MIL-OSI Australia: Why Productivity Matters

Source: Reserve Bank of Australia

Introduction

Thank you for the opportunity to speak here today at the Australian Business Economists’ Annual Forecasting Conference. There has been lots of discussion about productivity in recent years. In some economies this discussion has been about subdued growth in overall productivity, including in Australia since just before the pandemic. There has also been discussion about the outlook for productivity. For example, the extent to which artificial intelligence, quantum computing and other technologies will support future productivity growth. These are important issues that I expect will come up in discussions today.

In my remarks I’m going to focus on a different question: why does productivity matter? At the central bank we’re not experts in how to improve productivity. But trends in productivity are very important for the macroeconomy. In the context of the Australian economy, I will discuss how stronger productivity growth can support growth in aggregate supply, incomes and aggregate demand. I will then spend some time discussing recent productivity outcomes in Australia and how we’ve been thinking about those in our assessment of economic conditions.

But first, what is productivity? When we talk about productivity, we’re talking about how much output we get relative to what we put in. At an individual level, I increase my own productivity by making a shopping list before I buy groceries, so I don’t forget anything and avoid multiple trips to the supermarket. At the firm level, productivity might be improved by implementing customer relationship management software to streamline communication with clients and automate routine tasks. At the economy-wide level – which is what matters for the central bank and our dual mandate of full employment and low and stable inflation – productivity reflects a multitude of decisions like these. Ultimately it’s about how efficiently capital and labour are employed across the economy to produce goods and services.

How do we measure productivity? Economists typically focus on two measures: labour productivity, which measures how much output is produced for every hour worked; and multifactor productivity (MFP), which reflects how efficiently all inputs to production – such as labour, capital, energy and raw materials – are combined to produce output.

In a simple production function framework where a firm produces output using two inputs – labour and capital – labour productivity depends on two things. The first is how much capital each person has to work with. Providing workers with more or better capital – like machines or faster computers – can increase the amount of output each worker produces. This is referred to as ‘capital deepening’. The second is MFP. Improving MFP involves finding new ways to combine labour and capital to produce more output. For example, by reorganising a production line or using GPS technology to precisely guide machinery for planting, fertilising and harvesting. In this respect, labour productivity is not just about labour efficiency; it depends on firms’ decisions about how much capital to employ and how efficiently labour and capital work together to produce output.

In thinking about the relationship between productivity and aggregate supply, incomes and demand, I will focus mainly on labour productivity. This is because labour productivity most closely aligns with measures of economic living standards. It’s also easier to measure than MFP.

As you might sense, productivity is not about working harder, but working smarter. Many of the biggest productivity improvements have come from things that have made our lives easier, like computers, robots, the internet and smartphones – though personally I’m still questioning whether smartphones are productivity enhancing or a productivity sapping distraction.

Economists talk about productivity a lot. So I’ll now turn to the question of why productivity matters.

Productivity and supply

If productivity increases, the economy can produce more goods and services from all the available economic inputs. As such, productivity is a key driver of growth in the supply capacity of the economy, or potential output.

Productivity in Australia has been volatile in recent years but, looking through the volatility, is around the same level as in the few years before the pandemic. Productivity growth has also been consistently below the RBA’s projections for some time now (Graph 1). This has generated internal discussions about what trend labour productivity growth might look like in the period ahead, and what that means for estimates of potential output growth over the forecast period. The current assumption is that annual labour productivity growth will pick up to around one per cent in the medium term, which is close to its longer run average. This could be consistent with, for example, the rapid adoption of technology across many industries leading to higher productivity outcomes. However, the projected pick-up in productivity growth has not materialised in recent years and staff are currently assessing whether weak productivity outcomes are likely to persist.

Weak productivity growth in recent years has contributed to slower growth in the supply capacity, or potential output, of the economy than otherwise. Graph 2 shows one of our estimates of potential output, which is based on actual productivity outcomes observed in the data. The graph also shows a counterfactual path where productivity growth in recent years was higher, at its average rate in the two decades prior to the pandemic. This suggests that the size of the economy is a lot smaller than it would have been, had productivity growth been more like in the past (all else equal).

