New research uncovers how three waves collided to create historically low productivity growth but find the potential for it to recover to 2 per cent or more.
Nine years into recovery from the Great Recession, labour-productivity-growth rates remain near historic lows across many advanced economies. Productivity growth is crucial to increase wages and living standards and helps raise the purchasing power of consumers to grow demand for goods and services. Therefore, slowing labour productivity growth heightens concerns at a time when ageing economies depend on productivity gains to drive economic growth. Yet in an era of digitization, with technologies ranging from online marketplaces to machine learning, the disconnect between disappearing productivity growth and rapid technological change could not be more pronounced.
In this report, we shed light on the recent slowdown in labour productivity growth in the United States and Western Europe and outline prospects for future growth.
How micro patterns offer additional insight into the aggregate productivity slowdown
Why productivity growth is declining in advanced economies
What a sector view reveals about the slowdown and outlook
How to capture the 2 per cent or more productivity potential of advanced economies
While there are many schools of thought, we find three waves collided to produce a productivity-weak but job-rich recovery, with productivity growth falling on average to 0.5 per cent in the 2010–14 period compared to 2.4 per cent a decade earlier.
These three waves are the waning of a productivity boom that began in the 1990s, financial crisis aftereffects including persistent weak demand and uncertainty, and digitization. The third wave, digitization, is fundamentally different from the first two because it contains the promise of significant productivity-boosting opportunities, yet the benefits have not materialized at scale. This is due to adoption barriers, lags, and transition costs such as the cannibalization of incumbent revenues.
As the financial crisis aftereffects recede and more companies adopt digital strategies and solutions, we expect productivity growth to recover. We calculate that the productivity-growth potential could be at least 2 per cent per year across countries over the next decade.
However, capturing the productivity potential of advanced economies may require a focus on promoting both demand and digital diffusion in addition to more traditional supply-side approaches. Furthermore, continued research will be needed to better understand and measure productivity growth in a digital age.
Labour-productivity growth has been declining across the United States and Western Europe since a boom in the 1960s, and it decelerated further after the financial crisis to historic lows (Exhibit 1). The extent of the recent decline varies across our sample of countries. Sweden and the United States experienced a strong productivity boom in the mid-1990s and early 2000s followed by the largest productivity growth decline, which began even before the crisis. France and Germany started from more moderate levels and experienced less of a productivity-growth decline, with most of the decline occurring after the crisis. Productivity growth was close to zero in Italy and Spain for some time well before the crisis, so severe labour shedding after the crisis actually accelerated productivity growth. While productivity growth has started to pick up recently, it remains at or below 1 per cent a year in many countries in our sample.
Productivity growth has fluctuated over time; it has been declining since the 1960s and today stands near historic lows.
Average productivity growth over time for Spain, Italy, France, Germany, Sweden, UK & US, 1871–2016, %
McKinsey Global Institute analysis
Any explanation of the productivity puzzle should take into account not just these headline aggregate productivity numbers but micro patterns of the slowdown. We identify three patterns across our sample of countries. First, the recovery from the financial crisis has been characterized by low “numerator” (value-added) growth accompanied by robust “denominator” (hours worked) growth, creating a job-rich but productivity-weak recovery. This raises the question of why companies have been increasing employment or hours without corresponding increases in productivity growth (see Chapter 3 for more details). It also highlights the importance of examining demand-side drivers for slow value-added growth and low productivity growth.
Second, looking across more than two dozen sectors, we find few “jumping” sectors today, and the ones that are accelerating are too small to have an impact on aggregate productivity growth.1 For example, only 4 per cent of sectors in the United States were classified as jumping in 2014, compared with an average of 18 per cent over the last two decades, and they contributed only 4 per cent to value-added. The distinct lack of jumping sectors we have found across countries is consistent with an environment in which digitization and its benefits for productivity are happening slowly and unevenly.
Third, since the Great Recession, capital intensity, or capital per worker, in many developed countries has grown at the slowest rate in postwar history. An important way productivity grows is when workers have better tools such as machines for production, computers and mobile phones for analysis and communication, and new software to better design, produce, and ship products, but this has not been occurring at rates that match those recorded in the past. A decomposition of labour productivity shows that slowing growth of capital per hour worked contributes about half or more of the productivity decline in many countries (Exhibit 2).2
Two waves have dragged down productivity growth by 1.9 percentage points on average across countries since the mid-2000s (Exhibit 3). The waning of a boom that began in the 1990s with the first information and communications technology (ICT) revolution, together with a subsequent phase of restructuring and offshoring, reduced productivity growth by about one percentage point. Financial crisis aftereffects, including persistent weak demand and uncertainty, reduced it by another percentage point, as investment was low even when hiring returned.
We have found from our global surveys of business that 47 per cent of companies that are increasing their investment budgets are doing so because of an increase in demand, yet 38 per cent of respondents say risk aversion is the key reason for not investing in all attractive opportunities. We also found weak demand dampened productivity growth through channels other than investment such as economies of scale and a subsector mix shift (see sidebar, “Additional ways weak demand hurt productivity growth during the recovery”).
