Productivity - defined as output per hour of worked - is the single most important economic factor. And for the U.S., higher productivity will be key, if for no other reason than it’s the key to reducing the impact of the baby boom retirement on future worker incomes and government finances. As more baby boomers retire (and increasing numbers are in this recession) there will be relative fewer workers to support them. Unless we want a scenario where future retirees and/or get less we have to find a way to boost productivity faster than what is expected.
But it’s one thing to say this and quite another to do it, for Washington largely ignores productivity and one of the key reasons is because the conventional economists who get listened to tell them to ignore it.
Conventional economists actually provide little in the way of helpful advice to a policy maker seeking to formulate a productivity policy. In fact, they are more likely than not to scold any policy maker so bold as to suggest we need a national productivity policy. Neoclassical economist Alan Blinder explains that “Nothing – repeat, nothing – that economists know about growth gives us a recipe for adding a percentage point or more to the nation’s growth rate on a sustained basis. Much as we might wish otherwise, it just isn’t so.” Paul Krugman, offers the same counsel, pronouncing: “Productivity growth is the single most important factor affecting our economic well‑being. But it is not a policy issue, because we are not going to do anything about it.” It’s not just the dominant neo-classical economists who counsel such inaction. Neo-Keynesians largely agree. As neo-Keynesian Frank Levy agrees, stating, “We cannot legislate the rate of productivity growth ... That is why equalizing institutions are so important.” These aren’t outliers. The dominant economic thinking embodied in neoclassical and neo-Keynesian economics gives short shrift to productivity and largely counsel policymakers to manage the business cycle, reduce allocation inefficiencies, and depending on their political orientation, support greater fairness. No wonder they call economics the dismal science.
Conventional neoclassical economists not only say that there is little to do about productivity, many actually counsel policy makers to the extent they can do anything to spur productivity, it’s to do nothing, since for them government intervention only distorts the workings of the free market, producing allocation inefficiency. Nowhere does this constraint apply more than to tax policy. Whatever you do, goes the common refrain – so accepted that to challenge it is to be seen almost as a crank, – don’t make the tax code more complicated as we all know that it’s simplicity that drives growth. Moreover, if it involves spending (e.g., public investment), don’t, since that just increases the budget deficit, which we all know raises interest rates, which limits capital accumulation, which limits growth.
To the extent the neo-classical doctrine has any anything to say about a proactive role for the government in spurring productivity, they advise supporting what can be termed factor conditions that all firms can benefit from (e.g.,. free trade, better education, a good regulatory system, basic research).
Innovation economics (aka endogenous growth theory, evolutionary economics, neo-Schumpeterian economics) rejects these simplistic views. The evidence clearly shows that it is changes in organizations (e.g., business, government, non-profits) that drive productivity, with around 80 percent of productivity growth coming from organizations improving their own productivity and only about 20 percent coming from more productive organizations replacing less productive ones. So productivity is less about markets (which is what conventional economists study) and more about organizations (which is what innovation economists and business strategists study) and in particular how they use technology to drive productivity. Most conventional economists don’t bother to, as Nathan Rosenberg once stated “look inside the black box” of actual innovation in actual organizations. Yet it is there that the keys to raising productivity and the keys to the right productivity policy will be found.
In this sense, the innovation economics literature is clear: allocation efficiency and capital accumulation are just not that important, and better factor conditions, while important, are not enough.
One can envision a host of policies that, while distorting allocation efficiency, also boost productive efficiency and dynamic efficiency. For example, the R&D tax credit “distorts” allocation efficiency. It produces more innovation than the market would otherwise produce. But the innovation and productivity spurred by more R&D that the credit produces vastly exceeds any minor losses from “misallocation” of economic resources. Indeed, the lion’s share of growth is determined not by maximizing the allocation efficiency of resource, but by increasing productive and adaptive efficiency of organizations. Tax simplicity is actually anti-growth if it limits growth enhancing tax incentives to spur more investment in research, next generation capital equipment, workforce skills, etc.).
Likewise, the neo-classical focus on capital accumulation as the key to growth is not borne out by the innovation economics literature which finds that as much as 90 percent of productivity growth is due to innovation, not more capital. And it clearly shows that markets acting on their own will under-produce growth. In this case, public investment, even if it raises budget deficits, will be a key driver of productivity growth if its focused on activities that spur productivity (e.g., knowledge production, certain kinds of infrastructure, etc.)
Finally, the neo-classical notion that just getting factor conditions right is enough is clearly rebutted by studies of sectoral differences in productivity in nations. As former head of McKinsey Global Institutute, Bill Lewis showed in his excellent book “The Power of Productivity,” if factor conditions were the key, then there would not be dramatic differences in productivity in sectors (relative to global best practice) in particular nations. But there are, and these differences account for the lion’s share of productivity differences between nations. As a recent report from the McKinsey Global institute notes: “The report finds that the global competitiveness of industry sectors in countries such as Japan, Korea, and Finland vary immensely, despite the fact they all exist under the same macroeconomic policy rubric, noting that sectoral policy factors largely explain these differences in outcomes. It’s only policies that are grounded in deep sectoral understanding that can ultimately drive productivity effectively. But for neo-classical economists, who undersnad markets, but generally not industry, such a view is tantamount to the ultimate heresy “Industrial policy”.
Boosting productivity is key. But if we are going to get the policy framework right Washington needs to stop thinking that conventional economists are the only ones qualified to shape economic policy. It’s time to bring in business scholars, technologies, innovation economists, regional planners and others who have grounding in the real world of organizations and industries.