Labour productivity
Labour
productivity
(essay)
Abstract
The analysis in this paper dismisses
the notion of a genuine trade-off between employment and productivity growth.
Obviously, misguided policies to exploit such a trade-off have to be avoided.
However, there are no reasons to think that structural labour market reforms
boosting employment will typically entail negative implications for longer-term
productivity growth. The dynamic response of productivity to positive labour
supply and wage shocks may entail a temporary reduction in productivity growth
rates, which, in principle could be considered as benign; anyway, the size of a
negative effect of this type is estimated to be fairly small. In particular,
this paper reaches the following conclusions: (i) The increase in employment
since the mid 90s has indeed been to a significant extent the result of such
positive labour market shocks, with about one half of the additional jobs
attributed to structural improvements; (ii) Positive employment shocks can only
account for a very small fraction of the observed productivity slowdown;
consequently, the decline of labour productivity growth must be considered as
predominantly caused by other factors and probably not just a temporary
phenomenon.
1.
Introduction
The so-called Lisbon strategy
involves efforts on several fronts both to improve labour market performance
and to raise productivity growth in the EU. This twin aspiration is neatly
summed up in the phrase ‘more and better jobs’, which implies higher employment
rates but also more productive, higher-quality employment.
The strategy sets explicit targets
for ‘more jobs’: an employment rate of as close as possible to 70% and a female
employment rate of over 60% by 2010. The Stockholm summit a year later added a
further target of an employment rate of 50% for older working-age people. Given
the rate of employment growth required to meet these targets, the Lisbon
conclusions also established an implicit target for productivity growth with
the statement that - if the recommended measures were implemented against a sound
macroeconomic background - it should be possible to achieve 3% GDP growth.
These targets have met with
criticism in some quarters on several counts. Some regarded them as
over-ambitious, particularly since the European Council (as opposed to
individual Member States) lacks full control of the necessary instruments to
meet its objectives. There were doubts about whether a credible strategy had
been set out, or even whether EU leaders realised the extent of the reforms
that would be required. Others pointed to the risk of policy distortions -
there are many ways to raise employment rates, for example, but not all of them
are fully consistent with raising economic welfare. On the other hand, the
Lisbon targets appeared to score an initial public relations success, being
widely interpreted as a signal that the EU was taking economic reform
seriously. (Even then, however, it was noted that this might damage the
credibility of similar exercises were the targets to be missed by a wide
margin.)
Two clear advantages of the Lisbon
strategy, and especially the employment rate targets, are often overlooked in
these discussions. First, the commitment to raising employment rates (i.e.
raising labour force participation as well as reducing unemployment) represents
a clear rejection of an idea that has been one of the great weaknesses of
European employment policy in recent decades, namely that high unemployment can
be cured by discouraging labour supply. If this seems obvious today, it is not
so long ago in some countries that married women were discouraged from working,
while older workers were actively encouraged to quit the labour market through
early retirement schemes, partly in response to high unemployment. Even more
recently, governments in some EU Member States were entertaining a similar
notion - that employment in persons might be boosted by means of regulatory
restrictions on hours worked.
Secondly, the Lisbon strategy
embodies the idea that structural improvements in the functioning of markets
are required for a sustained increase in employment rates and higher
productivity growth. Clearly, at any given moment, output and (un-)employment
are determined by real demand in the economy. However, over the longer term,
real demand will generally tend towards a level consistent with stable
inflation, this level being determined by overall supply conditions in the
economy. By focusing on the functioning of labour, product and capital markets,
as well as investments in R&D and human capital, the Lisbon strategy seeks
to raise employment and growth potential in a sustainable manner.
In addition, while one may ask
whether the employment rate is the ideal variable to target, there is no doubt
that low employment rates in several EU Member States are a symptom of poor
labour market performance, and that improving labour market performance would
lead both to higher employment rates and to greater economic welfare. The
benefits of higher employment rates for the sustainability of the public
finances (at least in the short-to-medium term) were also noted.
Against this background, this paper
focuses on a crucial question for the strategy of ‘more and better jobs’:
whether and in what sense there are trade-offs between employment growth and
productivity growth. Concern has been raised in some quarters that raising the
employment rate in the EU will result in lower productivity growth. Indeed,
there is a grain of truth in this: a rising employment rate implies that
productivity growth will be temporarily below full potential, simply because
the number of workers per unit of capital is increasing. In addition, those who
move from unemployment or inactivity into employment are likely, on average, to
have a relatively low level of productivity, at least at first.
