The secret of productivity growth is not technology

This article is brought to you thanks to the collaboration of The European Sting with the World Economic Forum.

Author: Philipp Carlsson-Szlezak, Global Chief Economist, Boston Consulting Group & Paul Swartz, Director and Senior Economist, BCG Henderson Institute

• Technology fuels productivity growth but tight labour markets provide the spark for this growth because firms typically need to make better use of technology when hiring new employees is not possible.
• The tight labour market conditions that can spur productivity growth tend to be localised and so economies benefit in different ways and at different rates.
• Policymakers should view tight labour markets as both a risk and an opportunity to see productivity grow.

The idea that technology drives productivity growth is both a commonplace and a common frustration. Economies operating at or near the technological frontier have long seen sagging trend growth rates despite marvellous technology – from artificial intelligence to bioengineering to robotics – proliferating at breakneck speed.

This matters because productivity, or output per input, pays for higher wages and is the foundation of long-run prosperity. In that sense, it matters most in rich economies where higher productivity growth would allow political debates to shift from (re-)distributing a relatively stagnant economic pie to sharing a growing one.

Yet, there is an often-overlooked factor in the debate about technology and growth. Yes, technology undoubtedly plays a critical role, but we should think of it as the fuel of productivity growth. The spark is provided by tight labour markets, i.e. when firms are forced to better utilise technology because they cannot add labour easily.

So how can cyclical tightness spur productivity growth? Which types of economies are set to benefit from this relationship? And why should policymakers see tight labour markets as both an opportunity and risk?

[Technology is] the fuel of productivity growth. The spark is provided by tight labour markets—Philipp Carlsson-Szlezak, BCG & Paul Swartz, BCG Henderson Institute

Understanding the spark of productivity growth

Availability is often not enough to prompt broad adoption and utilisation of technology – integration can be costly and there may be implementation risks. It is often easier for firms to continue to grow with the next incremental hire.

When labour markets are tight and wage growth runs above long-run trends, however, firms will face downward pressure on margins even when revenue is growing. Such a pressure cooker economy can force executives, managers and workers to adopt and better utilise existing technology, instead of looking to an expensive labour market for extra capacity.

The charts below back up this observation. The chart on the left correlates more than 60 years of US business investment (relative to its 5-year average) with 5-year productivity growth. If simple availability and investment in technology drove productivity, we would see a relationship, but that is not the case.

Contrast that with the chart on the right, which correlates US labour market tightness (i.e. unemployment relative to the level of “full employment”) with productivity growth. It does show a clean relationship. Clearly, when it’s hard to hire, something stirs in how productively the economy operates.

The fuel of productivity growth is global, but the spark is local

While the frontier of technology can diffuse around the globe through trade and global value chains, the labour market conditions that provide the spark for adoption are far more localised. This means that productivity growth may diverge in countries with similar technological capabilities.

Rapid tightening – or loosening – of labour markets can occur as the byproduct of strong cyclical dynamics (such as the recovery currently underway). Or it can happen as the result of the structural organisation of local labour markets. In other words, economies have different capabilities when it comes to harnessing the nexus between labour market tightness and productivity growth.

What is competitiveness?

What is economic competitiveness? The World Economic Forum, which has been measuring countries’ competitiveness since 1979, defines it as: “the set of institutions, policies and factors that determine the level of productivity of a country.” Other definitions exist, but all generally include the word “productivity”.

The Global Competitiveness Report is a tool to help governments, the private sector, and civil society work together to boost productivity and generate prosperity. Comparative analysis between countries allows leaders to gauge areas that need strengthening and build a coordinated response. It also helps identify best practices around the world.

The Global Competitive Index forms the basis of the report. It measures performance according to 114 indicators that influence a nation’s productivity. The latest edition covered 141 economies, accounting for over 98% of the world’s GDP.

Countries’ scores are based primarily on quantitative findings from internationally recognized agencies such as the International Monetary Fund and World Health Organization, with the addition of qualitative assessments from economic and social specialists and senior corporate executives.

Explore the full report

Consider the difference between Europe and the US, two advanced economies that operate at the technological frontier. The US is set to benefit from a tight labour market as the lack of easy labour is already forcing firms to invest and reinvent their businesses and processes. This will underpin not only faster growth, but also allow workers to claim a growing share of output.

In Europe, the recovery is more modest and the labour market is less flexible, making a bidding war for labour less likely. If Europe can only protect but not engender flexibility in the labour market, the recovery gap versus the US will widen because the spark for greater technology adoption and utilisation will be less powerful.

Economies differ in their capabilities to harness the nexus between labour market tightness and productivity growth.—Philipp Carlsson-Szlezak, BCG & Paul Swartz, BCG Henderson Institute

Balancing the risks and benefits of tight labour markets

Ignoring the benefits of tight labour markets could come at a cost for policymakers and executives. Take once more the US economy. It is on a path to achieving higher output in 2024 than was once expected pre-pandemic, i.e. “overshooting” its old trend path. Owing to strong and sustained fiscal stimulus, the rapid return to labour market tightness has been framed as an inflationary threat. Often a picture is painted of an impending wage-price spiral and a Federal Reserve falling behind the curve and smothering the cycle once forced to raise rates to reign in price growth.

Our own view has been that the price growth of recent months relates to transitory mismatches as the economy reopens. Our bigger concern, however, is that a narrow view of labour market tightness (i.e. focusing only on the risks) will carry costs.

The benefits of a hot economy, as outlined above, represent as much a macroeconomic opportunity as a threat – two dynamics that need to be balanced. Part of this balancing act is acknowledging that tight labour markets push productivity growth and thereby can expand an economy’s capacity. This would actually narrow the dreaded overshoot, even as economic activity remains strong.

The benefits of a hot economy represent as much a macroeconomic opportunity as a threat – two dynamics that need to be balanced.—Philipp Carlsson-Szlezak, BCG & Paul Swartz, BCG Henderson Institute

For firms as much as for policymakers, it could be a mistake to look at the pressures of a hot economy as all bad. In many ways, firms that fail to engage in technology adoption and utilisation are like policymakers who end a hot cycle before its benefits can unfold. The strongest outcome will likely be when cyclical pressure is kept up for an extended period. This will require a view that embraces the benefits of a tight economy alongside its risks.