After a short-term hangover from COVID-19, Australia’s productivity performance risks returning to business as usual.

    This column has noted Australia’s lacklustre productivity performance before. Last August, for example, it cited the Productivity Commission’s warning of “a seemingly entrenched slowdown in the rate of productivity growth”. This long-running concern is reinvigorated by recent weak productivity numbers and potential implications for inflation and monetary policy.

    Start with productivity. Every quarter, the ABS publishes an estimate of labour productivity as measured by GDP per hour worked. Beginning in the June quarter 2022, a series of seven consecutive declines in annual productivity growth culminated in a 0.4 per cent year-on-year drop in the December quarter 2023. The same sequence also included the three largest annual drops in labour productivity in the history of the series.

    Next, inflation. The Reserve Bank of Australia (RBA) closely monitors unit labour cost (ULC) growth, given by the difference between growth in nominal labour costs and productivity. As then Governor Philip Lowe explained in June 2023, “There is a close relationship between inflation and growth in ULCs: over the entirety of the inflation-targeting era, the cumulative increase in the consumer price index has closely matched the rise in ULCs”. Granted, causation runs both ways. But all else being equal, continued rapid growth in ULCs will tend to imply ongoing high inflation.

    A sustainable equilibrium for Martin Place would probably look something like labour cost growth of 3.5 per cent less labour productivity growth of one per cent, implying ULC growth of around 2.5 per cent. Instead, we have the December quarter 2023 mix of falling productivity and ULC growth of around 6.5 per cent (closer to seven per cent for non-farm ULCs).

    As productivity goes backwards, ULCs have risen at some of their fastest rates since the 1990s. Yet the RBA seems unconcerned by negative quarterly productivity numbers. Its February Statement on Monetary Policy argued, “Much of the recent weakness in productivity has been a by-product of the pandemic and the economic cycle and will likely unwind over the next few years”. It highlighted three temporary factors:

    • The rapid and large-scale employment of new workers in an unusually tight postpandemic labour market, requiring additional time before becoming fully productive in new roles
    • The yet to fully fade effects of pandemic- and weather-related disruptions in key industries
    • A post-pandemic surge in hours worked that had run ahead of business investment, leading to “capital shallowing”.

    Stop-go scenario

    Analysis of Australia’s annual productivity data is consistent with this view as, after surging during the earlier phases of the pandemic, productivity has reversed in equally dramatic fashion. For example, after growing by 1.6 per cent in 2021–22 and 1.8 per cent in 2020–21, GDP per hour worked fell by 3.7 per cent in 2022–23. That decline is the biggest fall in the series’ history and reflects a similarly historically unprecedented increase of 6.9 per cent in hours worked, outpacing a three per cent increase in real GDP.

    In contrast, the early pandemic’s slump in hours worked exceeded the accompanying fall in output. Likewise, consider aggregate productivity growth across the market sector (the 16 industries where prices are set in markets — excluding ownership of dwellings and the three non-market industries of public administration and safety, education and training, and healthcare and social assistance, where measuring productivity is difficult due to the absence of market prices). In 2022–23, labour productivity, as measured by gross value added (GVA) per hour worked, dropped by a record-breaking 2.9 per cent, after rising by 2.5 and 1.7 per cent in 2020–22.

    The drivers of market sector labour productivity can be split into two components — multi-factor productivity (MFP) growth and changes in the capital-labour ratio. Growth in MFP is the difference between growth in real GVA and the combined growth in inputs of capital and labour. It measures disembodied technical progress due to improved efficiency of input use.

    Changes in the capital-labour ratio show increases (capital deepening) or decreases (shallowing) in capital per worker. The 2022–23 fall in labour productivity reflects a modest contribution from a 0.5 per cent fall in MFP alongside a much larger one from capital shallowing.

    Industry sectors take a hit

    We can also decompose market sector labour productivity growth into a direct or within-industry effect and a reallocation effect between industries. Over the past two years, productivity growth within individual industries has dominated. In 2022–23, labour productivity dropped in 11 of the 16 market industries. The steepest falls were in wholesale trade (-11.4 per cent), arts and recreation services (-10.2 per cent), and electricity, gas, water and waste services (-7.2 per cent). When weighted by industry size, declines in accommodation and food services trade (-2.3 per cent) and wholesale trade together accounted for more than half the overall productivity decline.

    In contrast, during pandemic-hit 2019–21, the reallocation effect was much more important as workers switched from lower to higher-productivity industries, lifting aggregate productivity performance.

    Finally, we can decompose the direct labour productivity effect into MFP and capital deepening for each industry. Once again, the main driver was capital shallowing, particularly pronounced in the accommodation and food services, wholesale trade, and transport, postal and warehousing industries, where growth in hours worked significantly exceeded increases in capital services. Falls in MFP growth played a supporting role.

    Overall, recent productivity developments seem to largely reflect the temporary impact of pandemic-related distortions within individual industries, where a surge in hours worked has led to capital shallowing. By the end of 2022–23, GDP per hour worked had returned to close to its prepandemic level while market sector productivity was above it.

    Unfortunately, once this adjustment process plays out, and absent any other changes, Australia seems destined to return to the same disappointing productivity performance the Productivity Commission warned us about before COVID-19.

    AICD chief economist Mark Thirlwell GAICD has focused on the international political economy at the Bank of England, JPMorgan, Austrade and Export Finance Australia.

    This article first appeared under the headline 'Asleep at the wheel’ in the May 2024 issue of Company Director magazine.

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