However, there are three reasons why
this is not a cause for concern. First, the temporary negative effect on
productivity growth is estimated to be rather small. Secondly, even if growth
in productivity - GDP per employed person - is negatively affected, a higher
employment rate unambiguously raises growth in GDP per capita in the short
term. Newly employed people clearly contribute more to GDP than they used to,
even if their productivity is below average. Thirdly, there are few reasons to
think that a higher employment rate has any negative implications for
longer-term productivity growth, which is what really matters for the
competitiveness and dynamism of the EU economy. These points -important ones
for the Lisbon strategy - are supported by two separate pieces of analysis: an
econometric analysis of the dynamic response of productivity to structural
employment shocks, and a simulation based on the Commission’s macroeconomic
model. Thus, there is no genuine trade-off - in the sense of prioritising one
of the two - between policies to raise the employment rate and policies to
foster productivity growth.
2. More and better jobs - an
example of goal inconsistency?
2.1 Background considerations
At the moment, EU GDP per capita in
purchasing power parities is around 70% of the US level, with 1/3 of the gap
due to productivity differentials and 2/3 due to a lower labour input (i.e. a
lower employment rate and hours worked compared with the US). Consequently,
improving the EU’s productivity performance and raising employment is
fundamental to increasing the long-term growth potential of the EU economy.
However, several observers have argued that the twin goals of raising both
employment rates and productivity growth may be difficult, or even impossible
to pursue simultaneously, given a perceived negative trade-off between
employment and productivity.
The basic argument for the existence
of a negative relationship between employment and productivity is derived from
straightforward comparative-static reasoning. For any standard production
function, average factor productivity will decrease with rising output as the
expansion of production will require the bringing in of less and less
productive factors into operation - less fertile soil, older and less efficient
equipment and machinery, workers with lower abilities and skills, etc. Then,
obviously, higher employment will inevitably be associated with lower output
per worker and vice versa. Thus, in such a comparative-static setting it is
easy to construe a situation where, for example, regulations and restrictions
excluding low productivity workers from employment result in a higher level of
actual labour productivity, but it will come at the price of lower employment;
similarly, reform efforts to price back low productivity workers into
employment will mean more jobs, but this will be associated with lower overall
productivity.
In comparing labour productivity
levels across countries, such considerations of a comparative-static nature can
be useful. There appears to be widespread agreement that measured labour
productivity in Europe relative to the US may be upwardly biased as a result of
the exclusion of more low productivity workers. Indeed, the EU employment rate
falls short of the US level by some 10 percentage points, with lower
participation rates and higher unemployment rates disproportionately affecting
low skill workers. In a similar vein, the capital-labour ratio appears to be
typically higher in the EU than in the US, driving up measured labour
productivity in Europe. Thus, both economic theory and a quick inspection of a
few aggregate figures suggest that one should control for these effects in
productivity comparisons. Obviously, in consequence, a Europe at full
employment may well see a significantly larger labour productivity gap vis-à-vis
the US than the current actual figures suggest.
By how much could the productivity
gap rise? A simple calculation could be performed focussing on comparisons of
total factor productivity levels, using the following relationship:
(1)Y/L = (K/L)1-α
. TFP
Graph 1: TFP and labour
productivity gap
Source:
Commission services
However, the notion of a negative
relationship between employment and productivity levels emerging in
comparative-static considerations should not be confused with a genuine
trade-off between employment and productivity in a long-run dynamic sense. One
of the “big” stylised facts in economics is that in the long run technical
progress is neutral with respect to employment. History has told us that the
process of capital accumulation and technological innovation has not meant the
“end of work” and despite notions of “factories without workers”, it is clear
that from an overall perspective workers have not been replaced by machines. In
standard economic growth theory this long-run neutrality proposition has been
captured by the concept of labour-augmenting technical progress. Along this
balanced growth path, labour productivity, real wages and the capital intensity
of production grow at the same rate, driven by (exogenous) technical progress.
Technical progress is called total factor productivity growth, indicating that
this concept should not be seen in a narrow “engineering” sense. Given that TFP
determines our standards of living in the long run, clearly policy makers want
it to grow faster than in recent years.