It’s important to keep in mind that, in this counterfactual world where supply capacity was much higher, incomes and demand would also have been higher too. Let me turn to that now.

Productivity, incomes and wages

While productivity growth contributes to growth in the supply capacity of the economy, it also contributes to growth in incomes and demand.

At times, labour productivity (output per hour worked) and real income per hour track one another closely (Graph 3). Looking through the volatility, both are currently around similar levels as in the period prior to the pandemic.

Other factors besides productivity can affect growth in incomes per hour. For example, higher prices for Australian exports can generate higher incomes domestically. So the terms of trade – the prices we receive for our exports relative to the prices we pay for our imports – can also be an important driver of incomes in the domestic economy. We can see this in the decade from the early 2000s: despite the slowing in productivity growth, real incomes per hour continued to increase, partly owing to substantial increases in the prices received for Australian exports like iron ore and coal. The surge in demand for our exports, particularly from China, supported profits in the mining industry and related parts of the Australian economy, as well as demand for labour and wages growth.

Over the longer run, labour productivity and real wages – as measured by average earnings from the national accounts – also tend to move together (Graph 4). Over the inflation targeting period, labour productivity has grown at an average annual rate of 1.1 per cent and real labour earnings have grown at 0.9 per cent. So, higher productivity not only benefits firms, it also benefits workers by increasing their purchasing power. The Productivity Commission has previously pointed to the productivity of bakers as a reason we can consume more bread or spend that extra money elsewhere – in 1901 it took 18 minutes of the average worker’s time to afford a loaf of bread, while today it’s just 4 minutes. There must be a joke in there somewhere about how we spend our dough.

In the short run, however, growth in real wages and labour productivity can and do diverge as the economy adjusts to economic shocks. For example, and as noted previously, increases in the prices received for Australian exports can have an impact on domestic profits and wages (and without an increase in labour productivity). Ultimately, however, it is very hard for an economy to support real wages growth in the longer run without productivity growth.

Productivity and consumption

Productivity growth also tends to support consumption growth. When productivity and incomes are growing more strongly, people are able to spend more and consumption grows more quickly. Weak growth in consumption per capita over recent years has coincided with weak growth in productivity, real incomes and real wages (Graph 5).

Similar patterns have been evident in other economies, where subdued productivity growth has been associated with slower growth in household incomes and consumption (Graph 6). The exception is the United States, where growth in both productivity and consumption has been relatively strong.

Recent trends in productivity

So far I’ve focused on the importance of productivity growth for aggregate supply, incomes and demand over the longer run. I’ll now turn to recent trends in productivity growth in Australia and some potential implications for the near-term economic outlook.

Discerning recent trends in productivity is difficult because of volatility in the data associated with the pandemic and other supply disruptions. Looking through the volatility, labour productivity growth has been low, averaging 0.2 per cent per year between 2017/18 and 2023/24 (Graph 7).

Reverting to the simple production function framework that I noted earlier, the slow growth in labour productivity over recent years has reflected slow growth in both MFP and the amount of capital available to each worker.

MFP growth averaged 0.2 per cent per year between 2017/18 and 2023/24, which was well below its historical average. Some have argued that slower MFP growth could reflect temporary factors. For example, tight labour market conditions over recent years have been associated with large numbers of individuals entering the workforce or changing jobs; this may have weighed on productivity as some individuals were trained or retrained and some firms adapted production processes to accommodate strong employment growth. If this was the case, MFP growth could pick up as the economy adjusts. However, work by some RBA staff finds that temporary factors like these have not been the primary cause of slow MFP growth, suggesting that structural factors could be weighing on productivity growth.

Slow growth in the amount of capital available for each worker in the Australian economy – or a lack of ‘capital deepening’ – has also contributed to slow growth in labour productivity (Graph 8). Capital per worker was broadly unchanged for around five years leading up to the pandemic and – looking through the volatility in the data during the pandemic – is currently a bit below those levels. In other words, overall investment has not kept pace with the strong growth in employment recently.

