Output And Wages Linked To Prosperity

Rising labour productivity leads to higher employment, income and profits

Article written by: Luke Jordan, Laurence Wilse-Samson

We are a few months into the season for collective bargaining. Most headlines are and will be dominated by nominal wage rises, which sit alongside gross domestic product (GDP) growth, inflation, the deficit and interest rates as the economic indicators discussed most often.

What is less likely to be discussed is the number that sets the parameters for all of those – growth in labour productivity. That refers to the amount of output, net of inputs, produced by each hour of labour. It measures how quickly a given amount of work is producing more goods and services. GDP growth is simply growth in productivity added to growth in hours of work.

In turn, how quickly output per hour of work grows tells us how quickly hourly wages can rise without stoking inflation. It arises when there’s too much money chasing goods. When productivity is high, and goods are growing quickly, the looser monetary policy can be – and still maintain stability.

Productivity also has a decisive influence on the relationship between wages and competitiveness. If it is stagnant or declining, even below-inflation wage rises may reduce competitiveness. Conversely, if productivity is rising quickly, the effective cost of labour may decline even as wages rise rapidly. This belies the contention that lower wages are “necessary for competitiveness”, that wage rises will “necessarily hurt exports”, or that above-inflation wage increases are “inflationary”. It depends on productivity.

It is also not the case that productivity growth necessarily reduces employment. Greater efficiency will reduce the number of employees needed to produce the previous amount of goods and services.

But the keyword is “previous”. The gains from efficiency will be divided between labour, management and capital, depending on their respective bargaining power. The share to labour increases wages and creates additional demand for goods and services, as does that to management and the owners of capital, if it is reinvested. Greater efficiency leads to greater demand, and employment, wages and profits rise together.

That cycle can break down. The surplus can be captured in part or whole by management and capital. If that happens under tight monetary policy and low fiscal incentives to invest, an economy can end up in a vicious cycle where productivity growth is slow, wage growth even slower (in real terms) and unemployment still rises or stagnates.

That is what is occurring in South Africa today. But that does not mean we should reduce productivity growth. That would close the only route to a high-wage economy. The answer must be to fix the causes of a skewed distribution of productivity gains and stagnant demand, while accelerating productivity growth.

That is what happened in the post-war United States and Europe, and in rapidly growing Asia. It has happened in China, where wages have risen on average 15% a year for the past decade. In most industries in China, nominal wages now exceed those in South Africa. But productivity has risen just as quickly, so the quadrupling of wages in a decade has neither hurt exports nor stoked inflation.

Unfortunately, in South Africa productivity growth has performed very poorly. Long-run data is hard to find – in itself an indicator of low priority – but in the past few years it has grown at a mere 1.3% to 1.5%. This is low compared with countries at similar levels of development.

Productivity, more than GDP growth, is perhaps our central economic problem. It is arithmetically impossible for us to become a rich country if wages do not grow significantly faster than inflation, but they cannot do so unless productivity grows far more quickly. As long as it does not, our largest policy battles will remain lose-lose. Productivity sets the constraints for many of the decisions that we make in the economy. It’s the way to grow the pie.

If this is our central challenge, what can be done about it?

Labour productivity is most usefully broken down into two components: capital deepening, or the amount of capital per unit of labour; and total factor productivity (TFP), which measures how much value a unit of mixed capital and labour produces.

Capital deepening is principally a question of investment. For us, that means greater domestic investment. That is a far from trivial task. In South Africa, it is likely to require changes to the tax structure, more effective industrial policy, and a change in the monetary policy mandate. It also means a stable electricity supply and greater infrastructure investment overall.

But in the long run total factor productivity counts most. It is determined by the technology embodied in equipment and structures, the quality of labour, and the quality of management. Put more simply: How leading edge are the companies in the economy? How skilled are their workers? And how well are they managed?

These are all deep-rooted features of an economy. They are structural variables that require structural reforms. Given the range of variables, these reforms vary widely, not only in their content but also in the way which of them will make a difference and when. The International Monetary Fund (IMF) has recently published a useful review of the evidence, categorising structural reforms by their likely short-, medium- and long-term effect.

At the top of the list are research and development, increased competition and higher skills. All three areas are ripe for reform in South Africa. In 2012-2013, we spent 0.76% of our GDP on research and development. That is not terrible for a middle-income economy, but it can be improved significantly. The developed world and rapidly growing developing economies, such as China, spend between 1.5% and 2% of GDP on it, whereas the United States spends closer to 3% and Japan and Korea 3.5% to 4%.