Actual labour productivity growth
can of course deviate from the balanced labour productivity growth rate over
the short-to-medium term due to capital-labour substitution; faster than
“balanced” productivity growth indicates labour shedding, and a shortfall of
actual relative to “balanced” productivity growth is a characteristic of what
is loosely called labour-intensive growth. Obviously, then, the employment
neutrality hypothesis will not hold over the short-to medium term. In
consequence, pressing ahead with labour market reforms may entail a temporary
reduction in measured productivity growth below full potential, but this should
not be regarded as a trade-off in any sense. A higher employment rate implies
an unambiguous increase in GDP per capita with no negative implications for the
long-run productivity growth of the existing workforce. Thus, there is no
inherent problem to act on both fronts simultaneously, raising the “balanced”
rate of productivity growth using all the available instruments to stimulate
TFP growth, whilst at the same time encouraging the labour-intensive growth in
the medium term that is needed to move towards full employment.
2.2
The dynamic employment-productivity relationship in recent years
EU employment and productivity
growth patterns have diverged sharply over recent years. Compared with the
first half of the 1990’s, the period since then has witnessed a significant
increase in the contribution of labour to EU GDP growth but unfortunately this
has been accompanied by a reduction in the contribution from labour productivity,
with labour productivity growth having come down by about one percentage point.
From a purely growth accounting perspective, the 1 percentage point decline in
EU labour productivity emanates from 2 sources. Firstly, 50% can be
attributed to a reduction in the contribution from capital deepening i.e. lower
investment. Secondly, the remaining 50% appears to emanate from a deterioration
in total factor productivity i.e. a decline in the overall efficiency of the
production process. On top of this, cyclical conditions are estimated to have
depressed annual labour productivity growth by around 0.5 percentage points in
recent years.
By comparison, over the same
timeframe, the US has been able to combine a strong employment performance with
acceleration in labour productivity growth. Against this background, this
section investigates to what extent the recent slowdown in labour productivity
growth may merely reflect a response to a series of positive shocks to labour
supply and jobs emanating from structural reforms and employment-friendly wage
developments.
Graph 2, as a starting point for the
analysis, decomposes labour productivity growth into its two components, with
the US and the Rest of World included for comparison purposes. The productivity
growth slowdown is evident, with the EU’s long established superiority in terms
of labour productivity growth having disappeared over recent years.
Graph 2:
Decomposition of Labour Productivity Trends
The benign interpretation of the
observed productivity growth trends sees the recent deterioration in
performance mainly as the mirror image of structural labour market
improvements. Under this view the EU may now simply be in a transition phase
whereby wage moderation and positive labour supply shocks may have initially
created a negative trade-off between employment and productivity growth,
basically via a temporary decline in capital-labour substitution. However, the
dynamic adjustment path towards a new equilibrium with higher employment and
lower structural unemployment will also involve capital accumulation that
should eliminate the trade-off over the medium-term. The more pessimistic view,
on the other hand, is that the labour productivity growth slowdown reflects a
genuine negative shock, either in the form of a decline in total factor
productivity growth or additional pressures on capital productivity; clearly,
in such a scenario, prospects for a recovery of labour productivity growth are
much bleaker.
Obviously, both interpretations are
likely to contain an element of truth, posing the analytical challenge to
derive inference on the relative magnitude of the employment and productivity
shocks and their respective consequences for overall productivity and
employment developments. The picture is complicated by a third possible factor,
namely aggregate demand. Both fiscal consolidation and precautionary household
savings could have contributed to a decline in growth and, in particular, of
productivity growth.
We have employed both a structural
VAR analysis and a simulation using the Commission’s QUEST model to study these
three shocks, shocks to employment, shocks to productivity and shocks to
aggregate demand and to measure their relative importance for productivity and
employment. What is of specific interest in the context of this paper is the
dynamic response of productivity to structural employment shocks. In technical
terms, we use a structural VAR (SVAR) methodology, based on Stock and Watson
(1988) and Blanchard and Quah (1990), for the identification of structural
shocks. The intuition for shock identification in Blanchard and Quah is based
on the idea that demand shocks only have temporary effects while supply shocks
have permanent effects. Stock and Watson extend this approach and allow for
separate supply contributions from labour and productivity (TFP). In order to
identify different supply contributions, namely those coming from employment
and those coming from productivity, additional identification criteria must be
introduced. Stock and Watson use long run restrictions implied by the
neoclassical growth model for that task. The neoclassical growth model appears
to be suitable, since there are at least three important features in the long
run trends which are compatible with this model:
· A close trend
correlation between the growth of labour productivity and capital intensity.
