Synopsis: Why productivity growth has slowed down and what to do about it

Click here to read the original article.

Discussion:

This article discusses the reason for a sluggish productivity growth. The OECD attributes this to a lack of “diffusion” – or spreading of innovation – to less innovative firms, thereby blocking productivity growth. Its suggested remedy is to intensify global competition in order to cut out the slow and old firms.

While some argue that the slow productivity may be attributed to the slowing pace of innovation in general, the OECD shows that top competitors of each sector are innovating now more than ever. Thus, the OECD research concludes that the petering of productivity could be a product of the distribution of innovation slowing down.

The reason why this distribution is not happening as quickly as before is due to the fact that “creative destruction” has lost its edge. This may be caused by increased government regulation, which traps workers in jobs for which they are overqualified. In turn, these unproductive firms tend to drag down aggregate productivity by absorbing valuable resources. This, in turn, reduces the growth of more innovative firms. Prime examples of this are Italy and Spain.

Key Terms:

1. Creative destruction is a famous concept by Austrian economist Joseph Schumpeter. The general idea is that creative destruction happens when something new destroys something old, like when the print media was destroyed by online news.

2. A zombie firm is a firm that needs constant support from the government (in the form of bailouts, etc.) to stay afloat. Without the help of the government, this firm would collapse. Japan had a number of zombie firms in its economy before its economic bubble burst and it slipped into depression. Although the number of zombie firms has drastically reduced since then, it still has an unusually high number of such firms.

Context:

1. This article states that one reason why slowing productivity growth is happening is because of “a slowing in the pace of productivity enhancing innovation”. Tyler Cowen, who is mentioned in an earlier blog post, discusses this idea in his book “The Great Stagnation”, saying that the ‘low hanging fruit’ of technological innovation (i.e. the obvious and easy to reach ones) have all been plucked, and innovating new technology will be much harder from now on.

2. The OECD research on the innovation of top firms in each sector begs the question: how do we measure productivity? My guess is that they measure the value of output divided by the number of workers.

3. The OECD claims that the “breakdown of the diffusion machine” has slowed productivity growth, but I would like to raise the question of whether or not there was a diffusion machine earlier that was working properly.

Discussion:

This article from The Economist newspaper (yes, they insist it is a newspaper and not a magazine) discusses recent research that finds the causes of a macroeconomic problem (inequality) in a microeconomic variable (size of the firm). The research focuses on growth disparity in wages, instead of focusing on wealth disparity (as Piketty does) to explain rising income inequality across the world. Growth in wage disparity is increasing despite varying policies on taxation, minimum wages and corporate pay.

A new paper by Holger Mueller, Elena Simintzi and Paige Ouimet, called "Wage Inequality and Firm Growth", links the increasing inequality of wages on the size of the firm, i.e. the bigger the firm, the more unequal the wage pay. It is common knowledge among many economists that economies of scale "allow workers at bigger firms to be more productive than those at smaller ones. That, in turn, allows the bigger firms to pay higher wages".

Theoretically, this should not increase wage inequality, if all workers at the firm receive a proportional pay increase. However, this paper shows that most such firms distribute progressive pay increases. This trend is very similar to "the trend in income inequality in America and Britain... since the 1990s, when pay for low and median earners began to stagnate", the writers of the research paper note.

They suggest two possible reasons for proportional pay increase:

1) The low-skilled workers who demand higher wages can be easily automated away

2) Entry-level workers may accept low wages as the chance of promotion at a larger firm is higher than that at a smaller firm.

They also note that the job requirements in smaller versus larger firms explain why the most senior people reap such high wage increases. A janitor's job requirements are the same in small- and large-scale companies, but a manager's skill set for large companies is not only more demanding, but also rarer.

The article then discusses potential causation between the rise in income inequality and the rise in wage inequality. The research paper shows that the size of the largest 15 firms in OECD countries and their income inequality, stating that this relationship is strong.

Another recently published paper, "Entry Costs Rise with Development" by Albert Bollard, Peter Klenow and Huiyu Li shows that "the trend towards bigger firms is only likely to accelerate". The higher productivity in big firms leads to increased barriers of entry for smaller ones, as shown by the fact that, in America and Europe, startup rates for companies are falling. Since the 2008 crisis, higher barriers in the form of limited access to capital "has caused the number of new businesses to collapse," the article says.

Some economists point out the positives of this: bigger firms have much higher investment rates, which increases growth in the economy. In fact, it is the preponderance of small firms that is holding the PIGS economies back from economic recovery.

If governments wish to reduce this inequality, they should reduce barriers to entry to spur competition, by improving small businesses' access to credit. But, they should also be wary of too much crude redistribution, as it dampens economics growth.

Key terms:

1. Economies of scale: This is when a firm reaps the cost benefits due to their large size or output. According to Wikipedia, it is when “cost per unit of output generally [decreases] with increasing scale as fixed costs are spread over more units”.

2. Corporate pay comprises of various forms in which companies pay its workers, including for example, share options.

Context:

1. The first new paper by Mueller, Simintzi and Ouimet is here. The second new paper by Bollard, Klenow and Huiyu is here.

