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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15 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.

  3. Matthew,

    You rightly point out that the:

    “Growth in productivity grew at about 2% a year in Britain until 2008, during the financial crisis. It then stopped growing …..”

    So have you considered the possibility that “stagnation of productivity” ISN’T “a fact of life, and actually” DOESN’T “represent(s) a struggle against human alienation” ?

    In other words and as Bill Mitchell says in his blog:

    “The point is that something connected with the GFC has led British labour productivity to flatten out. And the cause of the productivity slump is not related to the Brexit referendum”

    It can’t be related to that, of course, because it started before the EU referendum or anything else that’s happened since 2008. And this “struggle against human alienation” just co-incidentally started to happen at the same time as the GFC ?

    And why is there such a sense of “puzzlement” about all this? The mainstream economic view that suggested that everything was all resolved, economic slumps were a thing of the past, we were in a so-called “Great Moderation” has proved to be seriously defective. The economy just doesn’t function as conventional models which assume a measure of equilibrium tend to assume.

    The first step in solving a puzzle is to consider that there is probably a perfectly rational, and not too complex, explanation if we just jettison a few prejudices.

    http://bilbo.economicoutlook.net/blog/?p=37118

    1. Well yes that aspect of my explanation is a bit wacky, though I think anecdotal evidence stares us in the face everywhere. I am disappointed though that the element of explanation that relates to the Baumol effect does not get more recognition, because it is simple mathematics and entirely mainstream. If productivity growth concentrates in a small part of the economy, then it will have less impact on the overall stats as time passes.

      You may remember why I think Bill Mitchell is wrong. A closer review of the statistics shows that the “rot” began well before the GFC, and, indeed in a period when the evidence shows that the British economy was overheating. All the gains in productivity prior to the GFC were concentrated in just 5 sectors of the economy, comprising just 11% of the economy as a whole. Most of that was the finance sector, and the GFC showed that up to be a chimera. The reference to that is in my response to Lawrence Cox in the comments to this article. So we can’t look to GFC or to austerity to provide an answer, or not a complete one.

      I think one has to consider a variety of explanations, and weigh them all up in light of the evidence. Snatching conclusions from correlations in broad aggregate stats doesn’t pass muster. You have to dig deeper and see if the hypothesis still holds. In Mitchell’s case I don’t think it does.

  4. The Baumol effect doesn’t have to be an effect at all! I think the fallacy in your argument is to suppose that workers displaced by better technology have to move into lower productivity jobs. If they move into jobs which are also of a higher productivity then total production will rise. GDP will rise.

    So say GDP rises by 5% from £2 trillion to £2.1 trillion. This means we have to have another £100 billion of spending from somewhere. The Government has to ensure that this comes from somewhere.

    The increased technology enables the Government to deficit spend to expand the economy in the way it otherwise could not without causing increased inflation.

    Therefore, if we see evidence of workers being displaced in the way you describe, it is evidence that the Government is not playing its proper role in the development of the economy.

    Of course, growth isn’t the only option. Improved technology can be used to ensure we have shorter working hours. The government then has to decide how to bring its influence to bear on the market to achieve this.

    1. The genius of Baumol’s insight was to see that new jobs are less and less likely to be created in the more productive sectors. Agriculture, where the productivity revolution started, is now a vanishingly small part of the economy. Manufacturing is well on the way to that same fate. The question is whether the same rate of productivity growth can be had in the service sectors where the jobs are being created – or at any rate where the greatest level of growth unsatisfied demand is. Actually not personal trainers per my post, but care work in the health and social care sectors. But I’m not sure how that is to happen. The government’s efforts to raise productivity by choking off the money aren’t going well.
      Doubtless there are some exceptions. I think that a government programme of house building cutting out the developers could be used to raise building productivity, which I’m told has lots of potential for better productivity.
      One thing that Baumol predicted, apparently, was a rising size of the state sector as private sector productivity advances. That makes sense. So much of unsatisfied demand either rests in the health sector or with people on low incomes requiring state support. But that won’t raise productivity.