A third wave, digitization, contains the promise of significant productivity-boosting opportunities, yet the benefits have not materialized at scale. There are several reasons that the impact of digital is not yet evident in the productivity numbers. These include lag effects due to the need to reach technological and business readiness, costs associated with the absorption of management’s time and focus on digital transformation, as well as transition costs and revenue losses for incumbents that can drag sector productivity during the transition. As a result, the short-term net impact of digitization is unclear.
We have found that digitization has not yet reached scale, with a majority of the economy still not digitized. The McKinsey Global Institute has calculated that Europe overall operates at only 12 per cent of digital potential, and the United States at 18 per cent, with large sectors lagging in both.3
While the ICT, media, financial services, and professional services sectors are rapidly digitizing, other sectors such as education, healthcare, and construction are not. We also see the lack of scale in our sector deep dives. For example, in retail, online sales are two times more productive than store sales yet remain on average below 10 per cent of total sales volume and come with transition costs like declining footfall in stores.
In addition, we find companies are experiencing substantial transition costs. In a recent survey we conducted, companies with digital transformations underway said that 17 per cent of their market share from core products or services was cannibalized by their own digital products or services. Today, we find that companies are allocating substantial time and resources to changes and innovations; however, these do not yet have a direct and immediate impact on output and productivity growth. As a result, we may be experiencing a renewal of the Solow Paradox of the 1980s, with the digital age around us but not yet visible in the productivity statistics.
The importance of these waves was not equal across countries (Exhibit 4). The first wave mattered more in Sweden and the United States, where the productivity boom had been more pronounced, while financial crisis aftereffects were felt more broadly across countries.
Our sector analysis provides an alternative lens to examine the macro trend of declining productivity growth. We find the three waves played out in different ways and to different degrees across sectors (Exhibit 5).
Few sectors illustrate how this perfect storm impacted productivity growth across countries as well as the retail sector. By the time the crisis hit in 2007, the retail sector was at the tail end of an IT-enabled productivity boom through supply chain restructuring that began around 1995. Then weak demand resulting from the financial crisis and recovery made matters worse in two ways: through an overall reduction in sales without a corresponding reduction in labour, and a switch to lower value-per-unit products and brands.
There was a decline in productivity growth in most sectors and countries.
Average productivity growth across sectors for Spain, Italy, France, Germany, Sweden, UK & US, 1871–2016, %
Source: McKinsey Global Institute analysis
As demand began to recover and wages across countries remained low, retailers hired more than they invested. In the middle of this slow recovery and challenging demand environment, the rise of Amazon and the wave of digital disruption occurring in the retail industry added to productivity growth from the shift to more productive online channels, yet the growth was accompanied by transition costs, duplicate structures, and drags on footfall in traditional stores.
In another example, in auto manufacturing, a boom that began in the 1990s from a wave of restructuring of global supply chains reached maturity by the time the financial crisis occurred. When demand shocks hit, companies reacted by cutting investment and reducing employee hours worked. As demand slowly improved, companies added back hours, but they were slower to increase investment.
Today the industry is in the middle of digital disruption from electrification, autonomous driving, connectivity, and shared mobility trends. Original equipment manufacturers (OEMs) are focused on the digitization of vehicle content, increasing connectivity and adding infotainment features, and the evolution toward autonomous vehicles.
Yet these digital trends remain subscale. In 2016, only about 1 per cent of vehicles sold were equipped with basic partial-autonomous-driving technology. But today, 80 per cent of the top ten OEMs have announced plans for highly autonomous technology to be ready by 2025. If technology and regulatory hurdles are overcome, McKinsey estimates that up to 15 per cent of new cars sold in 2030 could be highly autonomous.
As financial crisis aftereffects continue to dissipate and digital technologies are further integrated into business processes, we expect productivity growth to recover from current lows across sectors and countries. Overall, we estimate that the productivity-boosting opportunities could be at least 2 per cent on average per year over the next ten years, with 60 per cent coming from digital opportunities. The opportunities we have identified include those that boost operational efficiency, reduce costs, streamline labour requirements, and enhance innovation (for example via automation) as well as those that are reshaping entire business models and industries and changing barriers to entry (for example, via online marketplaces and platforms).
There is no guarantee that the productivity-growth potential we identify will be realized without taking action. While we expect financial crisis-related drags to dissipate, long-term drags may continue, such as slackening demand for goods and services due to changing demographics and rising income inequality and a rise in the share of low-productivity jobs; all of these factors may be further amplified by digitization. At the same time, the nature of digital technologies could fundamentally reshape industry structures and economics in a way that could create new obstacles to productivity growth.
While we found that weak demand hurt productivity growth in the aftermath of the financial crisis, looking ahead, there is a concern that some demand drags may be more structural than purely crisis-related. There are several “leakages” along the virtuous cycle of growth. Broad-based income growth has diverged from productivity growth because declining labour share of income and rising inequality are eroding median wage growth, and the rapidly rising costs of housing and education exert a dampening effect on consumer purchasing power. It appears increasingly difficult to make up for weak consumer spending via higher investment, as that very investment is influenced first and foremost by demand for goods and services, and rising returns on investment discourage investment relative to earnings.
