The pandemic caused the deepest economic disruption since World War II, disrupting both supply and demand, and the way ahead is extremely uncertain. Will the stars align for economies after the COVID-19 crisis?
Despite the pressures on them and high levels of uncertainty, early evidence indicates that many firms were bold and innovative in response to the pandemic. Companies shifted rapidly to online channels, automated production tasks, increased operational efficiency, and sped up decision making and innovation of operating models. This could potentially more than double the rate of annual productivity growth observed after the global financial crisis.
New McKinsey Global Institute (MGI) research finds that there is potential to accelerate annual productivity growth by about one percentage point in the period to 2024. That would be more than double the prepandemic rate of productivity growth—a welcome positive.
The stakes are high. Starting at US 2019 per capita GDP, the difference between having, during ten years, a per capita growth rate like that after the end of World War II and the one experienced after the global financial crisis, for instance, amounts to 27 percentage points, or about $17,000. Achieving 1 percentage point of additional productivity growth per year in every country to 2024 would imply an increase in per capita GDP ranging from about $1,500 in Spain to about $3,500 in the United States.
Realizing this potential requires action to be more widespread and demand to be robust. Both are possible but not given. Early evidence suggests that most action thus far is focused on large, superstar firms. Moreover, 60 percent of the productivity potential could come from action to improve efficiency through, for instance, accelerated digitization and automation. Absent action, the risk is rising inequality and unemployment, undermining demand just when it is needed most and putting the prize of a productivity dividend in doubt.
Much depends on the decisions taken by businesses and policy makers. If action that could enhance productivity remains concentrated and if demand is not robust, the recovery could look similar to the sluggish decade after the global financial crisis. If action broadens and demand is strengthened, a period of fast economic renewal more akin to the post-war years could follow (Exhibit 1).
The research explores the potential path ahead for productivity growth to 2024 in the United States and six large European economies—France, Germany, Italy, Spain, Sweden, and the United Kingdom. Together, these seven economies account for 40 percent of global GDP. Eight sectors are examined in depth that, on average, for around 60 percent of the nonfarm business economy, as well as five additional sectors accounting for 40 percent of the nonfarm business economy for which relevant trends are extrapolated from the eight focus sectors.
Despite uncertainty, some firms responded boldly to COVID-19, acting in ways that have the potential to increase productivity
As economic activity plunged during the pandemic, many firms took bold steps that could transform their business over the long term. Some companies’ pace of digitization and other technologies quickened, firms became more efficient and agile, remote working became the norm, and many businesses—and people—went online for the first time. The advances on a range of drivers that have boosted productivity in the past may offer the potential to raise the economy-wide pace of productivity growth considerably. However, positive action appeared to be concentrated in large leading firms.
The use of technologies such as digitization and automation appears to have accelerated in some companies during the pandemic. With the right conditions in place, this has the potential to raise productivity by substituting employees or contribute to raising output per worker. In the December 2020 McKinsey Global Economic Conditions survey of executives, 51 percent of respondents in North America and Europe said that they had increased investment in new technologies (excluding remote work technologies) during 2020. Companies digitized many activities 20 to 25 times faster than they had previously thought possible, one McKinsey survey found.
There was also a broad shift toward online channels during 2020. According to McKinsey’s Digital survey, a similar 59 percent and 60 percent of respondents in North America and Europe, respectively, said that they were experiencing a significant increase in customer demand for online purchasing and/or services as a result of COVID-19. One retailer achieved three years' of prepandemic rates of growth in e-commerce in eight weeks.
The pressures of the pandemic also forced many businesses to become more efficient, to rethink their product, business, and operating models, and become more agile, all of which could potentially drive faster productivity growth. According to our executive survey, 42 to 45 percent of respondents in Europe and North America reduced their operating expenditure as a share of revenue between December 2019 and December 2020. One telecom firm increased its use of digital interactions in response to customers’ desire for contactless resolution of issues. It deployed a virtual collaboration tool that enabled remote maintenance, and achieved about $50 million of savings as well as higher resolution rates and customer ratings.
Human and physical capital accumulation are two crucial elements that typically drive growth in productivity, too, but here the evidence was more mixed. On human capital, a recent McKinsey report found that COVID-19 has accelerated the adoption of fully digitized approaches to learning. On the other hand, the temporary closure of educational institutions and the fact that many workers were outside the labor force for a relatively long period due to lockdowns could have a negative impact on skills. The pandemic had a generally negative impact on short-term accumulation of physical capital. In the United States, total investment (gross fixed capital formation) remained flat between the third quarters of 2019 and 2020, having risen 4 percent between 2018 and 2019 and 5 percent annually between 2015 and 2019. Europe experienced a much steeper drop in overall investment.
