David Dodge: Improving Canada's productivity
Remarks by Mr David Dodge, Governor of the Bank of Canada, to the Canadian Council for Public
Private Partnerships, Toronto, 28 November 2005.
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Investing in productivity
Today I want to discuss the importance of efficiency in Canada's economy. Specifically, I'll focus on
some of the elements that contribute to productivity growth in Canada-a subject that I've addressed
before and that you've been hearing a lot about lately.
Let me start by explaining what we mean when we talk about productivity. Measures of productivity tell
us how much output we produce from the use of tangible inputs-such as skilled workers and capital
equipment-and intangible inputs-such as technological advances and managerial and
entrepreneurial know-how. Productivity rises over time as we boost output by finding new and more
efficient ways to use these inputs.
When measuring productivity, economists often prefer to use a measure called total factor productivity,
which includes all these inputs-capital, labour, innovation, and know-how. In practice, however, it is
very difficult to measure total factor productivity. That's why analysts usually focus on the more
commonly used and better-understood measure, labour productivity. This measure tells us how much
output is produced per worker or per hour worked. Labour productivity has the added advantage of
being closer to measures of standards of living and more directly comparable across countries. Of
course, labour productivity is affected by experience and education, by the amount of capital
equipment (notably machinery and equipment) that is available to workers, and by innovation and
know-how.
We care about productivity because it is critical to our national standard of living. There are other
factors that affect our living standards-changes in our terms of trade and in
employment-topopulation ratios, for instance-but productivity growth is the main contributor to sustained
improvements in real incomes and rising standards of living over the long term. But productivity growth
in Canada, measured as real gross domestic product per hour worked, has averaged less than 1 per
cent per year so far in this century. Frankly, we must do better.
The components of productivity
But what does "doing better" actually mean? First, it means increasing the amount and the quality of
physical capital per worker-giving employees better tools to work with. It also means allocating
resources more efficiently and being more innovative. In my remarks today, I'm going to focus on the
two latter elements-efficient allocation and innovation.
I'll start with efficient allocation. At any point in time, we allocate resources among competing uses,
always trying to use the resources we have as efficiently as possible. The goal is to move to the point
where, given current production practices and knowledge, we are getting the absolute most out of the
labour and capital resources at our disposal.
The second element of productivity is innovation. This means generating new knowledge, improving
technology, and enhancing both the processes and the organization of production. To take advantage
of innovation, we also need to upgrade the skills of our labour force and, in some cases, change our
business and managerial practices. Innovation and skills enhancement, when combined, lead to
continuing growth of output per unit of input.
For long-term improvements in productivity, we need both innovation and more efficient allocation.
And so enterprises, sectors, and governments must follow the practices and policies that not only will
allocate resources more efficiently, but also provide the framework to encourage innovation.
Productivity through innovation
When we talk about encouraging innovation, we're talking about two things. First, there are the
incentives to encourage product innovations. These include the encouragement of research and
development (R&D) that generate the "eureka!" kind of knowledge creation that's done at universities,
research institutes, and knowledge-intensive companies. But just as important, although sometimes
overlooked, are the research and development that lead to incremental improvements in the design
and performance of existing products.
This kind of innovation requires investment. In Canada, we make quite large public investments in
research through our public institutions. Research spending by Canadian companies and private
sector institutions, on the other hand, tends to lag that of other countries.
But dollar amounts don't tell the whole story. Research success depends not only on the amount that
you invest, but also on how efficiently you invest it. That's why it is hard to judge the innovative
capacity of an economy or an enterprise by the raw dollars that it spends on R&D. The fact that the
R&D budget of Apple Computer has lagged behind the computer industry average would come as a
surprise to anyone who has a new iPod on his or her Christmas list. Others are probably in a better
position than me to offer advice on ways to get more bang for your research buck, but this will be an
important part of future discussions on productivity.
processes
The second type of incentive to encourage innovation relates to improving the used by an
organization. For example, how can an organization use new technology to restructure its business
and managerial practices? And what incentives drive that restructuring? Well, the most obvious
incentives are the need to maintain a competitive edge, the desire for profit, and the fear of going
bankrupt. That is why economies that have intense competition in domestic markets-from both
domestic and foreign firms-are the most innovative. Indeed, competition encourages both product
and process innovation.
