Productivity and Structural Reform
While many people have provided opinions about why countries succeed and fail economically, they have not shown linkages between causes and effects. As a result, their opinions can be misleading. For example, everyone knows that having a more educated population is better than having a less educated population, so naturally we hear that improving education is important to improving productivity. However, indicators of the cost-effectiveness of education are lacking and correlations of the factors with subsequent growth don’t exist. That is dangerous. For example, if policy makers simply educate people without considering the costs and paybacks of that education, they will waste resources and make their economies less productive even though we will become more educated people. To make matters worse, the views of those who influence policies typically reflect their ideological inclinations (i.e. being politically left or right), which divides people. For this reason, objective good indicators that are correlated with subsequent results are needed so that the facts speak for themselves and help people reach agreement about what should be done.
A country’s production (GDP) will equal its number of workers times the output per worker (productivity). One can increase one’s productivity either by working harder or by working smarter. Productivity is driven by how cost-effectively one can produce, so, relative productivity (i.e. competitiveness) will have a big effect on relative growth. In a global economy those producers who are more competitive will both 1) sell more in their own country and other countries, and 2) move their production to countries where they can produce more cost-effectively. Likewise, investors will follow these opportunities.
Competitiveness (i.e. relative productivity levels) is driven by what you get relative to what you pay in one country versus another. Countries are just the aggregates of the people and the companies that make them up. As you know with the individuals you hire and the products you buy, those that offer the most value for money are the most competitive and do better than those that don’t.
Since people are the largest cost of production, it follows that those countries that offer the best “value” (i.e. the most productive workers per dollar of cost) will, all else being equal, experience the most demand for their people. That is why the per-hour worked cost differences of educated people (i.e. their income after adjusting for hours worked each year) is one of the best indicators of productivity. Other obvious and important factors that influence productivity include cost of uneducated people, levels of bureaucracy, attitudes about work, raw material costs, lending, and capital market efficiencies (i.e. everything that affects the value of what is produced relative to the cost of making). In other words, there is a world market for productive resources that increase the demand, and hence the growth rates, for the countries that are most competitive because of “the cost of production arbitrage.” The cost of production arbitrage has been a big driver of growth—in fact overwhelmingly the largest. To reiterate, the magnitude of this competitiveness arbitrage is driven more by the cost of the workers relative to how hard they work, their education, and investment levels, than by anything else. These variables characterize the value of hiring a worker in a given country and doing business there (i.e. what you pay for is what you get).
Of course, barriers to the flow of trade and capital (like China’s closed door policies until the early 1980s, geographic isolation, etc.) can stand in the way of people, companies, and countries being allowed to compete. As these barriers break down (i.e. transportation becomes cheaper and quicker, telecommunications reduce impediments to intellectual competition, etc.) or increase (i.e. trade barriers are put up), the ability to arbitrage the costs of production, and in turn the relative growth rates is affected.
While countries that operate efficiently will grow at faster paces than countries that operate inefficiently, the countries that will grow the fastest are those that have big inefficiencies that are disposed of. As an example, in 1970s and 1980s, China had a well-educated, intelligent labor force that could work for cheap, but faced a closed-door policy. Opening the door unleashed China’s great potential. Looking forward, while the United States is relatively efficient, it would not grow as fast as Russia (i.e. which has competitively priced educated people with low debt) if Russia could significantly reduce its barriers to productivity (i.e. corruption, lack of development of its debt/capital markets, lack of investment, lack of innovation, bad work attitudes, lack of adequate private property laws, etc.).
Culture is one of the biggest drivers of productivity. It’s intuitive that what a country’s people value and how they operate together matters for a country’s competitive position. Culture influences the decisions people make about factors such as savings rates or how many hours they work each week. Culture can also help explain why a country can appear to have the right ingredients for growth but consistently underperform, or vice versa. For example, in Russia, which has a lot of untapped potential, the culture that affects lifestyles (i.e. alcoholism, the low drive to succeed, etc.) causes it to substantially under-live its potential, while in Singapore, where high income levels make their labor relatively uncompetitive, their lifestyles and values (i.e. around working, saving and investing) allow them to realize a higher percentage of their potential. While lots of elements of culture can matter, the ones that matter most are: 1) the extent to which individuals enjoy the rewards and suffer the penalties of their productivity (i.e. the degrees of their self-sufficiency), 2) how much the people value savoring life versus achieving, 3) the extent to which innovation and commercialism are valued, 4) the degree of bureaucracy, 5) the extent of corruption, and 6) the extent to which there is rule of law. Basically, countries that have people who earn their keep, strive to achieve and innovate, and facilitate an efficient market-based economy will grow faster than countries that prioritize savoring life, undermine market forces through highly redistributive systems, and have inefficient institutions.
Indebtedness is also important. Countries that have a) low amounts of debt relative to incomes, b) debt growth rates that are low in relation to income growth rates, and c) easier monetary policies grow faster over the next 10 years than countries with d) high amounts of debt relative to incomes, e) debt growth rates that are high in relation to income growth rates, and f) tighter monetary policies. This is true with one exception, which is when adequate financial intermediaries don’t exist. Institutions and capital markets that facilitate these transactions have to be in place for the system to work.
While productivity and indebtedness can be thought of as separate concepts, they are ultimately a function of the choices people make and their psychology. There tends to be a psychologically motivated cycle that occurs as a function of one’s past level of prosperity and whether one experienced improving or worsening economic conditions. When a country is poor and focused on survival, its people who have subsistence lifestyles don’t waste money because they value it a lot and they don’t have any debt to speak of because savings are short, and nobody wants to lend to them. Even though the country’s labor is low-cost, it is not competitive, and the lack of investment stymies future productivity gains. Some emerge from this stage and others don’t, with culture and location being two of the biggest determinants. For those that do—either because a country removes a big barrier like being closed to the world (as China did in 1980) or simply because a more gradual evolution makes their labor attractive—a virtuous cycle can kick in. At this stage, the investments are not just inexpensive; the stock of infrastructure and other physical capital is also typically low and there is lots of room to adopt existing technologies that can radically improve the country’s potential. Leveraging up (increasing one’s indebtedness) can feed back into higher productivity and competitiveness gains, which produce high returns that attract more investment at a time when the capacity to leverage is high. The key is that this money and credit must be used to produce investments that yield enough returns to pay for the debt service and finance further growth (so that incomes rise as fast as or faster than debts). Yet as countries grow wealthier, more and more of the credit tends to fuel consumption rather than investment. A process that was once virtuous can become self-destructive. The decreased investment in quality projects means productivity growth slows, even as the borrowing and spending makes incomes grow and labor more expensive. People feel rich and begin taking more leisure—after all, asset prices are high—even though their balance sheets are starting to deteriorate. At this point ,debt burdens start to compound, and incomes grow faster than productivity growth. In other words, the country tends to become over-indebted and uncompetitive. The country is becoming poor even though it is still behaving as though it is rich. Eventually the excess tends to lead to bubbles bursting, a period of slow decline and deleveraging. Suffice it to say that when looking at a country’s potential to grow, it is critical to look at the country’s productivity and indebtedness holistically, as part of its stage of development. As a general rule, about two-thirds of a country’s 10-year growth rates will be due to productivity and about one-third will be due to indebtedness.