Economic update March 2024: the productivity puzzle
Key points
- Australia’s productivity growth has shown signs of improvement following a period of weakness in 2022 and 2023.
- The pandemic is the main component for the dip in Australia's productivity growth.
- History shows us productivity fluctuations follow global crises and technological advances.
- AI could be the innovation that boosts productivity, but more investment will be needed to maximise benefits.
What is productivity growth?
In economics, productivity growth refers to improvements or increase in the efficiency of work or production, without a change in resources or output.
Productivity growth can result in better profit margins for business, and it can also help stimulate the jobs market. This means higher incomes and a better standard of living for people.
Australia’s productivity growth is starting to improve
In recent years, productivity growth in Australia has shown signs of improvement following a period of weakness in 2022 and 2023. This was put down to a variety of factors.
The transition to working from home (WFH) more often being a preferred option, responding to the strong demand for less-experienced workers in the labour market, and the increasing significance of service sectors in the economy – which, has historically been a challenging sector for growth.
Another suggested cause is the substantial increase in employed workers over the past few years hasn't been adequately matched by an increase in investment.
Manufacturing and utilities were two sectors that experienced the productivity slump
The productivity slowdown has been more evident in some sectors of the economy, such as manufacturing. Manufacturers were understandably not wanting to invest much in the 2010s when the Australian dollar was high and unit labour cost growth was strong due to the mining boom. Rising energy prices was another issue. Manufacturing investment jumped at the end of COVID, although the growth of capex budgets in the sector appears to be slowing.
Utilities was another industry that experienced slower productivity growth. Investment was flat in the sector for much of the 2010s, with a lack of political agreement on the direction of energy policy a likely factor. The result was ageing power stations needing a lot of maintenance. Investment in the sector has picked up strongly in recent years which should lead to a pickup in productivity.
Increased government regulation has affected all sectors, including Finance
Another cause put forward for weaker productivity growth has been the increase in government regulation. Businesses across all sectors of the economy have reported that regulation has been a bigger factor impacting business performance over the past 15 years, with the largest reported increase being in the Finance sector.
The global increase of regulation in Finance was a result of the Global financial crisis (GFC). Before the GFC, the Finance sector was fast growing across the world, with high productivity growth – but it wasn’t sustainable (this was less the case in Australia). The result is that regulators traded-off slower growth and lower productivity in the Finance sector for increased safety.
Skill shortages are also hitting productivity levels
Rising skill shortages could be another factor that holding back productivity growth. Unsurprisingly, all sectors reported more worker shortages in 2022 compared to the last cyclical low in the unemployment rate in 2007, when the unemployment rate low was around 4 per cent.
But most industries also reported a higher rate of skill shortages in 2019 when the unemployment rate was above 5 per cent.
Productivity fluctuations could be a sign of history repeating itself
But the main reason for the recent fluctuations in productivity growth, including the recent bounce, can be attributed to the disruptions caused by the pandemic. UK data illustrates similar large swings in productivity growth also occurred during the last major pandemic (Spanish Flu) in 1918-19.
The big picture is that productivity growth comes in waves, powered by technological advances that come into widespread use. We can see this in the history of UK productivity growth. Productivity growth was strong in the mid 1800s as the UK continued to enjoy the benefits of the Industrial Revolution. But those benefits gradually declined, and so did productivity in the last few decades of the 1800s. Productivity growth dropped sharply around the time of the First World War and the Spanish Flu pandemic, before bouncing back to the rates seen pre-World War One.
Productivity then boomed in the couple of decades post Second World War as large-scale investment based on the latest technologies (electrification, motor vehicles) replaced war damaged capital stock. Productivity began to slow in the 1970s as the benefit of these technologies began to diminish. The slowing was mitigated in the 1980s as economies initially benefitted from a number of factors including the entry of China and Eastern Europe into the global trading system and the widespread adaptation of personal computers.
Could AI be the technological advancement the world needs for productivity growth?
There is currently a lot of excitement that artificial intelligence (AI) might be the next big technological development that boosts productivity growth. There is no doubt that AI does have plenty of potential, and research suggests that productivity growth has improved in particular areas. More widespread productivity improvements will require further development of AI, as well as structural changes both within business and the wider economy.
If AI does end up being the next ‘big thing’ for productivity for Australia, it will require significant investment. Currently, Australia invests around half as much into software as the US (relative to the size of the economy). It is probably not necessary for Australia to invest as much as the US as they are the country at the technology frontier with the largest IT sector.
Maximum productivity benefits will be achieved if the adaption of AI occurs across the economy. The size of capex software budgets differs significantly across industries. Unsurprisingly, professional services (which includes the IT sector) has the biggest budget. But all sectors of the economy will need to invest more to maximize the productivity benefits. One key reason limiting the amount of software investment even within large firms is the lack of IT skills.
We really do live in interesting times.
