Economists need to try a lot harder to understand productivity

Most of the new discoveries acknowledged by the award of a Nobel Prize – such as about the role of information – are attempts to learn more about aspects of the economy’s workings that are oversimplified or simply assumed away in the “neoclassical” model of markets and the economy that was set in concrete by the late 19th century, but which still dominates economists’ thinking about the economy.

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Trouble is, apart from some modifications arising from the work of John Maynard Keynes and his followers after the failure of conventional economics at the time of the Great Depression, few of these advances in thinking get incorporated into the model all economists carry in their heads, nor the mathematical models that academic economists spend so much of their time playing with.

Why not? Because if you want to express economic ideas in equations rather than words, you have to keep it simple. There’s little room for complications or nuance in econometric models.

This is particularly true of the findings of behavioural economics, which uses social psychology to test the assumptions of neoclassical economics – such as that all of us always act rationally, and that we’re rugged individualists, whose decisions are never influenced by what other people are doing. Almost always, behavioural economics finds those assumptions grossly oversimplified at best.

The great test of any model is the accuracy of the predictions it makes about what will happen next. Even the most sophisticated models’ forecasts are often wrong and, not infrequently, seriously wrong. Every economist knows this, but desperately tries not to think about it.

The forecasts in the federal budget, for example, which are given great attention on budget night are quite unreliable, but nobody does anything about it. The Reserve Bank went year after year predicting that wages would grow far more than they actually did.

Clearly, the Reserve may know a lot about money, but its understanding of how the labour market works is woeful – something I’m not sure its boffins admit even to themselves. To them, the labour market works the same simple way every market works.

Their basic mistake comes from the neoclassical model’s implicit assumption that both parties to every economic transaction have roughly equal bargaining power. A boss bargaining with an individual worker? No probs.

The point is, rather than the mathematising of economics making the discipline more rigorous, it’s diverted the profession’s attention from what it really should be doing: being like a scientist and working to fix their model’s oversimplifications and dubious assumptions, in the hope this will make its predictions more reliable.

With the cost-of-living crisis coming to an end as the inflation rate returns to the 2 to 3 per cent target range, and interest rates fall back to more normal levels, the government can turn its attention to a problem we – and all the rich economies – have had for a decade or so: only slow improvement in the productivity of businesses and government providers of services.

Right, so what can economists tell us about productivity? Short answer: not all that much. What they do know is that improving productivity – increasing output faster than you increase inputs of raw materials, labour and physical capital – is the main way capitalist economies have been able to improve their material standard of living over the decades.

They’ve also figured out that most productivity improvement comes from the application of advances in technology, particularly labour-saving equipment. So spending on research and development should help. A better educated and trained workforce probably helps ,too.

So, what else can our learned economists tell us about productivity – how it works and how we can get more of it?

Not much. If productivity’s so important to our standard of living, you’d think economists would have put an enormous research effort into learning more and more about where productivity comes from and how we get more of it.

Sorry, we’ve been too busy with our maths and our modelling. Economists are great believers in innovation. They’d like to see a lot more of it. But they don’t practise what they preach. In academia, all the pressure is to stick to the orthodoxy. New ideas are usually wrong.

Ross Gittins is the economics editor.

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