Investors should go where productivity growth is brightest

If this column is obsessed with the notion that demographics and productivity are the factors that shape a nation’s destiny – and in doing so dictate the returns produced by its stock market – then so be it. Sure, we can argue that other factors can be equally important; for instance, a nation’s geographic boundaries, its natural resources, the weight of its history and sheer good (or bad) luck. But it would be tough to argue that any of those are consistently more important.

Of those two main movers, demographics tends to be the driving force. A nation’s population profile more readily influences productivity than the other way around. That said, causality can be reversed. Faster productivity growth means more wealth creation and, as a nation becomes wealthier, its demographic profile changes; in particular, its age-dependency ratio shifts from the young to the old as children become more expensive to raise and wealth brings longevity.

Even so, productivity is the more mysterious factor and every economist knows of its importance. Not for nothing did Paul Krugman, a Nobel prize winner, say “productivity isn’t everything, but in the long run it’s almost everything”. Despite this, productivity remains a puzzle. No one quite knows why, for instance, some nations are more productive than other ostensibly-similar nations or why levels of productivity sometimes change rapidly.

That being so, it has to be interesting when a globally-renowned specialist in the field produces a paper that sheds some light. The author is Martin Neil Baily, a UK-born US-based economist who was chairman of the Council of Economic Advisers during Bill Clinton’s presidency. His Lessons from Productivity Research for the Brookings Institution – arguably the world’s best-known think tank – focuses on two aspects of productivity. First, it sheds light on the influence of just a few industries on productivity growth. Second, it examines perhaps the biggest productivity puzzle of them all – the startling decline of Japan.

Since productivity is a measure of the amount of output produced by a given level of input, conventional analysis tends to focus on the inputs and lumps them into four categories: natural resources (mostly land), capital (mostly via the equipment it buys), labour and – most mysterious – ‘total factor productivity’. In a sense, the last is a misnomer. Total factor productivity (TFP) has become that part of productivity growth that can’t be measured by changes in the other inputs. In a way, that makes it the stardust factor. It includes innovation, entrepreneurialism, je ne sais quoi, whatever. Everyone knows it is important, but no one knows precisely what it is.

Despite that, in 1957 Robert Solow, another Nobel prize winner, reckoned that about 80 per cent of the growth in labour’s productivity came from this residual factor. And Baily has been able to tease out which parts of the US economy contributed most to its growth in total factor productivity (TFP) for the period 1987 to 2019. Overall, he suggests that America’s total factor growth was 0.75 per cent a year and that almost all of it, about 85 per cent, came from just three industrial sectors – manufacturing, which accounted for nearly half the growth, retailing and wholesaling.

Digging down further, Baily finds that almost all of manufacturing’s increase in TFP came from the sub-sector for computers and electronics. While manufacturing TFP grew by 1.38 per cent a year, the computers sub-sector grew by 1.35 per cent – “a remarkable finding”, he says.

An intuitive response might be to say ‘what else would you expect’? After all, the success of America’s tech giants not only powers its stock markets but gives the anecdotal impression of powering the economy. True enough, yet it may not be that simple since, for example, the contribution of Amazon (US:AMZN) is not to the computers sector but to wholesaling and retailing. Similarly, the impact of Google owner Alphabet (US:GOOGL) and Facebook owner Meta Platforms (US:META) show up in the services sector, which showed only a miniscule rise in productivity over the 42-year period.

The difficulty might actually be one of measurement since Baily notes that some studies have found significant errors in the way specific digital goods or services were measured. Another study, from 2016, concluded that measurement errors were not large enough to change the chief findings about US productivity.

In addition, economists – much like investors – can become enamoured of technology, and tech’s effects on manufacturing are more readily evident and more easily measurable than its effects on many service industries, especially those that are light on fixed assets. Thus technology gets an important role in the study of productivity growth despite the fact that, as Baily notes, “the high-tech sector is small in all countries, even in the United States and Japan”.

Never mind the size, feel the quality; or, at least, the role of technology in raising productivity might be quite subtle. There is what’s labelled ‘hard technology’, which is basically the physical stuff that is available globally and can be bought by anyone. Then there is ‘soft technology’ or organisational technology. According to Baily, this “can be harder to transfer internationally and can depend on company-specific skills and culture”.

He cites the super-productivity of the Japanese auto industry which, in the 1990s, left its US equivalent, and even Germany’s, far behind. In particular, there is the familiar example of Toyota, whose productivity was enhanced by its work culture, the best-known elements of which were its practice of continuous improvement and its ‘keiretsu’. Continuous improvement did what it said by making incremental changes to designs and production processes, often based on suggestions from the shop floor. The keiretsu was the close relationship between Toyota and its web of suppliers, all of which were supposed to be working towards the goals of cutting costs and raising product quality.

The contrast between Japan’s best practices and the methods of the US auto industry was stark. To generalise, US carmakers maintained distance between themselves and their suppliers while usually having more than one company supply the same component. That put carmakers in a strong position to cut buying-in costs, but the squeeze it exerted on suppliers’ profits deterred investment and, in time, drove suppliers either out of business or into low-wage parts of the world.

Then again, US companies seem to do a lot of that, which might be what we should expect from a nation that runs on a version of capitalism that’s rather red in tooth and claw. Given that, however, we might also wonder why productivity levels in the US have been well-maintained over the post-war decades compared with other major nations (see the chart). While the US missed out on the surge in post-war productivity enjoyed by Japan and Germany, the decline in its pace of productivity growth has been much more sedate than those two. As a result, of the four nations shown in the chart, the 10-year rolling average for productivity growth is currently the highest – or should we say ‘least low’? – in the US.

Meanwhile, Japan’s productivity decline has been startling. Arguably, this is better illustrated by Table 1 than the chart. Its marvellous growth rates of the 1950s and 1960s were built on the combination of an economy running on newly built post-war infrastructure and a wonderful demographic dividend. Given that, productivity growth was always going to fade. However, in the 2010s growth was almost non-existent. In seven of the 14 years 2006-19 Japan’s productivity actually fell year on year. For a nation that still has so much going for it, one wonders, how did Japan actually manage that?

The other pertinent question is whether the UK is going in the same direction; granted, the two economies have important structural differences, in particular that too much of Japanese industry is sheltered from competition. But if so, Table 2 makes for miserable reading. The table juxtaposes Japan’s average annual productivity growth per decade against average changes in the Nikkei 225 index of Japanese equities. The volatile – but mostly falling – 1990s and 2000s are a reminder of what happens when investors fall deeply out of love with overhyped markets. Even the bounce-back in the 2010s is partial – at its current 27,600, the Nikkei index is still 30 per cent below the level at which it peaked 33 years ago.

For long-term investors wanting to sidestep such a prospect, the direction should be plain – go where the productivity growth looks brightest.