2. What does the phrase “limited access to capital” mean? In a nutshell, it means loans or equity to finance the business venture.

3. In the last paragraph, the author mentions “too much crude redistribution”. This will be explained in the S&P article on the link between inequality and growth in America that I will be publishing soon.

4. The author seems to assume causation between the size of the firm and the level of inequality in a country. The author mentioned research where the first paper by Mueller, Simitzi and Ouiment find that “the relationship between rising levels of income inequality and the size of the firms was strong”. This statement suggests correlation. Later on, the author states that a few solutions to the rising inequality is to lower barriers of entry, thereby increasing competition and allowing smaller firms to participate in the market. This suggests causation. While there may be evidence to show direct causation between inequality and firm size, it has not been mentioned in this article.


5. On the note of disproportionate wages, perhaps more skilled workers get higher pay because they are the ones who can create the benefits of scale, i.e. they are the ones who can make the products to be shared worldwide. This point should not be taken to mean that I am suggesting that more skilled workers deserve the disproportionate wage rises; that is outside the domain of economics. But the question is whether they disproportionately "create"the higher returns to scale; that is a question well within the realm of economics, but the authors of paper have not addressed it directly.

6. The data in this article was taken from Britain. If they had used the same methodology in the US, would they have come up with different results? Arguably, much wealth in the US has been created by small start-up firms and hence is it possible that one might not find similar disproportionate pay rises in larger firms?

Synopsis: Wage gap as a cause of inequality.

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Synopsis: An analysis on the relationship between inequality and growth.

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Discussion:

This article aims to understand the relationship between inequality and growth better. In 1975 an American economist, Arthur Okun, stated that there was a trade-off between equality and efficiency.

Inequality is undoubtedly important, as, otherwise, the lure of large financial rewards, innovation and risky entrepreneurship would cease to exist. Nevertheless, inequality could hinder growth if “those with low incomes suffer poor health and low productivity as a result… [as well as threatening] public confidence in boosting policies like free trade”, according to the article. Government responses to inequality can also create a crisis; according to a 2010 book written by Raghuram Rajan, the Governor of the Reserve Bank of India (RBI), governments often respond to inequality by “easing the flow of credits to poorer households”. More about why this creates a crisis is explained in "Context".

Finding the exact relationship between inequality and growth can be challenging. While some studies suggest that inequality is just mildly bad for growth, others suggest that the nature of the relationship changes as poorer countries become richer. Still others say that, rather than the level of inequality, it is the trend in inequality that matters.

A research paper by IMF economists Messrs Andrew Berg and Jonathan Ostry in 2011 shows that perhaps it is the duration of growth spells that will give us the answer to the link between inequality and growth. They reckon that sustaining a growth spell is much harder than getting an economy growing. They also suggest that, according to the article, “when growth falters, inequality is often a culprit”.

Still others say that inequality is not a culprit but rather governments that tax and spend to try and reduce it. In another paper, Messrs Berg, Ostry and Charlambos Tsangarides analyse the separate effects of inequality and redistribution. They gather data about market income and net income in 173 economies. It is shown that in economies that redistribute heavily, their Gini coefficient is cut substantially. In economies that do not redistribute heavily, their Gini coefficient is cut considerably less. The paper shows that governments of more unequal countries redistribute more, and rich economies redistribute more than poor ones do.

While spreading wealth does not carry growth penalties – growth in income per person is not considerably less in countries with more redistribution – Messrs Berg, Ostry and Tsangarides suggest that redistribution may lead to shorter growth spells.

Inequality has more of a correlation with low growth, i.e. the higher the Gini coefficient, the lower the average annual growth. Therefore, redistribution that reduces inequality may boost growth.

Perhaps, the lesson to be learned is that reckless redistribution may harm growth, but sensible redistribution may help.

Key words:

On the chart labelled “A little off the top”, there are two words in the legend: net income and market income. Net income is income after tax and transfers. To see a precise definition of market income, read the glossary in this S&P article, which I will be analyzing in a blog post soon.

Context:

1. In the third paragraph, the author states how “governments often respond to inequality by easing the flow of credit to poorer households. When the borrowing binge ends everyone suffers.” In fact, this is one of the main reasons for the 2008 financial crisis that stemmed from the US. On this note, it is worth mentioning that allowing sub-prime lending (easing the flow of credit to poorer households) is actually a means of redistribution by the government.

2. To read the IMF paper by Messrs Berg, Ostry and Tsangarides, click here.

3. Arthur Okun, quoted in this article, is well known for Okun’s Law, which details the relationship between a country’s unemployment and production. The relationship he observed is inversely proportional: increases in unemployment lead to decreases in production. To read more about this on Investopedia, click here.

Synopsis: A summary of “Capital in the Twenty-First Century” by Thomas Piketty

Click here to read the original article.

Discussion: This article summarises “Capital in the Twenty-First Century”, by Thomas Piketty, a book that discusses past inequality trends and predicts future ones.