· Capital intensity
and productivity grow at a similar rate in the long run.
· If one looks over
long periods of time and across the EU and the US, the employment rate appears
to be unrelated with productivity growth.
Using the neoclassical growth model
this leads to the imposition of the following long run restrictions:
· The labour market
shock can have short and long run effects on employment, productivity and
inflation.
· The productivity
shock can have long run effects on productivity and inflation but only short
and medium run effects on employment. This constraint arises from the
assumption that real wages are indexed to productivity in the long run.
· The demand shock
can have a long run effect on inflation only but not on employment and
productivity. No long run constraint is imposed on inflation.
and the vector, then the
moving average representation of this model is given by:
with
where the matrix A(1) shows the long
run restrictions. Note, this particular structure is particularly suited to
test for the short, medium and long run effects of an employment shock.
Allowing for a non-zero long run productivity effect of an employment shock
allows one to test for labour quality effects associated with a permanent
change in the employment rate. A similar analysis of the employment effects of
productivity shocks has been conducted by Gali (1999).
The empirical results are presented
in two steps. In step one, the impulse responses from the estimated VAR are
presented. These responses give the impact on employment and productivity of a
unit shock to employment, productivity and demand. Recall that the identifying
restrictions imply that temporary unit shocks to employment can have permanent
effects on employment and productivity, while a unit shock to demand
(inflation) can only have temporary effects.
In order to evaluate the
quantitative magnitudes of these shocks, they are compared to similar shocks
simulated with the Euro area QUEST model. This comparison is useful since it
shows whether orders of magnitude from these shocks are similar when two very
distinct empirical tools are used, with the VAR model imposing very little
economic structure (apart from the long run constraints), while QUEST consists
of explicitly estimated structural equations and estimated adjustment lags.
· Employment shock: A
positive employment shock initially leads to an increase in productivity;
however, this short run positive effect in the VAR model is partly spurious. In
the medium and long run the effect on productivity is negative, i.e. an
increase in employment is associated with a decrease in labour quality. Note,
though, that this negative long run effect is estimated to be small: a shock
which leads to a permanent increase in the level of employment of about 1% is
associated with a long run productivity level effect of about -0.1%. Analysis
based on QUEST model simulations yields fairly similar results to the VAR
approach, but the negative impact upon the productivity level is slightly
stronger (-0.3 instead of -0.1) over the medium term; moreover, the QUEST model
analysis does not reveal any short run increase in productivity.
· Productivity shock:
A positive productivity shock is associated, in the short-run, with a small
negative employment effect. The order of magnitude of the employment effect is
only about one tenth of the size of the productivity shock. By implication,
this analysis suggests that a structural slowdown in labour productivity growth
will, by itself, not be associated with an expansion of employment. Again, in
the QUEST model analysis a qualitatively similar pattern to the VAR emerges,
but the short-run negative employment response appears to be somewhat stronger.
· Demand shock: The
demand shock is initially associated with a positive employment and
productivity effect. This result appears quite plausible, since a demand shock
is likely to lead to better capacity utilisation in the short run. As the
demand effect fades away and employment is slow to adjust, the productivity
effect turns negative and dies out within a year.
Graph 3:
Impulse response analysis
3a)
Employment shock
3b) Productivity shock
3c)
Demand shock
Graph
4: QUEST analysis
4a)
Employment shock
4b)
Productivity shock
In the second step of the empirical
analysis, the shocks are cumulated over the period 1995q1 to 2003q4 in order
to derive an estimate for the structural component in employment growth and its
likely impact on productivity and vice versa. The results of this exercise are
depicted in Graph 5. The cumulated size of the employment shock over the period
1995-2003 is estimated at about 5%. Thus, roughly one half of the overall
observed employment expansion over that period is attributed to structural
trend improvements. According to the VAR approach the cumulated productivity
cost of this structural employment expansion may have amounted to
¾ of a percent; the QUEST model
simulations would put the productivity cost somewhat higher at
1 ½ per cent. Roughly translated into
year-on-year figures using a mid-point between the VAR and QUEST estimates,
this implies a reduction in annual productivity growth of around two tenths of
a percentage point, equivalent to some 20 % of the observed total productivity
growth slowdown, which could be attributed to positive structural shocks in the
labour market.
