Key points
Labour productivity is closely related to return on investment and can be either in a virtuous or vicious cycle with investment.
With much of the world, Australia has been experiencing a labour productivity growth decline for the past thirty years.
Declining labour productivity renders interest rates a more powerful but also more dangerous policy instrument by lowering their headroom.
Two competing theories offer explanations of this phenomenon: Keynes suggests it is the satiation of innovation drivers, Schumpeter argues it is the growth of restraining forces.
Labour Productivity: what it is, why it matters
Labour productivity is an extremely simple and extremely informative number. In its simplest form it is simply GDP divided by hours worked. So, it is the amount of new wealth produced by an hour of work.
This number is probably the single most important statistic that determines the wealth of nations because it’s a measure of how much we can produce per person, with our current capital and current technology, or “efficiency”. If, for a given population, we want to grow, we need to grow our labour productivity either by adding more capital (factories and machinery), or we need our efficiency to advance. Trevor Swan (and also Robert Solow) famously showed how, over the medium to long term, because capital must have diminishing returns, all our long-term growth must come from efficiency.
So, if our labour productivity growth is slowing, it’s a signal that our efficiency in the employment of labour and capital is slowing, and we can expect our underlying economic growth to slow.
But there’s also an aspect of a feedback loop in labour productivity. It’s closely related to (but is not the same as) what economists used to call the “marginal efficiency of capital”. The marginal efficiency of capital is closely related to what is more commonly known as the return on investment. If it’s declining, it means an additional dollar of investment in new jobs or new factories or new machines or, indeed, in new technologies can’t be expected to go as far. That means that the new investments which might lift labour productivity become harder to justify.
When labour productivity is growing, it’s easy to ignore because we have a virtuous cycle. Investment in new jobs, factories, machines, and technology goes further and further each year, attracting more investment to obtain a better return. When labour productivity is in decline, it becomes increasingly harder to ignore because we get a vicious cycle. A zeitgeist of stagnation begins to spread in which it becomes harder and harder to justify the new investment which might break the stagnation.
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