What If We Have It All Backwards?

Slow productivity growth is now recognised as not requiring tight monetary policy to keep demand in check. But what if tight monetary (and other) policies make productivity worse?

• Traditionally, economic theory has assumed that monetary policy is ‘neutral’ in the long run. That is, it can affect inflation, and short-run fluctuations in growth and the labour market but it has no implications for growth or unemployment in the long run. In Australia, the standard discourse also assumes that productivity growth is more or less fixed, or else determined by government policy. And until recently, it was assumed in many quarters that weak productivity growth meant that demand had to be constrained – by monetary and other policies – to match the weak growth in supply.
• What if we have it all backwards? A growing body of research suggests that tight monetary policy can in fact reduce long-run growth. One way this might happen is that by slowing demand, tight monetary policy reduces the incentive to invest, and thus the future capital stock and future productivity. This is on top of the ‘scarring’ effects on workers that we normally think of as long-run effects of recessions.
• We should not pick only on monetary policy here. Policies that reduce the incentive to invest in the right labour Skills and Smarts or labour-saving Stock of capital reduce future productivity growth. More broadly, we need to remember that Skills and Stocks are stocks, not flows. Short-run changes to the stock of something – whether a workforce, a capital stock or a housing stock – can have long-lasting effects on economic outcomes.

This week’s Productivity Roundtable (together with the pre-roundtable roundtables that preceded it) responds to growing concerns about slow growth in productivity and thus potential growth. There are many ways to boost potential growth: the Treasury ‘Three Ps’ of Population, Participation and Productivity. Recall that only the latter two unambiguously boost living standards, along with Price: what we get for what we sell to the world relative to how much we pay for the things we buy from the world. The recent downward revisions to the RBA’s assumptions about potential growth look to be equally split between a slowdown in trend growth in labour productivity (from 1.0%yr to 0.7%yr) and a slower rate of population growth (1.2%–1.3%) compared with the 1.5–1.6%yr rates typical in the years before the pandemic.

Recall also that labour productivity comes from labour Skills, the Stock of capital, and the Smarts involved in putting the two together (multifactor productivity). Any of the deeper drivers of productivity – be it the level of competition, regulation, technology or tax – work through one or more of these three aspects of productivity.

It has long been known that deep downturns stemming from wars and financial crises have long-running effects on future growth potential. Destruction of capital, or lack of funding for investment both weigh on the capital stock. This is on top of the long-recognised effects of deep downturns on the labour market – the ‘scarring’ effect of long-term unemployment, or of entering the labour market at the wrong moment.

More recently, it has been recognised that this kind of path dependence does not only apply to the deep downturns borne out of crisis. Some research finds that downswings in the business cycle more generally do not end with a strong cyclical bounce-back to the prior trend. It can be a slow grind, never quite getting back to the previous path.

A growing body of research (for example, here, here, here and here) also suggests that tight monetary policy affects potential growth and productivity. One way this can happen is by influencing investment decisions, which would add to the capital stock. While studies do not typically find that the level of interest rates helps predict investment directly, it does affect the level of demand. This in turn affects investment because there has to be a market for the output to make the investment worthwhile. A separate but related mechanism involves the re-allocation of capital to the most productive uses.

We can see, then, why an extended period of weak demand is so toxic: by discouraging current investment or shifts of capital into the most productive uses, it reduces the capacity to meet future demand. The fires of recession (and plain old soggy growth) are not cleansing – they are just destructive. Unfortunately, the same literature generally finds that loose monetary policy does not directly add to capacity in the long run, though a short-run boost to productivity from reallocation is implied by some models.

This is why the RBA’s pivot to no longer believing that weak productivity growth requires it to tamp down demand is so consequential – and so welcome. That change of heart avoids what could have become a significant policy error.

We should not only pick on monetary policy here. Other policies might also contribute to a low productivity growth malaise. Consider the skilled migration program. While it is widely admired as being targeted on skills shortages and effective in its operations, an issue arises where a skill shortage is defined to be any moment where you cannot find the right person at the current wage. If you can obtain an essentially infinite supply of people with the necessary skills from offshore at the current wage rate, why try to entice the local worker with a somewhat higher wage? And more to the point, why train local workers, or invest in labour-saving capital when you can always get someone from offshore at the current wage rate?

This suggests that it would help to set the bar for defining a skills shortage higher than the current wage rate. That would let local market forces take some of the adjustment. It would also ensure that firms sometimes have an incentive to invest in labour-saving technology – the Stock of capital – or better processes – the Smarts around how labour and capital combine.

The broader point here is that policy discussions need to allow for long-running consequences coming from things that are a stock – a quantity at a point in time like the number of workers with a particular skill, or the number of homes – rather than a flow, such as the amount of consumer spending in a quarter. The Stock of capital and the Skills of workers are stocks of this kind. The Smarts of the way we design our business processes are also long-lasting. Flows, by contrast, are inherently more ephemeral.

Getting things wrong with the stocks is far more consequential than the problems that many current policy proposals are designed to fix.