Solow Paradox 2.0: The Lagging Impact of Technology Advances on Productivity Growth
Fewer workers is one of the key reasons for our stagnant economic growth. Over the coming decades, the labor force is expected to shrink in most parts of the world as fertility rates continue to decline, especially in advanced and emerging economies. The US labor force is growing very slowly while fertility rates keep hitting record lows.
Our aging economies are thus dependent on productivity gains to drive long-term economic growth, future prosperity and higher standards of living. Which is why few topics have generated as much concern among economists and policy makers as the sharp decline in productivity growth in the US and other advanced economies over the past decade, - despite accelerating technology advances.
“Labor productivity growth is near historic lows in the United States and much of Western Europe,” noted Solving the Productivity Puzzle, a report published earlier this year by the McKinsey Global Institute (MGI). The report analyzed the productivity-growth declines across a sample of seven countries, - France, Germany, Italy, Spain, Sweden, the United Kingdom, and the United States, - which represent about 65% of the GDP of advanced economies. Their average productivity growth in the 5 years between 2000 and 2004 was 2.4%. A decade later, - in the 5 year period between 2010 and 2014, - their average productivity growth had declined to .5%. While starting to pick up recently, productivity growth remains at or below 1 percent in many of the countries in the study, still quite low relative to historical levels.
According to McKinsey, this sharp decline in productivity growth, - from 2.4% to .5%, - is due to the collision of three key waves.
The waning of the mid-1990s productivity boom. By the mid-2000s, the decade long productivity boom from the IT and Internet revolutions of the 1990s as well as the restructuring of companies and global supply chains had run its course, reducing productivity growth by close to one percentage point.
The lingering impact of the global financial crisis of 2007-2008. After the crisis, a number of industries, - financial services and construction in particular, - went from boom to bust, due to uncertainty, declining investments and weak demand, depressing productivity growth by another almost one percentage point.
Lagging impact of digitization. Our continuing technology advances should have been able to overcome the two percentage decline in productivity growth of the first two waves. But their benefits have not materialized in the short term due to several adoption barriers. McKinsey expects that we will see at least a 2 percent productivity-growth potential over the next decade. “As financial crisis aftereffects recede and more companies incorporate digital solutions, we expect productivity growth to recover; the good news is that we are seeing an uptick today in economic variables like productivity and GDP growth across many countries.”
US productivity grew at only 1.5% between 1973 and 1995. This period of slow productivity coincided with the rapid growth in the use of IT in business. “You can see the computer age everywhere but in the productivity statistics,” said MIT Nobel Prize laureate economist Robert Solow in 1987, in what’s become known as the Solow productivity paradox. The Solow paradox was finally resolved in the mid-1990s, leading to a decade-long productivity boom.
Why do we keep seeing such lagging effects? In a 2014 article, The Economist pointed out that realizing the benefits from technology and innovation takes time, often decades, and varies hugely from industry to industry. “Economists take the relationship between innovation and higher living standards for granted in part because they believe history justifies such a view. Industrialisation clearly led to enormous rises in incomes and living standards over the long run. Yet the road to riches was rockier than is often appreciated.”
Moreover, the more transformative the innovations, the longer it takes for them to be embraced by companies and industries across the economy, - the reason being that they require considerable investments in additional, complementary innovations, as well as in education to provide workers with the necessary skills in the new technologies.
The steam engine and electricity, are each examples of such transformative industrial-age innovations. James Watt’s steam engine ushered the Industrial Revolution in 1781, but its impact on the British economy was imperceptible until the 1830s because productivity growth was restricted to a few industries. Similarly, productivity growth did not increase until 40 years after the introduction of electric power in the early 1880s. It took until the 1920s for companies to figure out how to restructure their factories to take advantage of electric power with new manufacturing processes like the assembly line.
Decades later, computers were first used to automate back-and front-office processes from the 1960s through the 1980s, an era of slow productivity growth which gave rise to the 1987 Solow Paradox. It wasn’t until the 1990s that the long expected IT productivity boom finally arrived. Companies realized that using IT to automate existing processes wasn’t enough. Rather, it was necessary that organizations leverage technology advances to fundamentally rethink their operations, and eliminate or reengineer business processes that did not add value to the fundamental objectives of the business.
Perhaps we are experiencing a kind of Solow Paradox 2.0, with the digital age more around us than ever except in the productivity statistics. There are several reasons for this lag. First of all, we’re in the early deployment years of major recent innovations, including cloud computing, IoT, big data and analytics, robotics, and AI and machine learning. “Translating technological advances into productivity gains requires major transformations in business processes, organization and culture, - and these take time… The challenge of adoption in the current digital wave may be even harder because of the broad range of uses of digital that not only help improve current processes but fundamentally transform business models and operations.”
While leading edge companies are already leveraging these advances, most are still in the learning stages. The most sophisticated companies have been pulling far ahead of everyone else in deploying these advanced technologies. According to McKinsey, “Europe overall operates at only 12 percent of digital potential, and the United States at 18 percent, with large sectors lagging in both. While the ICT, media, financial services, and professional services sectors are rapidly digitizing, other sectors such as education, health care, and construction are not.”
There’s substantial room for much of the economy to boost productivity. “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 policy makers 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 percent a year that drives prosperity across advanced economies for years to come.”