To help understand the recent slow growth in productivity, I’ll look at productivity outcomes in various parts of the economy.

I’ll start with the non-market sector – which includes the health care, education and public administration industries – where employment growth has been very strong over recent years. The level of measured productivity in some parts of the non-market sector is low relative to the aggregate economy. So, as the non-market sector has become a larger share of the economy in recent years, this has weighed on overall productivity growth in the economy. Our estimates suggest that the rising share of non-market employment lowered the economy-wide measure of labour productivity growth by around 0.3 percentage points per year on average from 2017/18 to 2023/24, as shown by the yellow bars in Graph 9. This compares with around 0.15 percentage points per year over the previous decade, and so the recent effects have been a bit larger than in the past.

But there is more to the story about productivity and the non-market sector. I have emphasised measured productivity because it is very difficult to measure output – and therefore productivity – in parts of the non-market sector. The central measurement problem is a lack of meaningful prices for some non-market output, such as public hospital services provided to public patients. This makes it very difficult to accurately identify quantities of output, which are needed to measure productivity. For example, research by the Productivity Commission suggests that productivity in the health care industry is higher than official estimates. As such, the drag on productivity from the non-market sector may be overstated.

Noting the challenges of measuring productivity in the non-market sector, what’s been going on in the rest of the economy? Labour productivity growth in the market sector averaged around 0.6 per cent per year from 2017/18 to 2023/24 – below its average of 1.6 per cent over the previous two decades – though it picked up in 2023/24.

While the level of productivity in the mining industry in Australia is higher than in other industries, productivity growth in that industry has declined over recent years. Excluding mining, productivity growth in the market sector since 2017/18 has averaged 1 per cent per year, though this is still lower than its average over the preceding two decades and well below the rates recorded during the high productivity growth period in the 1990s.

More generally, a range of explanations have been provided for the slowing in productivity growth globally since the 1990s. A well-documented one for Australia is declining ‘economic dynamism’ – it now takes longer for inputs to production to move to higher productivity firms, and it also takes longer for firms to catch up to the global frontier of performance and technology. Evidence suggests that at least part of the decline in economic dynamism relates to declining competition in the economy. Regulatory barriers also appear to have played a role in Australia, notably in the construction industry. Other explanations include slowing human capital accumulation, declining trade integration, and mismeasurement.

What does the recent subdued growth in productivity mean for our assessment of economic conditions? While productivity growth is associated with growth in incomes and wages over the longer run, in the short run there can be material divergences between these variables. Over the past year or so, real average hourly earnings in the economy have grown faster than labour productivity. This exerts upward pressure on firms’ unit labour costs and is consistent with our assessment that labour market conditions are still tight, notwithstanding some easing in those conditions over the past couple of years.

What will happen from here? Our latest forecasts in the Statement on Monetary Policy incorporate a pick-up in productivity growth over the next couple of years, which would add to the economy’s supply capacity and help alleviate cost pressures. But there is considerable uncertainty around this projection. If productivity growth remains weak, the near-term outlook will depend critically on how the economy adjusts. If growth in demand is also weaker and wages adjust quickly to this slower growth in the supply capacity of the economy, there might not be a material impact on cost pressures. But if demand picks up as expected or wages adjust slowly to continued weak productivity outcomes, cost pressures could be higher than we expect. We will continue to monitor these developments carefully, alongside the full range of indicators we use to assess current economic conditions.

Concluding remarks

To conclude, productivity matters because it is a key driver of economic living standards. Over the longer run, higher productivity growth expands the supply capacity of the economy and supports growth in incomes, wages and aggregate demand. In the short run, however, there can be meaningful divergences in the growth rates of these important macroeconomic variables. Recent weak growth in productivity has constrained growth in aggregate supply. Whether productivity growth improves from here and how the economy adjusts are important questions for the economic outlook.

Thank you for your time today. I look forward to your questions.

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