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Fundamentals: The long view

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Economic debate tends to focus obsessively on short-term indicators while underestimating the importance of productivity and business investment, Daniel Ben-Ami explains

At a glance 

• Labour productivity and business investment are fundamental determinants of economic dynamism.
• Productivity growth has declined in the advanced economies since the 1970s.
• Some see low investment and poor productivity growth as a symptom of weak demand.
• The debate on the sources of economic malaise has important practical consequences.

Discussion of the euro-zone in recent years has focused, not surprisingly, on the short term and the urgent. For a long time, it seemed to many that Greece’s financial plight might trigger a systemic crisis in the region. There were even fears that the inability of the southern periphery to manage its debts properly could precipitate a break-up of the whole bloc.

Perhaps these concerns were overdone but, in any case, the threat seems to have receded. The euro-zone still has its problems, as do other developed economies (see panel, Is the euro-zone different?), but it appears relatively stable at present.

Nevertheless, the discussion of the region still focuses stubbornly on the short term. Much of it is concerned with actual and even potential movements in monetary policy and inflation rates. Although such factors should not be ignored, there is a down side to an excessive focus on it; long-term trends tend to get lost in the noise. 

Colin   an economist at BNP Paribas, puts it this way: “The financial crisis has, in some senses, clouded the underlying picture. We’ve had really bad growth rates in recent years. It’s difficult to say how much is due to the trend and how much due to the cycle.” 

The lack of debate on the secular (that is long-term) picture is all the more surprising since the challenges are widely recognised by experts. Keying in such terms as ‘competitiveness’, ‘productivity’ or ‘investment’ into the European Commission or European Central Bank (ECB) websites yields multiple hits. Indeed, as far back as the 1980s it had become common to talk about ‘euroscleroris’ to describe what was widely perceived as Europe’s economic stagnation at the time. The term was reportedly coined by Herbert Giersch, a prominent German economist, who advised several chancellors. 

Productivity: average annual growth rates within selected periods (%)

This article is an attempt to redress the balance in the current debate. It will start by examining why labour productivity and business investment are widely viewed by economists as fundamental to economic health. Next, it will look at the euro-zone’s record in these areas. Finally, it will consider whether such variables are either mismeasured or their importance misconstrued.

Long-term drivers

Perhaps the most fundamental indicator of the health of any economy is labour productivity. As Paul Krugman, a Nobel prize-winning economist, famously argued back in 1994: “Productivity isn’t everything, but in the long run it is almost everything. A country’s ability to improve its standard of living over time depends almost entirely on its ability to raise its output per worker” (The Age of Diminished Expectations, MIT Press).

It should not take much thought to understand why Krugman would make this point and most economists would agree. If, on average, workers produce more per hour then living standards can rise. Ultimately, all things being equal, it is the fundamental determinant of prosperity.

The central importance of productivity was recognised as far back as the eighteenth century. During that time, thinkers of the European Enlightenment – the intellectual current that placed great emphasis on reason, science and freedom – began to grapple with its role.

“The financial crisis has, in some senses, clouded the underlying picture. We’ve had really bad growth rates in recent years. It’s difficult to say how much is due to the trend and how much due to the cycle”
Colin Bermingham

Adam Smith, known at the time as a moral philosopher, tackled the concept in The Wealth of Nations (first published in 1776). In the opening chapter he used the example of a pin factory to show how specialisation plays a key role in raising output. If the factory is organised so that different employees play different roles it becomes possible to produce a lot more pins in any given time. Less well known, is that Smith took the example of pin making from illustrations in the Encyclopédie (Encyclopedia) compiled by French Enlightenment thinkers. 

Increased productivity within the factory helps create the basis for greater affluence in society as a whole. Not only does output increase inside firms but more companies specialise in different products and individuals develop specialist skills. Through trading with each other, it becomes possible for the entire economy to reap the benefits of specialisation.

This is not just an abstract economic model. Some time between about 1750 and 1800, just as Adam Smith was writing, economic growth in Europe and North America started to take off. This was first apparent in Britain’s Industrial Revolution. In the subsequent period, the prosperity of the western economies rose sharply. In many respects, the living standards we enjoy today are a legacy of the two centuries, or so, of economic growth that started in that period.