Demographic trends may further diminish investment needs through an ageing population that has less need for residential and infrastructure investment. These demand drags, are occurring while interest rates are hovering near the zero lower bound. All of this may hold back the pace at which capital per worker increases, impact company incentives to innovate, and thus impact productivity growth, slowing down the virtuous cycle of growth.
Digitization may further amplify those leakages, for example, if automation compresses labour share of income and increase income inequality by hollowing out middle-class jobs, and may polarize the labour market into “superstars” versus the rest. Unless displaced labour can find new highly productive and high-wage occupations, workers may end up in low-wage jobs that create a drag on productivity growth. Our ability to create new jobs and skilled workers will impact prospects for income, demand, and productivity growth.
Digital technologies may also dampen their own productivity promise through other channels. Various digital technologies are characterized by large network effects, large fixed costs, and close to zero marginal costs. This could lead to a winner-take-most dynamic in industries reliant on such technologies and may result in a rise in market power that can skew supply chains and lower incentives to raise productivity.
Furthermore, increasingly sophisticated pricing algorithms and tailoring of offerings to create markets of one could counter some of the improved market efficiency from online price transparency and comparison and review offerings. We did not find that rising concentration slowed productivity growth in our sector cases, but this may not be the case in the future if changes in industry structure reduce the competitive intensity as well as incentives to innovate and improve operational performance.
While the economic cost associated with networks has been well established, digital platforms may exhibit unique characteristics that make the implications different from past network industries. For example, consider the network effects from digital platforms such as Facebook and Google. Users of both platforms benefit from a growing user base, as social networks with more users allow for more connections, and larger pools of search data generate better and more targeted results. Yet these services are free to users, who determine their success, as revenue from advertising relies on the number of users. Therefore, incentives remain for digital platforms to innovate and stay ahead of the competition to ensure that they satisfy users, even though they may have strong bargaining power with their advertisers.
Our findings suggest that unlocking the productivity potential of advanced economies requires a focus on promoting both demand and digital diffusion, in addition to interventions that help remove traditional supply-side constraints such as red tape. To incentivize broad-based change, companies need competitive pressure to perform better, a business environment and institutions that enable change and creative destruction, and access to infrastructure and talent. Yet the additional emphasis on digital diffusion and demand is warranted.
Demand may deserve attention to help boost productivity growth not only during the recovery from the financial crisis but also in terms of longer-term structural leakages and their impact on productivity. Suitable tools for this longer-term situation include: focusing on productive investment as a fiscal priority, growing the purchasing power of low-income consumers with the highest propensity to consume, unlocking private business and residential investment, and supporting worker training and transition programs to ensure that periods of transition do not disrupt incomes.
On digital, action is needed both to overcome adoption barriers of large incumbent business and to broaden the adoption of digital tools by all companies and citizens. Actions that can promote digital diffusion include: leading by example and digitizing the public sector, leveraging public procurement and investment in R&D, driving digital adoption by small and medium-sized enterprises, investing in hard and soft digital infrastructure and clusters, committing to the education of digital specialists as well as consumers, ensuring global connectivity, and addressing privacy and cybersecurity issues. Furthermore, regulators and policymakers will need to understand the differences in the nature of digital platforms and networks from the network industries of the past and develop the tools to identify non-competitive behaviour that could harm consumers.
Other stakeholders have a role to play, too. How do companies, labour organizations, and even economists respond to the challenge of restarting productivity growth in a digital age? Companies will need to develop a productivity strategy that includes the digital transformation of their business model as well as their entire sector and value chain.
Boosting productivity growth starts with companies. Google's Hal Varian suggests a simple way to jumpstart productivity that also benefits employees.
In addition, they may have to rethink their employment models and reskilling approaches in order to develop a strategy, potentially together with labour organizations, that allows people and machines to work side by side and workers and companies to prosper together. Economists can play a key part by developing new and improved ways to measure productivity and by developing models that can assess the impact of technology on markets and prices.
While productivity growth in advanced economies has been slowing for decades, the sharp downturn following the financial crisis has raised alarms. We find that the most recent slowdown is the product of three waves: the waning of a 1990s productivity boom, financial crisis aftereffects, and digitization that holds the promise of boosting productivity growth but remains subscale and comes with lags.
As financial crisis, aftereffects continue to recede, primarily as investment grows and uncertainty diminishes, and as digitization accelerates, productivity growth should recover from historic lows. How strong the recovery is, however, will depend on the ability of companies and policymakers to unlock the benefits of digitization and promote sustained demand growth.
There is a lot at stake. A dual focus on demand and digitization could unleash a powerful new trend of rising productivity growth of at least 2 per cent a year that drives prosperity across advanced economies for years to come.
This article was originally written by James Manyika who is chairman and director of the McKinsey Global Institute, where Jacques Bughin and Jonathan Woetzel are directors, Jaana Remes and Jan Mischke are partners, and Mekala Krishnan is a senior fellow. Full credit goes to McKinsey, who published this article over a year ago. This article has been reprinted for the purpose of education.