We can and should try to double our spending. There are already tax breaks for private research and development, which should be maintained, while doubling the government’s contribution from R10-billion a year to R20-billion. Although high-risk research will always lead to some failures, most studies of research and development find double-digit rates of return when evaluated across portfolios.

Second is competition policy. Vigorous competition can help remove bad managers, and reallocate resources to more productive firms. Many of South Africa’s markets still feature large entrenched players. Too little has been done to encourage new entrants.

Third is skills. We must recognise our legacy. Apartheid deliberately deskilled most of our population to protect the income of the white working and middle classes. Today, though “skills” is an often repeated mantra, both public programmes and public pressure is half-hearted.

A chronic deficiency in skills both pushes up the price for them, thus increasing middle-class incomes, and protects the skilled from putting in more effort.

More money is needed, but it alone will not solve the problem. Skills programmes are fiendishly complex. In the US, private sector solutions – private vocational colleges funded by public loans to students – have led to widespread fraud and soaring student debt levels. Nor are successes easy to replicate – many countries have attempted to replicate Germany’s apprentice model but few have succeeded.

But this is not a counsel of despair. Sometimes effective programmes are hiding in broad daylight. In Latin America, for example, industrial skills programmes routinely fail, but agricultural extension programmes have triggered explosive growth in several countries.

In China, the government makes publicly available for every vocational college the entry scores of students, graduation rates and job placement rates. It vets how colleges set curricula in co-operation with local industry, rather than the curricula themselves.

In South Africa, we would need to experiment. We have the skills education training authorities (Setas), skills development levies, and public and private colleges. But little to nothing is being done about the core problems of information and co-ordination.

At the least, we should establish a free, simple-to-use system to obtain information about a college’s performance, perhaps with one-year and three-year placement rates accessible by phone. This would not be simple to set up, but neither would it be impossible – linking to the South African Revenue Services’ tax systems, for example, could automate the calculation of how many students are on employers’ payrolls.

In many cases, unions play a vital role in making skills programmes work. Skills training requires up-to-date information on the skills needs of a sector’s workforce. It also requires as much, or more, on-the-job training as training in colleges.

Individual employers are reluctant to provide this, because the costs are hard to recoup if trainees leave soon afterwards, public programmes easily become detached from shop-floor needs. Unions can help to square this circle by aggregating information, running programmes themselves, or monitoring and reporting “free riding” by employers or employees.

A final source of skills is foreign imports. As the Chinese leader Deng Xiaoping told the World Bank in 1978, “we need your ideas, not your money”. The TFP and skill spillovers from foreign investment are often far more important than the size of any such investment.

In theory, “critical skills” visas exist. In practice, when academics take one to two years to get visas to take up posts at our universities, we are damaging both research and development and skills. When companies cannot bring in the managers they need, we are damaging organisational quality and technical know-how. We need high-end skills, and we must make it as simple as possible for those who have them to come here.

That leads to tackling two shibboleths. First, labour market reforms. In that same review, the IMF stated that these reforms can be negative for TFP, especially in a monetarily constrained environment. Since the South African Reserve Bank has decided that South African monetary policy is at its lower bounds, such reforms will have little effect unless its mandate is changed to also consider unemployment and not just inflation. This would align the Reserve Bank’s mandate with that of the US Federal Reserve.

The other shibboleth is the idea that rising productivity entails otherwise avoidable automation. This is burying your head in the sand. Automation will affect almost every job category and every country. Agri-processing mills in the heart of the Malaysian jungle are automating; Chinese factories are installing hundreds of thousands of robots a year.

Rather than trying to turn back the clock, energy should be devoted to securing the policies and programmes that will harness technological abundance for higher growth and higher equity, rather than ever more inequality and stagnation.

We should set a national goal to double productivity growth. We need a serious and sustained conversation about how to overcome the legacy of apartheid and the failure of our present programmes to develop skills on a large scale. That conversation needs to be specific, detailed and pragmatic. We need to do all of this now, before our ability to trust and work with each other are poisoned by more years of the bad choices that low productivity imposes.

Luke Jordan is a cofounder of GrassRoot. He has worked for McKinsey & Company and the World Bank in China and India. Laurence Wilse-Samson is an economic consultant in New York. He has a PhD in economics from Columbia. The opinions expressed here are their own.

Article sourced from: Mail&Guardian