    2. Rather than using technology to increase leisure time I am suggesting raising the number of humanising but low productivity jobs. That may not do anything for the stats, but people may prefer that to leisure. The important point is to be guided by what people actually want, rather than managing economic statistics. Fundamentally that’s my central point. If people really do want to even more physical things and automated service interfaces, the so be it, subject to environmental sustainability.

  5. Matthew,

    My theory is that nearly everything in macroeconomics works the opposite way around to what is usually supposed. I should lay claim to a Martin’s Law on that! 🙂

    So the conventional wisdom of increasing productivity leading to increased wages needs to be turned around. If labour is cheap then it makes sense to use it, albeit inefficiently, rather than spending on capital equipment. So it might make more sense to employ someone to wash cars by hand rather than putting in a mechanised wash. Similarly if cheap labour is available from the EU then even previously highly efficient sectors like agriculture will regress technically.

    How are we going to manage without EU seasonal workers? Who’s going to pick the lettuce? Maybe we just have to pay workers more to pick them and that will encourage growers to think how best to mechanise the process.

    Once we start to think in these terms then there’s no real puzzle about low (nil?) productivity growth. It’s all because the power of workers to command decent wages has been depressed since the GFC.

    1. There’s a strong logic there. Though I gather the Bank of England economists have examined the hypothesis of cheap labour causing low productivity and found that it only provides a partial explanation (according to the FT though I may have got it wrong), it does fit with my understanding that productivity growth stalled in most of the economy before 2007. The influx of cheap labour started in about 2003 with the accession of Poland, etc. Still I wouldn’t hold your breath. Japan runs a very tight labour market (minimum immigration), loves technology, but still has flat productivity growth I think.

      1. The Japanese economy has never really recovered from the collapse in asset prices in the early nineties. First it was the ‘lost decade’, then it became the ‘lost two decades’. So arguably they went through a 2008 type down turn, a typical Debt Deflation some 15 years or so earlier.

        Japanese National Debt is over 200% of GDP. This simply means that Japanese people and companies are saving their money rather than doing anything productive with it. Presumably they would be doing something more positive if they thought that there was going to be a better return on their investment than buying up Govt bonds. If business people thought they had paying customers for any new investment they’d take it. It does all come down to internal aggregate demand in the end -except if you depress your currency and use that to create an export led demand.

        I think the immigration factor is overdone when it comes to analysing these problems.

  6. PS I was just doing a bit of reading on the Japanese economy and I found this on Wiki under Lost Decade (Japan)

    “The Bank of Japan has set a 2% target for consumer-price inflation, although success has been hampered by a sales tax increase enacted to balance the government budget.[30]”

    Typical neoliberal nonsense at work!

    It should really be the Government taking responsibility rather than the BoJ, but what seems to be happening is that the Government is raising taxes to depress the economy whereas someone somewhere else in Govt is doing what they can to reflate it.

    If you want more inflation then don’t raise taxes and/or don’t cut spending. If everyone who is saving too much sees inflation rise they are likely not to save so much themselves. So, ironically, raising taxes/cutting spending is likely to worsen the deficit and increase debt.

    That should only be done when inflation needs to be reduced.

    1. Japan has a budget deficit of 4.5%, the largest of the developed countries reported by the Economist – so hardly an example of austerity. Its occasional attempts at raising the consumption tax have repeatedly been blamed for growth hiccups. But what really stands out is the complete failure of the opening of both fiscal and monetary floodgates to have much impact on on the rate of growth – or inflation for that matter. This should show that economists need to rethink their ideas on inflation and aggregate demand policy. Both the neoliberals and the Keynesians have egg on their face. Which seems to show that economics is more of a religion than a scientific discipline.

      1. Matthew,

        A budget deficit of 4.5% doesn’t necessarily indicate an absence of austerity. It could be twice that and the same thing could be said. On the other hand, a budget surplus of 4.5% doesn’t necessarily indicate the presence of austerity.

        It all depends on what’s happening generally in the economy.

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