Graph 5: Cumulated euro area
employment shock 1995 Q1 to 2003 Q 4
A further interesting result of the
VAR model relates to the question of the structural versus temporary nature of
the productivity growth slowdown. Based on the underlying assumptions on the
short, medium and long term impact of the various shocks, the VAR model
attributes most of the decline in productivity to a structural trend decline in
productivity growth. As can be seen from Graph 6, the autonomous shock to
productivity explains a decline in the level of productivity of almost 5%,
which would translate into an annual average productivity growth rate effect of
the order of -0.6 percentage points. This is fully consistent with the growth
accounting result given earlier of a decline in TFP of the order of a
½ a percentage point, with TFP
considered to be a reflection of the structural component of the productivity
trend.
Graph 6 also indicates that the
autonomous productivity shock is unable to explain the increase in employment.
Therefore, it is necessary to look separately at both shocks in order to give a
complete picture of both the employment and productivity developments. However,
concerning productivity, the overall conclusion from the analysis suggests that
the decline in productivity growth is to a large extent structural in nature.
Graph 6: Cumulated euro area
productivity shock 1995 Q1 to 2003 Q 4
The empirical results presented
above are quantitatively broadly in line with other available evidence on
structural labour market improvements as indicated by a trend increase in
participation and a reduction in structural unemployment. Moreover, relating
the productivity effect to real wage moderation also suggests that the
estimated impact on short-run productivity developments is of a reasonable
order of magnitude. A stylised number for real wage moderation in the past 10
years or so would put the average annual reduction in real efficiency wages at
slightly less than ½ a per cent. Thus, back-of the
envelope calculations would suggest that real wage moderation could, on
average, have reduced annual actual labour productivity growth relative to its
balanced steady-state rate by about two tenths of a percentage point, which is
well within the range derived from the VAR and QUEST model approaches. Further
corroborating evidence stems from growth regressions suggesting that about 25%
of the productivity decline is due to the increase in employment.
In summary, and recalling that the
overall slowdown in average annual productivity growth has amounted to about
one percentage point, it emerges as a fairly robust result that only some 20 %
of this reduction can be attributed to the dynamic response of productivity to
positive structural shocks in the labour market.
3.
Conclusions
In a nutshell, the analysis in this
paper dismisses the notion of a genuine trade-off between employment and
productivity growth. Obviously, misguided policies to exploit such a trade-off
have to be avoided. However, there are no reasons to think that structural
labour market reforms boosting employment will typically entail negative
implications for longer-term productivity growth. In particular, this paper
reaches the following conclusions:
•The negative relationship between
productivity and employment in comparative-static considerations should not be
interpreted as a genuine trade-off.
•However, all else equal, a move
towards full employment is likely to see a widening of the labour productivity
gap between Europe and the US.
•The dynamic response of
productivity to positive labour supply and wage shocks may entail a temporary
reduction in productivity growth rates, which, in principle could be considered
as benign; in any case, the size of a negative effect of this type is estimated
to be fairly small.
•The increase in employment since
the mid 90s has indeed been to a significant extent the result of such positive
labour market shocks, with about one half of the additional jobs attributed to
structural improvements.
•Positive employment shocks can only
account for a very small fraction of the observed productivity slowdown;
consequently, the decline of labour productivity growth must be considered as
predominantly caused by other factors and probably not just a temporary
phenomenon. Indeed, a cyclical pick-up in labour productivity growth after the
recent period of weak output growth should not divert attention from the
“deeper” structural problem of a slowdown in trend productivity growth.
The implications of the above
findings for the Lisbon strategy are straightforward: Indeed, “the more jobs
the better” may serve as a simple catch-phrase characterising the principal
goal of labour market reform efforts since there is no genuine trade-off - in
the sense of a difficult decision to be made - between policies to raise the
employment rate and policies to foster productivity growth. Of course,
misguided policies attempting to exploit such a trade-off have to be avoided -
if, for example, policy-makers promoted sectors with low productivity growth
prospects, if they introduced unnecessary regulations leading to “over
manning”, if they discouraged young people from pursuing further education, or
if they used funds for public training programmes in an unproductive manner,
then employment might be raised at the expense of longer-term productivity
potential. However, none of these policies is advocated in the EU’s economic
and employment policy framework and, in consequence, the employment strategy
should not be blamed for the dismal productivity performance in recent years.