A new report by the International Monetary Fund—Gone with the Headwinds—outlines a pessimistic view for global productivity in the near- and medium-term future. In short, productivity growth is more likely to slow down than increase in the coming years due to demographic changes, underinvestment in human capital, and a lack of innovation (driven in part by a reluctance to invest in more profitable, albeit riskier, enterprises in favor of buttressing existing institutions that in earlier times would have been allowed to die in favor of newer, more dynamic and productive firms). The lack of innovation and productivity growth means overall growth an investment returns will likely be sluggish for the foreseeable future.
This broad conclusion—that productivity growth is falling—will not be new to those familiar with the new normal of low investment returns the global economy is going through, but the report provides a useful deep dive into the specific causes of this slowdown and some proposals to reverse this trend.
Before going further, it’s necessary to define some terms:
- Productivity is a measure of how much can be produced for a given input (the ratio of output goods to input goods). If a firm can use $15 of input goods (e.g. labor, capital, and raw materials) to produce $20 of output goods, but then increases that figure to $30 of output goods from the same $15 worth of input, their productivity has increased from a factor of 1.33 to 2.
- Return on investment is slightly different. This is the measure of how much a given capital investment returns for the investor. A large investment with no increase in productivity wouldn’t increase returns on investment; it would only yield a larger return in absolute terms due to a larger upfront investment. An increase in productivity for the same level of investment, on the other hand, increases investment returns, sometimes by orders of magnitude.
The IMF report finds the decline in productivity growth in the wake of the financial crisis to be widespread, and it is the largest contributor to the pre-financial crisis slowdown. For this reason, the report finds that “productivity growth is unlikely to return to the higher rates of the late 1990s (for advanced economies) or the mid-2000s (for emerging and developing economies) given the structural headwinds.”
What are the structural factors contributing to this slowdown? The damage done by the financial crisis is one of the culprits, even though productivity growth has recovered after slowdowns similar in size to the financial crisis. During a panic, there is often a “flight to quality” (sometimes more appropriately called a “flight to safety”), where investors fearful of losses in risky assets invest in safer assets, such as US Treasuries or gold.
This can often happen to firms not directly affected by the initial causes of an economic downturn, and withdrawal can put otherwise healthy firms at the risk of default. Tim Geithner’s Stress Test provides an interesting analysis of how many financial institutions would have weathered the storm of the financial crisis had investors not responded to the initial panic of the crash.
While this behavior is common in financial crises, the flight to safety has been persistent even amid the tepid recovery thus far, depriving higher-risk, higher reward firms of much-needed capital. This environment, according to the IMF report, “biases business investment toward more liquid, low-risk/low-return projectsâ€¦In return, these forces might have slowed technological progress.”
Risk of default isn’t the only uncertainty that has fed skittishness by investors. Political uncertainty, such as Brexit and the election of Donald Trump, and broader policy uncertainty also create an environment that discourages high-risk/high-reward investments.
This uncertainty in the wake of the financial crisis led to a period of increased capital misallocation (when investment in less-productive firms occurs at the expense of more-productive enterprises). Timidity by investors and loans to weaker firms that need to raise capital or risk default has led to the creation of “zombie firms” that persist due to fear that they would go under rather than a belief they are valuable investments. In short, the caution of lenders, in addition to policies that “impeded the growth of financially constrained firms relative to their less constrained counterparts” has led to an economy where creative destruction has been stalled and less-productive firms are taking capital that should be going to more-productive firms.
Other causes of low productivity growth highlighted in the report include factors that contribute to “secular stagnation” (a period of low or zero economic growth that isn’t caused by natural fluctuations in the business cycle). Among these is a lack of business dynamism among American firms — a phenomenon discussed more broadly in Tyler Cowen’s new book, The Complacent Class — particularly in the information and communication technology sector, which leads to a decline in spillover productivity gains in other sectors.
Other secular forces include an aging population, which may have slowed productivity gains by 0.2 to 0.5% per year since the 1980s. Coupled with low population growth, this presents a demographic hurdle that may be insurmountable, even in the long-term. Also noteworthy is a decline in the accumulation of “human capital” (decreasing improvements in educational attainment). Additionally, the slowing of the growth in global trade, both through failed efforts to increase trade liberalization and the maturing of China’s relationship in global trade, will further slow growth in the future.
This report comes on the heels of the IMF’s prediction in its Global Financial Stability Report that continued low returns on investment will further drive the transition from defined benefit to defined contribution retirement plans. As people live longer and interest rates remain stubbornly low, “the long vesting periods of employer-provided defined-benefit plans means that benefit cuts beyond a certain point could make them less competitive than defined-contribution plans, which offer more portability.”
If productivity fails to improve, investment returns will continue to lag, which spells trouble for retirement systems that need to maintain high rates of return. The report offers some policy recommendations, including increased spending on infrastructure (championed by the Trump Administration), improving healthcare outcomes to keep people in the workforce longer (also an issue the administration is committed to addressing), and improved migration policies in the form of greater immigration liberalization.
In the meantime, however, public sector pension systems should brace themselves for the new normal and base their funding policies on a more realistic investment return horizon.