But innovation means taking risks. Enterprises must also be given the incentives to take those risks.
And they should be rewarded by the market when they do so. Among other things, this requires a
financial system that appropriately prices the risks and potential returns being taken on by investors.
Finally, we know that innovation is not a government-driven process: It occurs on the shop floor, in the
start-up's laboratory, and in the minds of entrepreneurs. In our businesses and public sector
institutions, we need to develop a culture that encourages both the "eureka!" moments and the
incremental improvements that come from the incentive to stay just one step ahead of the competition.
Productivity through efficient allocation
Let me now talk about improving productivity through more efficient allocation of resources. Some of
the policies that promote better resource allocation are the same ones that encourage innovation. Let
me mention four elements that are critical.
First, we need an appropriate legal framework of property rights, including intellectual property and
contract law. This framework must also include suitable penalties for those who break these laws,
breach the public trust, or commit fraud.
Second, labour markets must operate efficiently, encouraging the flow of resources from
lessproductive to more-productive uses, and from shrinking sectors to growing ones. This flexibility is
encouraged through appropriate labour market policies, education, and training. I won't say more
about this-recent research by the International Monetary Fund and the Organisation for Economic
Co-operation and Development explores this issue thoroughly.
The third critical element is a financial system that operates efficiently, helping to allocate scarce
economic resources to the most productive uses, in the most effective way. In previous speeches, I
spoke about the importance of a well-functioning financial system and about the need to support the
efficiency of our financial institutions. I also spoke about the need to promote efficiency in the
regulation of securities markets and about the role that Canada's pension system can play.
Building the right infrastructure
The fourth key element is the construction and operation of the physical infrastructure that we need for
economic growth and development. I will focus the remainder of my remarks on this area. This critical
infrastructure includes public assets, such as highways, public transit and transportation facilities,
power, waterworks and waste water, schools, hospitals, and other facilities. It also includes private
infrastructure, such as pipelines, rail, and telecommunications networks.
To illustrate why infrastructure is an important means of encouraging more efficient resource
allocation, let me offer a few examples. Canada is envied around the world for its wealth of natural
resources. But getting these natural resources to market has always relied on railways, pipelines,
ports, and other transportation infrastructure. Similarly, Canada's world-renowned telecommunications
sector has grown out of huge investments in this country's land-based and satellite infrastructure.
The clusters of industrial, manufacturing, and technology companies located in our major centres are
there because our cities function well, with quality water, sewer, transportation, and municipal and
social services. These companies employ Canadians who were educated and trained by our public
schools, colleges, and universities. And these companies are funded by individuals who are willing to
invest their savings through a financial system that they trust.
Clearly, infrastructure plays a key role in creating an efficient, productive economy. But today, there
are clear signs of a public infrastructure deficit in Canada. And there is a growing concern that this
deficit could harm Canada's productivity growth and standard of living, unless we take steps to correct
it.
Estimates of the magnitude of this deficit vary considerably.1 But it is generally acknowledged that the
gap will not be reduced solely through government financing. No single means of development always
creates the right infrastructure, so it will take a number of different solutions. Through our history, we
have used various methods.
We have seen private infrastructure development, encouraged by governments through land grants,
monopoly rights, subsidies, and so on. In these examples, the private sector takes on the risk of
financing the infrastructure, with the promise of profits down the road. Perhaps the most well known
example of this type of infrastructure development is the Canadian Pacific Railway.
We have also seen purely public infrastructure building, in which the government or its agencies build
and operate the infrastructure. An obvious example is Canada's network of highways and roads.
Some infrastructure has been built and operated entirely by private companies, under the umbrella of
a legal framework that helps to protect their investment and of a regulatory structure that helps to
protect the consumer. Cable television is an example of this type.
