How to boost productivity growth in different economies

  • Technology fuels productivity growth, but tight labor markets are driving this growth, as companies typically need to make better use of technology when new employees cannot be hired.
  • Tense labor market conditions that can boost productivity growth tend to be localized and therefore economies benefit in different ways and at different rates.
  • Policymakers should view tight labor markets as both a risk and an opportunity for productivity to rise.

The idea that technology drives productivity growth is both commonplace and common frustration. Economies operating on or near the technological frontier have long experienced declining trend growth rates despite wonderful technology – from artificial intelligence to bioengineering to robotics – proliferating at breakneck speed.

This is important because productivity, or production by input, pays for higher wages and is the foundation of long-term prosperity. In this sense, it matters most in wealthy economies where higher productivity growth would allow policy debates to shift from (re) distributing a relatively stagnant economic pie to sharing a growing pie.

Yet there is an often overlooked factor in the technology and growth debate. Yes, technology undoubtedly plays a vital role, but we must see it as the engine of productivity growth. The spark is provided by tight labor markets – that is, when companies are forced to make better use of technology because they cannot easily add labor.

So how can cyclical tightening boost productivity growth? What kinds of savings should benefit from this relationship? And why should policymakers view tight labor markets as both an opportunity and a risk?

[Technology is] the engine of productivity growth. The spark is provided by tight labor markets

—Philipp Carlsson-Szlezak, BCG & Paul Swartz, BCG Henderson Institute

Understanding the spark of productivity growth

Availability is often not sufficient to incentivize wide adoption and use of the technology – integration can be expensive and there can be risks of implementation. It is often easier for businesses to continue to grow with the next additional hire.

However, when labor markets are tight and wage growth exceeds long-term trends, companies will face downward pressure on margins even as revenues increase. Such a pressure cooker economy can force executives, managers and workers to adopt and make better use of existing technology, instead of looking to an expensive job market for additional capacity.

The charts below corroborate this observation. The chart on the left correlates over 60 years of U.S. business investment (relative to its 5-year average) with 5-year productivity growth. If the sheer availability and investment in technology boosted productivity, we would see a relationship, but it doesn’t.

Compare this with the graph to the right, which correlates the tightness of the US labor market (ie, unemployment relative to the “full employment” level) and productivity growth. It shows a clean relationship. Obviously, when it is difficult to hire, something moves in the productivity of the economy.

Tense labor markets tend to have more impact on productivity growth than on investment.

Image: BCG Henderson Institute

The fuel for productivity growth is global, but the spark is local

While the technology frontier may spread around the world through commerce and global value chains, the labor market conditions that trigger adoption are much more localized. This means that productivity growth may diverge in countries with similar technological capabilities.

A rapid tightening – or loosening – of labor markets may arise as a by-product of strong cyclical momentum (such as the recovery currently underway). Or it can happen due to the structural organization of local labor markets. In other words, economies have different capacities when it comes to harnessing the link between stress in the labor market and productivity growth.

What is economic competitiveness? The World Economic Forum, which measures the competitiveness of countries since 1979, defines it as: “the set of institutions, policies and factors that determine the level of productivity of a country”. Other definitions exist, but all generally include the word “productivity”.

The Global Competitiveness Report is a tool to help governments, the private sector and civil society work together to boost productivity and generate prosperity. Benchmarking across countries allows leaders to assess areas that need strengthening and build a coordinated response. It also helps identify best practices around the world.

The Global Competitive Index forms the basis of the report. It measures performance according to 114 indicators that influence a country’s productivity. The latest edition covered 141 economies, representing over 98% of global GDP.

Country scores are based primarily on quantitative results from internationally recognized agencies such as the International Monetary Fund and the World Health Organization, with the addition of qualitative assessments from economic and social specialists and senior officials of companies.

Consider the difference between Europe and the United States, two advanced economies that operate on the technological frontier. The United States is expected to benefit from a tight labor market, as the lack of an easy workforce is already forcing companies to invest and reinvent their businesses and processes. This will not only support faster growth, but also allow workers to claim a growing share of output.

In Europe, the recovery is more modest and the labor market is less flexible, making a bidding war for work less likely. If Europe can only protect but not engender flexibility in the labor market, the recovery gap vis-à-vis the United States will widen as the spark for greater adoption and use of technology will be less powerful. .

Economies differ in their ability to harness the link between tight labor markets and productivity growth.

—Philipp Carlsson-Szlezak, BCG & Paul Swartz, BCG Henderson Institute

Balancing the risks and benefits of tight labor markets

Ignoring the benefits of tight labor markets could come at a cost to policy makers and managers. Take the US economy once again. It is on track to achieve higher production in 2024 than expected before the pandemic, that is, to “exceed” its old trend trajectory. Thanks to strong and sustained fiscal stimulus measures, the rapid return to tension in the labor market has been presented as an inflationary threat. The picture is often painted of an impending wage-price spiral and a Federal Reserve falling behind and stifling the cycle once forced to raise rates to rule price growth.

Our own view has been that the price growth of recent months is linked to transitory lags as the economy reopens. Our biggest concern, however, is that a narrow view of the tight labor market (i.e. focusing only on risks) will come at a cost.

The benefits of a vibrant economy, as noted above, represent both a macroeconomic opportunity and a threat – two dynamics that must be balanced. Part of this balancing act is recognizing that tight labor markets drive productivity growth and thus can increase the capacity of an economy. This would actually reduce the feared overrun, even if economic activity remains strong.

The benefits of a vibrant economy represent both a macroeconomic opportunity and a threat – two dynamics that must be balanced.

—Philipp Carlsson-Szlezak, BCG & Paul Swartz, BCG Henderson Institute

For businesses and policy makers alike, it might be a mistake to view the pressures of a booming economy as all bad. In many ways, companies that do not engage in the adoption and use of technology are like the decision makers who end a hot cycle before its benefits can manifest. The strongest result will probably be when the cyclic pressure is maintained for an extended period. This will require a vision that embraces the benefits of a tight economy alongside its risks.

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