A Viewpoint for the Future Markets Consultation

As part of the Future Markets Consultation, individuals and organizations were invited to submit a viewpoint on any topic that is of relevance for creating a more just and sustainable market economy in Europe. This is a viewpoint submitted by the Bertelsmann Stiftung, a German think tank.

Our current economic growth is neither inclusive nor is it sustainable. One of the key drivers for this development is what we call the triple productivity crisis. If we want to get on an inclusive and sustainable growth path, we need to address the three main drivers of this crisis and rethink our approach to productivity and growth strategies.

Our continent is facing both an ecological and a digital transformation which will fundamentally change previous ways of doing business. Politically, the goal is clearly set: The EU wants to achieve a modern climate-neutral economy by 2050 that is both competitive and inclusive. Against this backdrop, the importance of overall economic productivity – the ability to generate more with the resources employed – can hardly be overestimated. If we’re not able to operate more resource-efficiently and to translate the potentials of digitalization into productivity growth for all economic actors (not just for a few highly digitized and huge firms and some highly interlinked urban economies), neither sustainability targets nor promises of prosperity and participation will be fulfilled.

However, this task is not trivial since we’re facing a triple productivity crisis. We see the development of productivity stagnating in almost all developed economies since at least ten years. This is the first dimension of what we call the triple productivity crisis. This stagnation is a big challenge for our social security systems whose stability depends on growth. But behind this widely known phenomenon of a secular stagnation, the second dimension of the crisis often remains hidden: It is the increasing divergence of productivity driven growth between different types of firms and regions. Small and medium-sized enterprises (SME) and companies not based in booming – mostly urban – regions are losing out to the technological and digital frontier. The so called break down of the diffusion machine is already translating into social imbalances: Wage inequality and regional disparities are growing. The third dimension of the crisis arises from the basic definition of productivity. Our current understanding of productivity – the underlying narrative – contradicts the targets of a sustainable economic system, such as those set out in the European Green Deal.

Let us take a closer look at the three dimensions of the productivity crisis.

1. Persistent stagnation of productivity

Growth in aggregate productivity weakened in most industrialized countries in the 2000s. Since the 2008 financial crisis, this trend has intensified significantly. As productivity is the main driver of long run economic growth, developed economies need productivity gains to maintain their social security systems. This is even more true for aging societies such as the European ones, because the potential labor force is collapsing in almost all European economies due to demographic change. Put differently, we’re facing drastic losses in prosperity if productivity levels continue to stagnate while labor force shrinks.

But why isn’t productivity increasing more in the face of digital innovations? Many economists initially interpreted this surprising phenomenon as a measurement error. Today, it is clear that the slowdown in productivity growth is really happening, but the reasons are still debated. Some evidence suggests that the stagnation, especially since the financial crisis in 2008, is partly cyclical and due to weak investment activity. However, there are also structural reasons for weak productivity growth.

Two basic positions have emerged in the debate. Pessimists claim that developments in information and communications technology since the 1990s have less potential for change than pioneering innovations of the past. Optimists, on the other hand, predict a “fourth industrial revolution” in which digitization will lead to a new surge in productivity only in the future. This surge is yet to come if the potentials of digitization are better exploited.

Both explanations sound plausible. But do they reach far enough? Looking at the findings of the Organization for Economic Cooperation and Development (OECD) and the results of our project “Productivity for Inclusive Growth”, we get a different impression. According to these, it rather looks like we’re witnessing a complete reorganization of our corporate landscape due to the digitalization process.

2. Growing divergences in productivity growth

This is the second dimension of the triple productivity crisis: digitization appears to be dividing economic development. Differences in productivity growth between companies and regions have been increasing noticeably since the early 2000s. Some – especially large – companies and some – especially urban – regions are becoming more and more productive and are prospering accordingly. Other companies and, above all, rural areas are lagging behind. A few large metropolitan areas around the world account for a large share of patent applications, far ahead of the rest. This trend has become even more pronounced over the past 20 years as digitization has progressed.

These productivity differences translate into income differences and growing wealth gaps between regions and income groups. Productivity development and economic growth are thus becoming increasingly less inclusive, and opportunities for participation are declining.

We identified a whole bundle of drivers for this development. One factor is the increasing market power of global and national players. Particularly in the digital economy, “winner takes all” dynamics emerged, where a few highly productive companies assert themselves at the top of the market and increasingly exclude competitors. Due to the scalability of digital business models, market power, once acquired, can then increase rapidly. However, concentration processes of this kind are not limited to digital service industries. They are also finding their way into the manufacturing sector through the automation of production processes.

However, the drivers also seem to include the fact that the requirements for successful innovation capability are becoming increasingly complex and costly. Innovation itself is thus becoming more and more concentrated. Large and digitized companies are increasingly setting themselves apart from small and medium-sized companies, which are slower to adapt technological achievements and invest less.