Business investment has played an important role in this historical surge in productivity. A worker with access to better technology will, all things being equal, produce more than one with less advanced equipment. As a general rule, high levels of investment (also referred to by many synonyms, including capital spending, capex and gross fixed capital formation) are a sign of a economic dynamism and low levels are an indicator of weakness. Contemporary definitions of technology often include intangibles, such as software, rather than being confined to physical assets. 

The economic record

In the broadest terms, it is relatively straightforward to sketch the history of modern economic growth. Until some time between 1750 and 1800 the world economy was more or less static. There was probably expansion in fits and starts in some areas but it was not a systematic phenomenon. Then there was a sudden step change. The countries of Europe and North America started to grow systematically. Later on, other parts of the world started to grow too, although there is still generally a huge gulf between them and the advanced economies.

Of course, such a thumbnail sketch involves gross generalisations. For example, some European countries, most notably Britain, started to grow earlier, while others, most notably Germany, developed later. The periods of growth were also punctuated by periods of downturn. For instance, in the 1870s and 1930s there were episodes of severe economic contraction.

The decades following the Second World War are generally seen as a golden period of growth for the developed economies. In the early stages, there was recovery from the destructive impact of the preceding conflict but strong growth continued until the early 1970s. Since then, the dynamic to economic expansion has steadily weakened. The developed economies have continued to grow over that period but at a declining rate. They have also come to increasingly rely on extraordinary measures such as ultra-low or even negative interest rates and quantitative easing (QE).

The situation has become so bad that many economists have started openly talking about ‘secular stagnation’. Essentially, the idea is that the western economies have got caught in a serious rut. Larry Hatheway, the group chief economist at GAM, describes it as arguing that “one of the reasons we are caught in this slow growth cycle is simply the lack of demand”. From this perspective “demand itself is holding back investment”.

The idea was first raised by Larry Summers, a former US Treasury secretary and past president of Harvard, at an International Monetary Fund seminar in 2013. More accurately, it was re-raised – since, as Summers acknowledges, the notion dates back to the Great Depression of the 1930s.

This is the backdrop to the plight facing the developed economies. The emphasis here is on the euro-zone but broadly similar trends are apparent in both the US and the UK.          

Bart van Ark, the chief economist of the Conference Board, an independent research association, has spent much of his career examining such questions. The Conference Board’s Total Economy Database is regarded as a key source on global productivity trends.

The economist, who is also a professor at the University of Groningen in the Netherlands, puts the recent shift into historical perspective: “The first three decades after the Second World War, roughly until the mid-1970s, Europe had extraordinarily rapid productivity growth. First of all, it was catching up from all the losses during the war. Then it benefitted from pretty deep integration between advanced economies within Europe and from Europe being more engaged with the rest of the world.” 

Van Ark says productivity growth continued into the 1980s and 1990s but was offset by a significant weakening in the labour market. Labour participation rates started falling and regulation became more rigid. So productivity continued to rise for those in work but, when measured across the whole economy, the growth of average income per head started to slow.

Anton Brender

Two key factors changed the outlook in the mid-1990s. First, Europe was much slower to embrace digital technology than the US. Van Ark points to areas such as retail, transportation and logistics where the uptake was much faster on the other side of the Atlantic.

Second, labour participation – the proportion of the working age population that is actually working – picked up. Although this increase was, in some respects, welcome, it put downward pressure on the productivity figures. Many of the additional employees were absorbed into low-productivity sectors of the economy.

Van Ark points out that the turmoil since the mid-2000s has muddied the picture. Over that period the region has suffered two double-dip recessions and austerity. Investment has slowed, demand has weakened and confidence has been shaken.

Nevertheless, he says the region has recognised the need to keep up with the complicated transition involved in harnessing new information technologies. Europe’s industrial powerhouse has become particularly conscious of this shift. “Germany has really become aware that the shift to the digital economy has become an existential threat to its manufacturing-driven model,” he says. “That is why it has become so focused on its Industrie 4.0 programme” (on smart manufacturing).

In relation to business investment, the long-term trend is hard to discern for the euro-zone. It only came into existence as an economic bloc in 1999 with several new members joining since then. Many of its member states, if they existed at all, were members of the Soviet bloc until the early 1990s. However, it is clear that investment in the region has fallen sharply since the onset of the global financial crisis.


Although the headline figures are relatively clear they can be questioned from several different perspectives. Some of them are essentially questions over detailed interpretation while others are more fundamental.

