Economics 8: growth and productivity

by George Hatjoullis

GDP is either referred to as ‘nominal’ or ‘real’. Nominal GDP is just the money value of output at the current market prices. Real GDP attempts to measure output, over time, at constant market prices. The idea is to factor out the inflation component in nominal GDP. Producing the same amount of output at higher prices is simply inflation. The implicit GDP price time series that emerges is referred to as the GDP deflator. Using this time series of GDP prices one ‘deflates’ nominal GDP to get a time series of real GDP. It is real GDP to which most refer when using the term ‘GDP’. Nominal GDP is usually stated explicitly as such (problems in calculation will be ignored unless they become directly relevant). The GDP price deflator is a measure of inflation though not the one that usually appears in the headlines. The headline figure usually relates to a consumer price index (CPI). This measures the change in price, over time, of a basket of consumer goods. The latter is usually calculated on a monthly basis whilst GDP and its components is normally calculated quarterly. The methods of calculation also differ. The two methods of measuring actual inflation usually correlate well enough.

The reference to GDP growth is also slightly conflated. GDP may grow in any one year simply because it is moving back to potential. The rate of growth may be quite dramatic if it was at below potential. However, in economic theory, a reference to GDP growth may (more usually) be to the growth of potential. Potential depends upon the availability of labour, the stock of means of production and the productivity of these means of production (note the means of production includes land, mines etc). Potential expands as the labour market grows, new investment adds to the means of production and technological innovation improves the productivity of the means of production (in these days of high unemployment it is hard to think of labour as a constraint on output but do not confuse a state of being below potential GDP and the idea of expanding that potential). The labour constraint on potential GDP often comes up as a problem of an ageing population.

Productivity is a characteristic normally attributed to labour. Hence many statistics refer to output per manhour. This is because some human element is necessarily present in the production process. It implies that labour has some claim on the increased output arising from productivity. In practice this does not follow (this is not to say it should not follow). A manhour (or womanhour if you prefer) is an input into the production process and, in practice, is compensated just like any other factor. In the modern context another variable has emerged as the reference for judging the productivity of the means of production; the output of CO2. Concern about man-made global warming has made people and governments sensitive to CO2 emissions from the production process (the called carbon footprint). Processes that increase output per unit of CO2 produced in the process, may be preferred. There is a considerable effort to accommodate this externality through the introduction of carbon credits and a market in such credits. It is hoped that this will incentivize producers to minimise CO2 produced per unit of output.

Potential output could in principle be constrained by the supply of labour. In an ageing population, the burden of production falls on a smaller and smaller group of economically active people. If there is an insufficiently large group of people to work with the available means of production, potential output is constrained. In such circumstances one would expect real wages to be rising and the share of the active labour force in GDP to be rising. There would be pressure on participation rates as well. More inactive people would be encouraged into the labour force, in part by higher wages. However, there might also be compunction through lower welfare payments from the state and lengthening retirement dates. This is all too familiar in the UK (and elsewhere), so one might reasonably assume that the pension and welfare crisis is at root a symptom of an ageing population. Not enough people available to work with the available means of production. This does not fit all the facts and on closer inspection something else seems to be going on.

First, real wages are not rising. Second, people are being asked to work longer and take welfare cuts at a time of record youth unemployment. It could be that the youth unemployment is being caused by insufficient aggregate demand and the economy operating below current potential (because accumulated claims on GDP or net wealth, foreign demand and government spending are unable to make up the deficiency). There is thus a conflation of cyclical and structural influences that is confusing the debate. Lengthening retirement dates and cutting welfare payments is not helping the cyclical problem (economy operating below potential) but is the correct response to the structural problem (ageing population). There is some truth in this conflation but it is not the whole story. This brings us to the third point; productivity growth.

The evidence of improving labour and energy productivity is all around. The microchip and the internet are, at root, responsible for much of this growth in productivity. Very soon it will be possible to wheel a shopping trolley full of goodies out of a supermarket, checkout and pay, without any staff being directly involved. Heat pump technology has reduced the electricity used by a tumble dryer by 2/3. Look around and you will see many examples. Potential output is being boosted by productivity growth though it may take more new investment before this technology is fully incorporated. The youth unemployment may not fully disappear if potential output is growing.

The availability of amenable and not very expensive labour may delay the investment process. However, the profitability of new investment will eventually lead to action and a leap in potential output. This is how the market system works. Individual entrepreneurs and corporations look at profitability and invest. They do not worry too much about aggregate demand, partly because the can do little to affect it and partly because they have become used to the state dealing with any material deficiencies (one moral hazard issue of earlier lessons). So public policy is to encourage increased labour market participation at a time of productivity-driven increases in potential GDP. This sounds like a recipe for disaster.

Productivity induced growth in potential GDP will not absorb the growing labour force. Indeed it may create new unemployed (supermarket check-out assistants). The question of who will buy the increased GDP arises? The state is no longer able/willing to act as buyer of last resort. Overseas sales may help one country but cannot help the whole globe. If investors cannot now realise their, in principle, profitable output by exchanging it for monetary claims, output will fall to well below potential and stay there. This is more or less where we started this series of lessons.

The other element of the response to the pension crisis is that people should save more. In other words they should accumulate more claims on future GDP which they can then run down. This makes some sense and seems to fit with the assumed burst in investment. If these workers become bigger owners of the means of production by funding an investment boom, in the future they have the means to buy their own potential output. The distribution of GDP is thus widened by private means. Except that the sums never necessarily add up (for many reasons). There may be an equilibrium or stable solution but no one has yet identified it for the market system. The fundamental driver of market based system is pursuit of profit and realisation of this profit is required to keep the system going. This implies an unequal distribution of claims on GDP and introduces the logical impossibility of there always being sufficient demand to realise the claims of owners of the means of production on GDP. Increasing the active working population at a time of high productivity is not a solution to any problem! The need is to find ways of reducing hours (and years) worked and yet enabling people to continue to meet their needs, whilst retaining sufficient incentive for entrepreneurs and corporations to invest.

To recap:

1. ‘GDP’ usually refers to real GDP.

2. GDP growth properly refers to the growth of potential GDP.

3. Productivity of the means of production usually refers to output per manhour. It might also be expressed as output per unit of CO2 emitted.

4. Available labour could constrain potential output. Rising real wages would be evident and encourage increased participation rates.

5. Current policy is to extend retirement dates and cut welfare spending. An ageing population is cited as the cause. However, real wages are not rising and youth unemployment is high suggesting something else is going on.

6. Productivity growth has the scope to greatly increase potential GDP. Market based incentives will eventually see this potential GDP realised. Productivity driven growth in GDP economises on labour, rendering increased participation policies somewhat counter-productive.

7. In market based systems the problem is to sustain incentives to invest whilst ensuring a socially acceptable distribution of GDP.

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