The COVID-19 pandemic has exacted a gruesome death toll and, the stunningly quick developing of vaccines notwithstanding, the public health crisis is still far from being contained. Indeed, in spring 2021, Europe appears to be in a third wave and the disease threatens to become endemic, a structural change to which our economies will have to adapt. The pandemic has caused the deepest recession since WWII, hitting demand and supply simultaneously with different force depending on the industry (Baldwin 2020). Prospects for social-contact dependent industries have arguably changed for good.
While this might sound Panglossian, out of this mayhem there are signs that an upside may be emerging. Early evidence suggests that COVID-19 has pushed some businesses to adopt process innovations that were technologically possible, but largely under-utilised, before the crisis. These long-overdue improvements to the way that firms operate could yield a substantial productivity dividend, offering hope of a new phase of economic dynamism once economies reopen. Robert Gordon (2016) pointed to a similar dynamic when explaining the dynamic trajectory of output per working hour in industrialised (and industrialising) economies after WWII.
The shock of the pandemic may have induced a similar upside shock to multi-factor productivity. Under pressure from the dire circumstances, reluctance – a historical perennial – to apply new, different ways of doing things gave way to more bold behaviour (David 1990). Broad-based application of innovations is typically slow. Legacy techniques regularly survive for an extended period. This is one reason for the observed substantial variance in efficiency within industries (Syverson 2011).
The pandemic has now undoubtedly changed our economic environment, opening different perspectives. New McKinsey Global Institute (2021a) research explores potential paths ahead for productivity growth to 2024 in the US and Europe. A review of eight sectors indicates that there is potential to accelerate annual labour productivity growth by around 1% a year to 2024. If that were to materialise, it would be more than double the rate achieved after the Global Crisis. This would imply additional per capita GDP in 2024 ranging from about $1,500 in Spain to about $3,500 in the US. That would be a stunning outcome, but delivering it will require two key conditions to be in place – that productivity-enhancing action spreads widely, to many companies, and that demand is robust.
As economic activity plunged during the pandemic, many firms – and healthcare organisations – took bold steps that could boost labour productivity growth. From a sectoral perspective, the largest gains to be reaped, at about 2%, could be in healthcare, construction, ICT, and retail (see Figure 1).
The pandemic pushed companies to accelerate the deployment of technologies that had been around for some time including digitisation, robotics, and algorithmic process controls. With the right conditions in place, this ‘creative re-processing’ could permanently raise labour productivity by substituting technology for employees. A McKinsey Global Institute (2020a) survey conducted in October 2020 found that companies digitised many activities 20 to 25 times faster than they had previously even thought possible. A McKinsey executive survey in December 2020 found that 51% of respondents in North America and Europe had substantially increased investment in new technologies (excluding remote work technologies) that year.
In healthcare, the pandemic-induced increased use of telemedicine has the potential to be the largest driver of a potential acceleration in productivity growth. Industry experts say that 20% of healthcare could be delivered virtually – permanently. In construction, half of respondents to a May 2020 McKinsey survey said that they had already increased investment in industry transformation, including in digitisation (McKinsey Global Institute 2020c).
A broad shift toward online interaction channels occurred during 2020. In retail, e-commerce exploded (McKinsey Global Institute, 2020b). Before the pandemic broke, e-commerce was forecast to account for less than one-quarter of all US retail sales by 2024; during the first two months of the COVID‑19 crisis, the actual share of e-commerce in total retail sales rose from 16 to 33%. One retailer achieved three years' worth of pre-pandemic rates of growth in e-commerce in eight weeks. These are structural changes, establishing positive, self-reinforcing feedback effects. Reverting to previous ways becomes implausible.
An immediate response to pandemic-induced revenue shortfalls was for businesses to strive to become more efficient – to substantially rethink their product, business, and operating models, and to become more responsive to contextual changes. Surveys indicate that more is to come. The December 2020 McKinsey survey showed that about 75% of respondents in North America and Europe said they expected investment in new technologies to accelerate substantially in 2020–24, up from 55% who said they increased such investment in 2014–19 (see Figure 2).
Figure 1 Our sector analysis indicates potential for incremental productivity growth of approximately one percentage point per year through 2024
Source: McKinsey Global Institute (2021b)
Figure 2 Surveyed executives expect acceleration on most drivers
Source: McKinsey Global Institute (2021b)
Condition 1: Diffusion of supply-side change needs to spread
The first condition that needs to be in place is that proactive supply-side reorganisation needs to spread far more widely, particularly in sectors that are large enough for diffusion to have an impact on economy-wide productivity. However, as of the third quarter of 2020, corporate action appears concentrated in large ‘superstar’ firms, defined as the top 10% of firms by 2019 revenue and economic profit (Manyika et al. 2018).
MGI analysis used a number of (imperfect) metrics that are available at the firm level, such as R&D spending, investment, and M&A, as proxies for potential drivers that could in the short-and mid-term accelerate productivity. The metrics showed further advances for firms in sectors that were already ahead of their peers before the pandemic. For instance, between the third quarters of 2019 and 2020, capital expenditures declined by much less for large superstars than for other groups of companies. R&D investment by large US superstars grew by about $2.6 billion (66% 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 firms (34%).
If advances do not diffuse widely, any acceleration in productivity growth could fall short of potential, the gap between superstars and a long tail of lagging or even zombie companies could widen, income inequality and unemployment could increase (McGowan, 2017). In short, there could be a repeat of the ‘great divide’ observed in the aftermath of the 2008 Global Crisis in which, at best, only a minority of companies, households, and regions enjoy productivity and income growth.