Finally, there are public-private partnerships (PPPs). These take different forms. Many employ a mix of
public and private funding, with the operation and maintenance of the infrastructure performed by a
private enterprise on behalf of the government. The most familiar example of a PPP is the
Confederation Bridge between New Brunswick and Prince Edward Island. But there are still relatively
few existing PPPs in Canada. Other countries, such as the United Kingdom and Australia, offer many
examples of successful PPP infrastructure. Unlike most jurisdictions in Canada, these other countries
already have a well-developed legal and regulatory framework for PPP investments.
Each of these methods has advantages, but also problems. In the final analysis, it is all a question of
incentives. For example, when infrastructure projects are solely publicly funded, the usual incentives
to build and operate efficiently-the incentives to avoid bankruptcy and to make a profit-are not the
driving motive behind the investment.
The most efficient and timely allocation of resources for infrastructure occurs when the incentives are
right. And that framework of incentives usually includes some expectation of profit. This applies
equally to decisions on what to build and to decisions regarding how to operate the infrastructure once
it is in place.
The hardest incentive to get right is that of proper pricing. A lack of pricing that appropriately reflects
demand and supply conditions may be one reason why there have been relatively few PPP
infrastructure projects in Canada. It is particularly important to improve pricing mechanisms for
services that are provided through public infrastructure. Governments have often been unwilling to
price-to-market infrastructure-based services. As a result, shortages are managed through non-price
rationing, such as rolling electricity blackouts, highway congestion, or waiting lists for government
documents or services. And occasionally, we get the opposite problem-an over-build of infrastructure
that cannot be justified by demand. New technologies, such as transponders on vehicles to monitor
road use, and meters that allow peak-hour pricing of electricity, provide new opportunities to gauge
demand for these services, and to price them accordingly.
Another key incentive with respect to infrastructure investment is the incentive to manage risk. Private
financing of infrastructure through the markets tends to lead to better assessment of the risks of the
investment, because financial markets are better able to measure and price risk. This is not to say that
we should expect the private sector to shoulder all the inherent risks of major infrastructure
investments without any public sharing of those risks. But financing through markets provides a
mechanism by which we can better assess the economic merits of an investment.
The infrastructure investment climate
These are some of the complex issues facing us as we try to eliminate Canada's infrastructure deficit.
The timing is right to make these investments. During the early 1990s, governments had to deal with
large fiscal deficits and they simply did not have the cash to invest in building infrastructure. That is not
the case today. Further, over the next couple of decades as our population ages, more Canadians will
be saving for their retirement. This added saving will boost an already growing demand for long-term
financial assets.
Pension and endowment funds are now allocating an increasing share of their portfolio assets to
infrastructure investments, in an attempt to increase returns and better manage risk through portfolio
diversification. These funds are increasingly looking for longer-term assets that provide a better match
to their liabilities. So far, much of this investment has gone to projects in other countries. This is partly
because the domestic markets for PPP in these other countries are more developed than ours.
In Canada, we currently see three conditions that present us with a vital opportunity. We have
governments that are committed to investing in infrastructure, a private market with an appetite for
longer-term financial assets, and a pent-up need for those investments in Canada. If we get this right,
we can enhance Canada's productivity in two ways. First, the improved infrastructure can help to
boost the productive capacity of the private sector and help to achieve more efficient resource
allocation. Second, better infrastructure is a key component in attracting the companies and the
people who spearhead continuous innovation.
Conclusion
The Bank of Canada's mandate is to promote the economic and financial well-being of this country.
We know that an efficient and innovative economy is critical if we are to achieve sustainable growth
and prosperity for Canadians.
That is why, in past speeches, I have focused on the need to have efficient financial institutions and
markets. The right infrastructure is also key to promoting efficiency. And PPP is a practical way to
match the demand of savers for long-term assets with the economy's need to build critical
infrastructure. It is also a way to promote the efficient operation of that infrastructure. That is why I
have chosen to focus on this issue today.
I know that over the course of this conference, we'll hear some innovative ideas on how to achieve
these goals. Your deliberations are important. The right infrastructure can support and encourage
initiatives to increase productivity. Finding innovative and reliable ways to fund this country's current
and future infrastructure requirements is a key element of any effort to improve Canada's productivity
and raise living standards for Canadians.