1. How to use GuruFocus - Tutorials
  2. What Is in the GuruFocus Premium Membership?
  3. A DIY Guide on How to Invest Using Guru Strategies
Holly LaFon
Holly LaFon
Articles (9489)  | Author's Website |

GMO Commentary: Total Factor Productivity Growth Equals Totally Fictitious Pretentious Garbage

By James Montier and Philip Pilkington

March 14, 2019

In perhaps the most deliciously ironic example of misattribution of all time, Mark Twain is often held to have said “It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so”. There is no evidence that Twain ever said or wrote those words, but the sentiment is indeed valid irrespective of the authorship. It resonates particularly on the subject of so-called total factor productivity growth (TFP). This once arcane topic has found its way into more mainstream discussions. For instance:

The productivity slowdown is a major explanation for the stagnation in real incomes…This seems to reflect weak investment and, above all, declining growth of “total factor productivity,” a measure of output per input of capital and (quality-adjusted) labour. TFP is a measure of innovation, of the ability to produce more valuable output with given quantities of inputs. Without innovation, the rising prosperity of the past two centuries would have been impossible. In truth, innovation…is almost everything.

The Financial Times, 12 June 2018

So why are rich countries growing so slowly? Part of it is due to the lingering effects of the Great Recession, but part is due to a slowdown in the rate of productivity growth. Productivity is any economy’s long-term underlying engine of growth: once you put all of a country’s people to work and provide them with as much capital equipment as they can use, further growth depends on the efficiency with which they can create goods and services – i.e. on productivity.

Bloomberg, 8 October 2018

China’s economy is slowing…After the financial crisis, China’s total factor productivity growth – a measure of how fast an economy increases the efficiency with which it uses labour and capital – suddenly began to fall, and has stayed low ever since.

Bloomberg, 15 January 2019

As the above makes clear, economists often tend to fetishize productivity in general.

Productivity is often talked about as if it were a real thing – rather than the result of

calculation (output divided by hours worked). This is then compounded when so-called growth accounting exercises are undertaken, and the topic turns to the mysterious TFP.

Growth accounting is often framed in terms of a Cobb-Douglas production function:

Where Y is output, L is the actual number of hours worked, K is the value of the capital stock, and A is a scale factor, the exponent ɸ is often assumed to correspond to the observed labour share of income.

When Solow first laid out his framework way back in 1957, he himself noted “it takes something more than the usual ‘willing suspension of disbelief’ to talk seriously of the aggregate production function”. This is something of an understatement. There is almost no reason to assume such a thing exists at all.

As Franklin Fisher (an MIT professor) has written,1 “Indeed it is truly amazing that, after so many years, we should be having a symposium of aggregate production functions: for, perhaps even more than the square root of negative one, aggregate production functions are truly imaginary…Nevertheless, economists go on behaving as if there were no problem here”. Indeed one of our colleagues made what we believe was an appeal to the wisdom of crowds when he observed “plenty of economists seem to believe there is benefit of using a production function”. However, since we have spent a good deal of our lives disagreeing with the majority of economists this left us unmoved. We find it reminiscent of Greenspan’s statement in 1999 that “To spot a bubble in advance requires a judgement that hundreds of thousands of informed investors have it all wrong”.

Despite the tenacity of many economists, the aggregate production function is riddled with problems. As Joan Robinson long ago noted:2

The production function has been a powerful instrument of miseducation. The student of economic theory is taught to write Q = f (L, K) where L is a quantity of labour, K a quantity of capital, and Q a rate of output…He is instructed to assume all workers alike, and to measure L in man-hours of labour; he is told something about the index number problem involved in choosing a unit of output; and then he is hurried on to the next question, in the hope that he will forget to ask in what units K is measured. Before ever does he ask, he has become a professor, and so sloppy habits of thought are handed on from one generation to the next.

How do you go about adding up all the different types of capital in an economy? How do you combine shovels and semiconductors in some non-monetary fashion?3

This is just one of many ‘aggregation issues’. Even if one allows for the existence of well-defined and optimized production functions at the level of the firm (already an implausible belief), the aggregation from the micro to macro requires such stringent conditions that it is almost impossible to believe in an aggregate production function. For instance, you would need to believe that all firms employ different types of identical workers in the same proportion, you would need to believe all firms produce all outputs in the same proportion (no specialization in production), and you would need to believe all micro production functions are identical except for the capital efficiency coefficient. Clearly, these assumptions are at odds with reality.

Read more here.

About the author:

Holly LaFon
I'm a financial journalist with a Master of Science in journalism from Medill at Northwestern University.

Visit Holly LaFon's Website

Rating: 0.0/5 (0 votes)


Please leave your comment:

Performances of the stocks mentioned by Holly LaFon

User Generated Screeners

pascal.van.garsseHigh FCF-M2
kosalmmuseBest one1
DBrizanall 2019Feb26
kosalmmuseBest one
DBrizanall 2019Feb25
MsDale*52-Week Low
Get WordPress Plugins for easy affiliate links on Stock Tickers and Guru Names | Earn affiliate commissions by embedding GuruFocus Charts
GuruFocus Affiliate Program: Earn up to $400 per referral. ( Learn More)

GF Chat