Mr. Piketty, along with a handful of other economists, has gathered data from the beginning of the Industrial Revolution about the change in the concentration of income and wealth. During the 18th and 19th centuries in Western Europe, wealth inequality was rampant. National income was less than private wealth, the latter of which was concentrated in the hands of the elite few. Even when industrialisation increased the wages of the working class, this problem persisted. When WW1, WW2 and the Great Depression hit, the inequality of income and wealth reduced, due to high taxes, inflation and bankruptcies. After these shocks faded, the same problems are creeping back, so much so that the importance of wealth is reaching levels pre-WW2.

From here, Piketty outlines general patterns between wealth and growth. He explains that wealth grows faster than economic output in general, which represents in the expression r > g (where r is the rate of return to wealth and g is the economic growth rate). Ceteris paribus, “faster economic growth will diminish the importance of wealth in a society”, and the same vice versa. “Demographic change that slows growth will make capital more dominant”. However, it is only rapid growth or government intervention that will disperse the concentration of wealth, and prevent it from entering the patrimonial situation Karl Marx was worried about.

Mr. Piketty ends by saying that governments should step in now and impose taxes on wealth, lest it leads to soaring inequality or political instability.

Critics have question Piketty’s assertion that the future will resemble the past, arguing that returns to wealth decreases as the amount of wealth increases. They also add that today’s generations come upon wealth by working for it, rather than through inheritance. Furthermore, they question the feasibility of Mr. Piketty’s recommendations to governments, stating that they are ideologically, rather than economically, driven. Regardless, Piketty’s book as received major critical acclaim for its data gathering and analysis.

Key terms:

1) Welfare state: According to Brittanica, this is where the government plays an active role in taking care of the citizens of a state.

2) Return on wealth: This is the income from investing in wealth.

Context:

It is worth discussing Piketty’s idea of inequality. He discusses how r > g in general. He states that if the economy grows faster, then the importance of wealth will reduce, and if the economy grows slower, the importance of wealth will increase. This concept is illustrated in the diagrams below:

If the rate of return to wealth increases faster than the growth rate, then inequality increases. In other words, Piketty claims that inequality = r-g. Whether this is true or not will be discussed in another blog post.

In the introductory blog post I had posted about this inequality series, one of the questions I said that would be discussed is the link between growth and inequality. According to Piketty, faster growth reduces inequality.

Synopsis:  The ECB and how it avoids QE.

Click here to read the original article.

Discussion:

This article discusses the fact that the ECB is taking negligible steps towards helping the Eurozone economy in terms of monetary policy.

The ECB is facing major opposition from Germany, which fears that the launch of large-scale and proper QE might result in uncontrollable hyperinflation – a repeat of pre-World War 2 German economy.

As opposed to the QE that was used by the Fed and is being used by the BoJ, the ECB is instead enacting ‘penance’ measures – more to put up a show rather than to improve the economy, according to Pritchard.

Mr. Mario Draghi, the head of the ECB, has hinted at a EUR 1tn spend. As much as it sounds similar to QE, it is not, for two major reasons:

1) Central banks that enact QE take the risk on their own balance sheet; this is to say, whatever happens to the value of the sovereign bonds they purchase, they deal with it. Instead of doing so, they are offering LTROs (explained in the article) to banks in exchange for collateral.

2) The ECB is spending nowhere near the EUR 1tn promise – rather, its spending amounts to about EUR 450bn, perhaps lower. This equates to roughly EUR 17.5bn a month (and this spending will not start until the end of the year), 10 times less than the spending by the Bank of Japan.

Many economists also say that the lowered interest rates will have a negligible effect on the overall market at this point, i.e. conventional expansionary monetary policy just does not work for the Eurozone as of now.

Key terms:

1) Deleveraging: Where banks lower the amount lent to the public so that banks can keep up with the capital adequacy ratio.

2) Capital adequacy ratios: To protect bank depositors, governments have come up with this concept. The idea is that a bank must have a certain amount of capital in its bank, so that if the bank incurs losses and cannot pay depositors back, the banks can use some of its own capital to cover the losses. Usually, when capital adequacy ratios are discussed, the Basel rules are mentioned as well. These rules (Basel I, Basel II and Basel III) dictate the amount of capital needed in the banks. The more, the better for the depositors.

Context:

One thing worth discussing is the sixteenth paragraph: “Nor is it clear… said Mr. Roberts from RBS”. The statement being made here is that unless the ECB takes on bad bonds, there is no point in bothering with QE in the EU. The problem with this statement is that no economy that has practiced or is practicing QE (Japan, USA and UK) has taken on bad bonds; they have only ever taken sovereign (government) bonds. Government bonds are steady and trustworthy, and very reliable bonds to purchase. For a long time, the government and the central bank of a country have been split, where it is the government’s job to take on bad loans and liquidate frozen banks. The central bank has two objectives: to maintain steady and reasonable inflation, and to reduce unemployment. If an economy were to be taking on “bad stuff”, as Mr. Roberts from RBS (quoted in that paragraph) says, it would be only from the part of the individual governments, not the ECB.