Another potential driver of productivity growth is business dynamism, but here the situation is uncertain. Higher rates of entry and exit by firms that fosters increased competition, and M&A activity that promotes resource reallocation and consolidation can help the most productive firms to grow and move ahead of competitors. Total global M&A volume decreased by 21 percent in the first three quarters of 2020, compared with the same period in 2019. The volume slumped 43 percent in the United States in the same period. Firm entry and exit rates also fell in most countries during the pandemic, but this reflected deliberate government policies to avoid mass bankruptcies. From January to September 2020, compared with the same period in 2019, across our sample countries, bankruptcies dropped by close to 25 percent on average. The creation of new firms declined in most countries, with some exceptions. The rate of new business creation rose 12 percent in Sweden and by 18 percent in the United States. When direct governmental support tapers off, it remains to be seen whether we will see renewed business dynamism or the declining dynamism observed in some countries for years before the pandemic.
Measurable advances by firms so far appear concentrated in leading sectors and firms, particularly in the United States
Our analysis used a number of metrics available at the firm level, such as R&D spending, investment, and M&A, as short-term proxies for the range of potential drivers that could accelerate productivity. These are imperfect, but we need to look at large sets of firm-level data to get an indication of the breadth of advances. As of the third quarter of 2020, acceleration was not broad-based among firms or sectors, understandable given that the pandemic disruption was still severe.
Advances on the metrics we analyzed appeared greater in sectors that were already ahead of their peers across the same metrics before the pandemic in both Europe and the United States. The sectors that had the largest share of firms improving across metrics in the third quarter of 2020 had also been advancing on them before the pandemic, namely professional, scientific, and technical services; information technology (IT); healthcare; and communication services. These are large sectors, and if they achieve higher productivity growth, they could have a positive impact on productivity growth in the total economy. However, some other large sectors such as travel, transport, and logistics, as well as some subsectors of manufacturing, experienced less progress on the same measures.
Will productivity and growth return? An author of our new McKinsey Global Institute research discusses.
At the firm level, on almost all metrics, acceleration was less widespread during the pandemic than before it. The share of firms that accelerated on different metrics was very similar in the United States and Europe both before and during the pandemic. For example, 36 percent and 38 percent of US and European firms, respectively, increased their capital expenditure, compared with 57 and 58 percent prepandemic.
On many indicators, advances appeared concentrated among large superstar firms, particularly in the United States. This was true across many sectors, but particularly pronounced in professional, scientific, and technical services, IT, electronic manufacturing and healthcare. In the United States, the revenue and capital expenditure of large superstars declined by much less than those of the rest of companies analyzed between the third quarters of 2019 and 2020. Large superstar firms lost no revenue in this period, while their competitors experienced a decline of 11 percent. In addition, R&D investment by large superstars in our US sample grew by about $2.6 billion (66 percent of total R&D investment growth in the third quarter of 2020 from a year earlier), compared with $1.4 billion for all other types of firm (34 percent of total R&D investment growth). The superstar effect was less pronounced in Europe.
If advances broaden and demand is robust, annual productivity growth could accelerate by about 1 percentage point in the period to 2024
Significant productivity acceleration could be possible once the economic shock of the pandemic dissipates if corporate action spreads, and if demand strengthens. In the eight sectors reviewed, we estimate there is potential for an increase of 1.5 percentage points of productivity growth per year in the period to 2024. For the total nonfarm business sector, the potential could be 1.1 percentage points of additional annual productivity growth. Our sensitivity analysis suggests that the potential could range between 0.7 and 1.5 percentage points.
The largest potential incremental rise in productivity growth in 2019–24 could be in the healthcare, construction, information and communications technology (ICT), retail, and pharmaceuticals sectors at around 2 percentage points per year. Most of the other sectors we analyze could benefit from an acceleration in annual productivity growth of about 1 percentage point per year (Exhibit 2).
Surveys indicate that firms intend to take more action and expect an acceleration in productivity growth
Forward-looking survey evidence compiled in the course of 2020 together with responses to the December 2020 McKinsey Global Economic Conditions survey revealed significant intent to build on the changes many businesses made in response to the pandemic. For instance, the December survey showed that around 75 percent of respondents in North America and Europe said they expected investment in new technologies to accelerate in 2020–24, up from 55 percent who said they increased such investment in 2014–19. Many respondents also said they intend to move to more efficient and agile ways of operating, and a majority said that the COVID-19 crisis would accelerate their creation of new products and/or services (Exhibit 3).
The economic shock of the pandemic and firms’ response could exacerbate long-run demand drags, compromising the productivity potential
We estimate there could be a difference between potential supply growth and baseline growth in effective demand in 2024 of up to 6 percentage points expressed in terms of 2019 GDP.