Perhaps the most straightforward, at least in principle, is the question of measurement. Any economic figures are always subject to a degree of error. “There is always a measurement issue,” says John Bilton, the head of the global strategy team at JP Morgan Asset management.

Van Ark distinguishes between two different sorts of mismeasurement. One is to accept, in principle, the current concept of GDP – the standard measure of economic output – but accept that accurate measurement is always a problem. In his view, this could lead to an understatement of productivity growth by up to 0.3 percentage points. 

A more fundamental challenge is posed by the greater availability of free content in modern economies. By definition anything that is not monetised is not counted as part of GDP. But that raises difficult questions about how it should be valued.

Leaving aside the question of measurement there are other ways in which lower productivity growth is explained. One common route is to attribute it to demographics. The implicit assumption here – not usually openly stated – is that an older population is less capable of working hard than a younger one. Although this contention has a common-sense appeal it is open to question. It might have been true when a larger proportion of the population was engaged in hard physical labour but is likely to be less of a factor in this age of automation.

There is also a minority of economists who argue that the importance of investment is exaggerated. For example, Daniel Gros, the director of Centre for European for Policy Studies (CEPS), a policy think tank based in Brussels, argues against the idea that there is an investment gap. His argument rests on two main pillars. First, in his view, investment was artificially high in the run-up to the 2008 crisis. In other words, it was previously running at an unsustainable level. 

Second, he also links the question of economics to that of demographics. He shares the view that an older population is likely to mean lower investment rates. He concludes by arguing that it is consumption, rather than investment, that should be a priority for policymakers.

Gros’s conclusion is in line with the common counter-argument that low investment is more of a symptom than a cause of economic lethargy. Anton Brender, the chief economist at Candriam Investors Group, takes a similar view. “It’s not so much a supply constraint that is limiting productivity increases,” he says. “If we had a faster pick-up in demand then productivity would move up faster”.  

Brender argues that part of the fall in productivity growth is the result of labour hoarding. Companies are holding on to workers but, in conditions of weak demand, they have little incentive to bolster productivity. Such arguments are clearly close to the secular stagnation thesis.

The focus on demand is often combined with an emphasis on the importance of consumer confidence. One reason to question this view is its heavy reliance on psychology. The argument seems to be that if consumers simply feel more confident, then the economic outlook will improve. What some see as structural economic problems are reposed as matters of individual psychology.

Finally, perhaps most fundamentally, is the claim that the earth’s economic output is approaching, or already at, some kind of natural limit. From this perspective, growth is becoming increasingly hard to sustain. In essence, this is the opposite of the Enlightenment view which holds that, for all practical purpose, the potential for increased prosperity is limitless.

Fundamental questions about the drivers of the economy cannot be resolved here but it is important to recognise they are not just academic disputes. Any particular stance on these questions leads to strikingly different conclusions. For example, the view that bolstering investment is key runs counter to the claim that the emphasis should be on consumer confidence. And the argument that bolstering productivity is key clashes with the idea that economic growth is endangering the planet.

At the very least, it is sometimes necessary to go beyond day-to-day concerns to ponder such big questions. 

Is the euro-zone different?

Although the focus here is mainly on the euro-zone, it is important to recognise that there are similar trends elsewhere. Labour productivity growth has trended downwards across the developed world since the 1970s. Indeed, although absolute levels of growth are particularly low in the euro-zone it is arguable that the downward trend is more striking elsewhere.

Gross fixed capital formation as a percentage of GDP

Tappan Datta, the head of asset allocation at Aon Hewitt, says: “On a comparative basis, it is wrong to single out Europe. If you look at UK investment you see a similar picture.” He also says that the US is “fairly close”.

John Bilton, the head of the global strategy team at JP Morgan Asset management, holds a similar view. “Productivity growth round the world is at a low ebb,” he says. “The reality is we are in a low but positive growth regime”.

The contention that the US is part of the trend will no doubt surprise many. There has, after all, been considerable excitement about developments in Silicon Valley in particular. But a look at the figures (see graph) shows that, despite a slight recovery in the late 1990s, productivity growth is also falling.

Among the experts, debate on the US record has focused on Robert Gordon’s The Rise and Fall of American Growth (Princeton 2016). The professor from Northwestern University in Chicago argues that the scale of life-altering innovations the US enjoyed from 1870 to 1970 cannot be repeated. Whether he is right or not is a matter of intense debate. 

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