue goes back to well before 2008. And when haven’t employers been complaining about skill shortages? On the other hand, I suspect measurement issues mean that productivity growth is understated in some sectors (I would suggest education) – but not in ways that do much for tax revenues.

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