Overall, the jury is out on whether diffusion of potentially productivity-enhancing corporate action will be sufficiently broad-based to move the needle for entire economies. The situation looks somewhat more favourable in the US, despite more pronounced superstar dynamics, because SMEs account for a smaller share of the economy, and new business creation has risen during the pandemic—by 24% in 2020 compared with 2019. In Europe, SMEs make up a larger share of the economy, and new business formation fell sharply over this period in Southern Europe.
Condition 2: Demand needs to be robust
There is rising optimism that if and when the health crisis is contained, pent-up demand and savings stocked up during the pandemic could be unleashed, and there could be a strong initial bounce in demand, led by the consumer McKinsey Global Institute (2021a). The key question is whether – and how – demand can be sustained after an initial bounce back.
The large government economic support package in the US, notably the $1.9 trillion passed by Congress in March 2021, coupled with a large infrastructure bill currently being discussed as a medium-term follow-on initiative could create ‘high-pressure’ economic conditions, putting the US economy on a robust trajectory. In Europe, however, the situation thus far appears much less dynamic and substantially more vulnerable.
Healthy demand conditions need to persist to nurture sustained productivity increases. In a highly uncertain environment, with businesses experiencing low demand for their products and services, firms are understandably reluctant to commit resources to innovation and managerial reengineering, and the most productive firms find it more difficult to gain share.
Advanced economies had a demand problem well before the pandemic. Often, productivity growth had not translated into broad-based wage growth and consumption. In the US, median wage growth has been about 18% below productivity growth since 2000—6.5% of today’s GDP in forgone wages (Bughin et al. 2019). Moreover, investment rates were in long-run decline, reflecting factors such as aging, slow growth, and a shift to (less capital-consuming) intangibles.
The pandemic and the way that companies have responded to it could reinforce such drags (see Figure 3). Our sector reviews suggest that about 60% of the estimated productivity potential comes from firms taking measures to cut labour and other input costs, for example by increasing automation (McKinsey Global Institute 2021b).
Figure 3 The COVID-19 pandemic and responses of firms could exacerbate structural demand drags
Source: McKinsey Global Institute (2021b)
Will the right conditions fall into place after the pandemic?
The way ahead depends on policy choices made (see Figure 4). Unfortunately, growth akin to the years after the Global Crisis is a plausible outcome, particularly in Europe if there is no sustained and decisive action to spread advances more broadly, supporting demand and, concurrently, investment. At the same time, there is a distinct opportunity for the recovery to evolve as it did in the post-war years if such action is taken.
The stakes are high. Starting at US 2019 per capita GDP, the difference between having, for ten years, a per capita growth rate either like that after the end of World War II or the one experienced after the Global Crisis, for instance, amounts to 27%, or about $17,000.
Figure 4 Could productivity growth accelerate after the COVID-19 crisis?
Source: McKinsey Global Institute (2021b)
For innovation and diffusion on the supply side, large corporations need to continue investing in innovation and reengineering their organisations to become more flexible and adaptable, but should also consider how to catalyse change across their entire supply chains and ecosystems. Policymakers can support these efforts through, for instance, public procurement focused on innovation, direct R&D investment, and revising platform, data access, and competition rules, insolvency procedures, and product and labour market regulations.
On the demand side, large-scale, sustained, and direct government economic support could minimise or even reverse the potential demand gap, and, while there is a lively debate about the sustainability of such efforts, it appears important that government support is not withdrawn prematurely before economies have reached “escape velocity.’ In Europe, this might stretch certain readings of the fiscal rule book that is currently under review. There are substantial arguments for pondering a new approach (Blanchard et al. 2021).
But supporting demand is not only a job for governments. Firms, too, need to play their part in ensuring that productivity grows in a way that supports employment, median wages, and thereby demand. Companies clearly need to look after their bottom line, but they need also to grow revenue rather than solely seek efficiencies. They can ramp up retraining their workers to make them less vulnerable and rebuild their incomes. A sustainable recovery will face resistance unless median wage growth tracks productivity growth more closely than it has in the past. Some companies are responding to the pandemic by looking at how to strengthen the finances of their most vulnerable workers.
All need to invest more. Well-known focus areas include sustainability, infrastructure, and affordable housing, all of which have substantial investment gaps. Governments can support such investment by setting rules and pricing externalities, such as for carbon emissions. They can also look at rules governing land and housing markets to unlock investment. Furthermore, they can raise direct investment in high-priority, high-impact areas such as infrastructure, basic science, and skill building. To unlock funds, they could revisit the rules governing public investment, recognising it as a public wealth-building activity on a balance sheet rather than as a deficit-increasing fiscal expense.
What we found in terms of the business response to the pandemic gives rise to some optimism, and is reminiscent of Robert Gordon’s diagnosis: there exists substantial potential to lift productivity, at least for the next half decade that is the horizon of the survey (Chaney Cambon 2021). Admittedly, if these expectations pan out, this is not necessarily a trend shift—a new trente glorieuses (Fourastié 1979). The boost could prove to be temporary, but nonetheless would pull economies to higher output levels. Indeed, McKinsey surveys show that some businesses, in particular the larger ones, are prepared to commit substantial resources to this effort.
There is, however, a substantial downside risk. From the perspective of firms, weak demand increases uncertainty, and past MGI research indicated that this encourages firms to be defensive (Mischke et al. 2018). Therefore, the positive feedback loop could just as well work in reverse. This is a particular danger in Europe where, with still highly vulnerable firms, discussions about containing public sector deficits are gaining ground. Innovative firms are faced with higher hurdles. This can be self-reinforcing, providing the ground for mediocre perspectives.
The shock of the pandemic may prompt something of a supply-side miracle, but only if demand receives the attention it needs. The boldness and speed with which businesses and governments responded to the pandemic now need to be deployed in a new era of collective action to craft a broad-based, equitable, and sustainable recovery.
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