But its’s not only the innovation capability alone, it’s also the very basic capability to adapt new technologies. The OECD and others detect a decreasing diffusion rate of new technologies. Our own studies show a large and persistent gap in total factor productivity (TFP) between the most productive companies (Frontiers) and the rest (Laggards). The rather large and better digitized firms at the top seem to stand out from the large mass of SME that are slower to adapt technological achievements and invest less. The divergence in productivity growth between large companies and SME is particularly evident in the manufacturing sector.

3. What about resource productivity?

Economic productivity is generally regarded as a key driver of long-term growth. However, the focus is all too often on just one production factor: labor input. The goal of economic policy in most industrialized nations has been to increase labor productivity in various ways. However, this narrowing of the concept of productivity is increasingly incompatible with the objective of an ecologically sustainable economic system. A fundamental shift in our understanding of productivity toward a more comprehensive and differentiated approach is needed.

The European Green Deal states that the existential threat posed by climate change and environmental degradation calls for a new growth strategy in which economic growth must be decoupled from the use of natural resources. By 2050, Europe should no longer release any net greenhouse gas emissions. It is therefore clear that the use of resources in the coming decades will have to become much more efficient than it has been to date. More specifically, consumption must even be drastically reduced, as raw material deposits are finite or unabated consumption will lead to irreversible environmental damage that would permanently destroy planetary ecosystems.

While the goal is clearly stated, the implications of this transformation do not yet seem to have translated into action ­– and thought. At least not in the economic and growth models that continue to dominate in science and politics, where productivity is mostly understood as a set for increasing output. Primary resources, on the other hand, are all too often seen as a factor that can be used to any extent. As a consequence, resource productivity has been neglected and progress is slow.

In fact, economic policies around the world continue to pursue the primary goal of increasing labor productivity, the longstanding weakness of which is identified as a core problem for the prosperity of industrialized economies. Against the background of demographic aging and under the condition of high employment, labor productivity is supposed to increase in order to ensure accustomed growth rates in the future.

In this logic, the associated consumption of resources was often not or not sufficiently considered and, at worst, tacitly accepted as a side effect of economic growth. The German Federal Environment Agency, for example, points out that “German greenhouse gas emissions alone caused environmental costs of 164 billion euros in 2016.” The costs of climate change were estimated as high as 20 percent of global gross domestic product annually already in 2006. Mitigation efforts are estimated to be significantly less costly to society than the economic benefits of unabated resource use.

There is an obvious discrepancy between the traditional understanding of productivity, which follows a clear growth logic focusing on labor and capital, and the need for increasing resource productivity by reducing finite inputs of raw materials and energy.

What do we have to do?

The challenge is trifold: Our economies face a basic weakness regarding productivity growth. Moreover, growing divergences in productivity growth rates lead to an economy of different speeds. Both phenomena are driven mainly by the transforming power of digitalization. The third challenge is our own understanding of productivity. If we want to achieve any substantial progress towards an ecologically sustainable economy, we should also adapt our growth model and strategies currently applied. How can we act on these three challenges? There is no simple answer to that but on the basis of extensive research in the field, we can come up with some basic recommendations for policy action.

On the way towards a more inclusive productivity development, policymakers should make sure that innovation processes are supported more efficiently in all regions. Innovation policies must identify the comparative advantage of a region and exploit this specific advantage. This can help underperforming regions get back on their feet without holding back the leading regions.

But companies themselves are responsible, too: To become more innovative, they must invest more in research and development, in software, databases and in the skills of their employees – in short, in their knowledge capital. SME in particular are not yet investing enough in this key driver of innovation and productivity. In a digitalized economy, knowledge capital turns out to be as worthy as physical capital. Economic policy can help SME in their effort to cooperate more efficiently with the scientific institutions and along value chains rather than merely on a regional basis. Cooperative projects, networks and clusters can support SME to jointly tackle riskier innovations. It is also necessary to better connect the periphery to the centers, whether through improved mobility concepts or the consistent expansion of digital infrastructure to enable access to data and knowledge everywhere.

To counter the existential dangers of climate change and environmental degradation, we need a fundamental change in our understanding of the concept of productivity. Economic productivity should no longer be understood merely as labor productivity for the purpose of economic growth. Rather, productivity in the use of resources and energy should also receive the attention that is needed for the upcoming transformation of our economies. A greater awareness of the relationship between input and output must be created among decision-makers as well as in business and society.

For a boost in sustainable productivity growth, policymakers should expand their efforts to reduce resource and energy consumption, reduce dependencies on high growth rates and move closer to a circular economy in many areas. To this end, for example, resource use could be taxed more heavily, existing subsidies could be reduced in order to increase the pressure to improve efficiency. Increased recycling of end products and the avoidance of unnecessary material use are also important starting points. A circular economy should be the final goal of these policy measures.