It’s productivity, stupid!
Economists consider Adam Smith as one of the founding fathers of modern economic thought. Quotes and phrases from his book the Wealth of Nations like the ‘invisible hand’ are ubiquitous in economic journals and books. But what I also found interesting beyond the contents of the book is the order of the content. Adam Smith opens the book with a chapter on discussion of a pin factory. He explains how, by specializing in one or two specific tasks in the myriads of tasks required in making a pin, workers are able to substantially increase the rate at which the pins are made. He also goes on to explain how the experience gained by doing specific tasks more often, the workers can improve efficiency in performing those tasks. In other words, he points out that pin making is not just a static process but would improve over the period with learning and innovation.
In modern terminology, what Adam Smith was describing in the opening chapter of the book is how productivity improvements affect the supply side of economics. He then goes on to explain the benefits of external trade in expanding market demand to commensurate with increased supply achieved through productivity improvements. Having the discussion on productivity improvements upfront in his book, Adam Smith thus implicitly enshrines the importance of productivity improvements in economics.
It is true that it is difficult to measure productivity improvements. In economic calculations, it is defined as the residual gains in economic output after accounting for the effect of increases in capital and labor inputs. Shift toward information economy also makes it difficult to measure productivity improvements in new economic activities.
We normally like to discuss economic health in terms of GDP growth. Yet, we all know that the GDP growth rate can be misleading. It doesn’t tell you much about the economy’s health in future. Moreover, growth rates can be manipulated by overuse of economic resources in present at the expense of future. On the hand, there is a common consensus that improvements in productivity have long lasting effects and lead to higher economic activity in present and future. Natural resources can deplete in economic output production but it is hard to take away the learning and innovation in production process from future use. Therefore, in spite of the measurement issues, productivity improvement is a good indicator to have in discussions of growth in economic activity.
Even before the Covid pandemic, many countries were struggling to revitalize tepid economic growth. Associated with this issue is also the issue of low productivity improvements in recent years. Meanwhile, over use of natural resources has created negative externalities like climate change that are imposing additional current and future costs for overall economies. Aging population especially in many developed countries is also increasing the dependency ratio.
The current pandemic has brought further urgency on these issues. Additional fiscal and monetary stimulus is now being applied as a response to mitigate the pandemic inflicted adverse shock to economies. There is a growing debate on relative merits and effects of supply side vis a vis the demand side stimulus.
Unfortunately, lacking in all this stimulus impact debate is the emphasis on productivity improvements as one of the key measures. I believe that as difficult as it may be to incorporate productivity improvements in the discussion on merits of stimulus programs, it is worth the effort. It has the potential to take the edge out of political motivation for favoring specific constituencies or bias toward short term gains at the expense of substantial long term costs when devising these programs. By incorporating productivity improvements conditionality, many stimulus measures that are less effective or wasteful overall but are still pursued for political reasons would face additional scrutiny.
Indeed Adam Smith is still as relevant today in his observations as he was at the time of publication of his book in the late eighteenth century when industrialization was in its early stages.