Does productivity still matter?

Featured Image: Photo by Ravi Roshan on Unsplash

By Vania Sena (University of Sheffield)

As we start the seventh week of lockdown, it is probably a good time to take stock of the impact of the COVID-19 outbreak on the economy. So, what has happened so far? The outbreak has generated a contraction of the aggregate demand worldwide which according to almost all commentators will be even larger than the one experienced during the 2008-2009 financial crisis. Initial estimates from the OBR suggest that, in the UK social distancing measures may result in up to 35 percent drop in economic activity during the second quarter and a yearly contraction of anything between 7% and 15%, depending on the speed of recovery. Revenues have disappeared from one day to the other in a number of industries and reserves have been dried up to pay salaries, many of which are being covered by government schemes.

Unsurprisingly, the priority for the government has been to stabilize the economy where possible. However, the question more people are now asking is: what are the implications of COVID-19 for the long-term growth prospects of the economy? The UK economy will need to grow at a rate that allows it to address the challenges associated with the management of large government debt while improving the performance of the labour market. This would require a strong recovery in productivity growth to a level that predates the 2008 financial crisis. In addition, the characteristics of COVID-19 (i.e. the fact that the current outbreak is not a one-off but several outbreaks are expected for the next eighteen months) implies that building up the foundations for strong productivity growth is intertwined with building up resilience in the economy. In other words, building up resilience in the economic system has to become one of long-term objectives of economic policy along with strong productivity growth.

But what is resilience exactly? According to the definition from a dictionary, resilience refers to the ability of individuals or organizations to recover quickly from shocks. However, in the context of COVID-19, it has become clear there is no consensus on what resilience implies in practice. We all agree that public services need to build up excess capacity to be able to cope with future outbreaks; at the same time, it has been argued that excess capacity will be artificially generating inefficiencies that may eventually hamper productivity growth. Is this really the case?

Let us start from the fact that productivity may grow because of technological progress and of changes in efficiency; in turn these can be spurred by changes in the scale and scope of operations as well as variations in the usage of inputs. Importantly, organizations do not need to experience all of them to be able to increase their efficiency: for instance, for a given level of inputs’ usage, efficiency can be improved by changing the scale of the operations or its operations. In other words, developing excess capacity to be able to cope with future outbreaks implies rethinking the size and scope of the organizations. Increases in the scale of operations in such a way that organizations may find themselves exploiting increasing returns to scale may be helpful to increase efficiency while smart diversification or consolidation of activities increases the conditions to exploit economies of scope which can translate into efficiency gains, for a given level of capacity (whether in excess or not). So, large organizations with excess capacity can be better positioned to generate the productivity growth that the economy needs as well as to cope with the costs associated to excess capacity.

What are the implications of all this for economic policy? On the one hand, we will see an increase in concentration in some industries as large and productive firms will end up dominating a number of industries (where economies of scale and scope will permit it). Clearly, there is scope for regulators to monitor the process to ensure that building up resilience does not translate into inefficient outcomes for consumers and suppliers. On the other hand, there is a need to develop a fresh approach to business support. Clearly a model where large and productive firms are surrounded by micro firms (whether suppliers or competitors) which cannot cope with major shocks is not sustainable in an economy where resilience is a key objective. In this case, the sustainable scaling up of micro firms is the policy priority: all the standard tools of industrial policies (from finance to business support programmes) need to be geared towards companies that have the potential for scaling up and thrive so that industries can be dominated by a mix of firms which can be productive and resilient at the same time.

The bottom line is that productivity growth as a policy goal still matters but more importantly, aiming for productivity is not at odds with creating a resilient economy which can cope with major economic shocks.