A temporary consumer-lend burst of pent-up demand is likely once the health situation is fully resolved. However, longstanding structural drags on demand also need to be tackled if demand is to be robust over the longer term. Large-scale continuing fiscal support from governments, the Biden Administration’s $1.9 trillion support package being a prominent example, as well as further strong action by policy makers of the kind being discussed in early 2021 such as a large infrastructure package in the United States, could help mitigate or reverse these drags (Exhibit 4).
Without action to strengthen demand, however, growth could remain tepid, wage growth low, and, as a result, productivity growth slow as firms do not invest and the most productive firms find it difficult to grow as happened after the global financial crisis.
- After a potential burst of pent-up demand in the short term, the behavior of consumers and firms could dampen income and private consumption over the longer term. Before the pandemic, productivity growth had not always fully translated into broad-based growth in wages and consumption. Shifts by businesses that result from the pandemic, notably efficiency-focused productivity action could, over the longer term, dampen employment and incomes, and hasten labor-market polarization and propensity to spend. Our sector reviews suggest that about 60 percent of the estimated productivity potential comes from firms taking measures to cut labor and other input costs, for example by increasing automation. If these productivity gains are not reinvested in growth that drives jobs and incomes, they could lead to a widening gap between productivity and median wage growth, rising unemployment or lowering employment. The nature of the COVID-19 crisis and the action taken by firms could exacerbate longstanding structural drags on demand. Accelerating superstar effects could also lead to further rises in inequality, for instance if the labor share of income falls further.
- The pandemic and changes to the economic fabric it has prompted could depress already weak investment over the longer term. Going into the pandemic, investment rates were in long run decline due to factors such as aging and slow growth, and investment weakened further during COVID-19. While investment will inevitably at least partially recover from this collapse, a number of factors could be a persistent drag on investment. A weak macro and consumption outlook can reduce the need to invest. A shift to intangibles and superstar effects, as well as heightened risk and high hurdle rates, might decrease the investment intensity of production. And a potential increase in bankruptcies and corporate debt overhang can reduce the ability to invest.
- Debates on debt sustainability will shape future public investment and consumption. Government consumption and investment made a modest, but declining, contribution to demand growth before the pandemic as a majority of our sample of countries strove to stabilize public debt built up largely in response to the global financial crisis. This trend reversed dramatically when the pandemic hit. Public expenditure soared as governments sought to avoid an even larger economic collapse, but at the cost of very substantial increases in public debt. The longevity of public support, when it may taper off and how the transition out of it is managed will be a crucial aspect determining present and future aggregate demand and productivity growth.
Firms and policy makers need to work on three interlocking priorities
Businesses and policy makers were audacious in their response to COVID-19 and need to be bold in crafting a healthy postpandemic economy once the health crisis is contained and economies are fully open. CEOs can shape the outlook rather than solely responding to it through the new products and services they offer, the investments they make, and the wages they pay. The immediate interest of individual firms (for instance, cutting costs) can stand in the way of the collective interest of driving growth. Policy makers have a range of interventions at their disposal to engage with businesses to steer to the right outcomes. Our analysis suggests three interlocking priorities for business leaders and governments:
- How can innovation and other advances that can increase productivity growth be sustained and spread? To underpin strong long-term growth, large corporations need to consider how to catalyze change across their entire supply chains and ecosystems to spread advances more widely. Policy can support these efforts through, for instance, public procurement focused on innovation, direct R&D investment (subsidies or tax credits), and by revising platform and competition rules, bankruptcy procedures, and product and labor-market regulations.
- How can action by firms that could potentially boost productivity growth also support employment, median wages, and demand? Lifting demand through a combination of consumption and investment to match additional potential supply could add 6 percentage points of GDP by 2024, or around $2 trillion, in our sample countries. Businesses can help address demand drags by emphasizing growing revenue rather than solely seeking efficiencies, and by investing in reskilling workers who, without the right skills, risk losing their jobs or wage cuts, undermining demand. Policy makers have a range of tools to support demand and after-tax income from fiscal stimulus to wage setting norms and pre- and redistribution.
- How can investment be increased—and directed to the right places? Higher business, public, and household investment will be required to support both demand and productivity. Specific types of long-running investment gaps that could be closed now include sustainability, infrastructure, and affordable housing. For instance, in the United States, closing infrastructure gaps could produce an increase in annual investment equivalent to 0.5 percentage point of GDP. Businesses need to consider making environmental, social, and governance issues even more central to their decision making process. They can work toward setting higher sustainability standards and invest in line with those. Governments can support such investment by setting rules and pricing externalities, such as for carbon emissions; looking at rules governing land and housing markets; increasing direct investment in high-priority, high-impact areas such as infrastructure, basic science, or skill building; and revisiting the rules governing public investment, recognizing it a public wealth-building activity on a balance sheet rather than as a deficit-increasing fiscal expense.