Knowledge Center: Europe's Productivity Challenge

Europe can catch up with the United States. But to do so it must encourage competition, regulate business more astutely, change the role of the state, and develop new competitive strategies. A decade and a half ago, it wasn't just the more fanciful observers who thought that Europe was ready to challenge the world's leading economic superpower. The region was outpacing the United States in growth. Postunification Germany was being hailed as an economic giant in its own right. And in the European Union, the tide of integration euphoria, nurtured by the single-market program and plans for a single currency, was running quite high.

The intervening years have been a disappointment. The "old" continent, to be sure, appears rich, socially progressive, and culturally exciting. It has an impressive crop of global companies. But far from catching up with and overtaking the United States, Europe is finding that the economic cracks in the facade may be getting wider. A huge effort is now required not just to realize the full potential of Europe but also to ensure that an aging population doesn't overwhelm what it has already achieved. The consequences of failure would be relegation to the second economic division and a blow to Europe's self-esteem.

The inappropriate way the challenge has been framed is part of the problem: many Europeans, for example, believe that merely matching US growth rates is a sufficiently high aspiration. There is also a poor understanding of the causes of the malaise, Europe's welfare state supposedly being the main culprit. Others mistakenly blame globalization for threatening their standard of living.

The real issue is the staggeringly large—32 percent—per capita output gap between Europe and the United States. That gap is mostly a consequence of Europe's poor productivity over the past 10 to 15 years. Europe steadily narrowed the transatlantic productivity divide in the 1950s and 1960s but ran out of steam at the start of the 1980s. Signs of improvement in 2006 should not distract attention from the long-term trends or from the fact that the reality is actually worse than official statistics suggest. Matching growth rates will not be enough; Europe must instead focus on improving its labor productivity. Only by grasping the productivity imperative can Europe's policy makers and business leaders formulate a workable strategy to accelerate growth.

It's productivity, stupid

Europe's crisis is not only that it produces one-third less than the United States per capita but also that the gap between the two is not becoming notably smaller. There are three key explanations for the gap (exhibit). The most important is low labor productivity (16 percent less than that of the United States in 2004). The other two involve low labor inputs, which were 19 percent below US levels in the pre-enlargement European Union of 2004. In short, Europeans work fewer hours than their North American counterparts do. Many people exaggerate the role of the welfare state in Europe's economic problems; in reality it accounts for little more than a third of the labor input gap. Overwhelmingly, Europeans have opted for more leisure.

Labor productivity

The true gap in labor productivity between the two regions is probably even bigger than official statistics suggest. They do not, for instance, take into account the impact of Europe's lower employment levels, which exclude more of the least productive workers—those with limited skills and experience who are the first ones laid off. If the average unemployed person in the European Union is, say, 30 percent less productive than his or her employed counterpart, the official statistics overstate productivity, at least at levels close to full employment, by approximately 4 percent.

Large shares of so-called output in Europe, moreover, do not reflect real economic activity. In business, economic output is measured by market outcomes: the difference between the value of goods and services sold and their inputs. But that doesn't apply to public-sector workers such as teachers, the police, firefighters, or tax collectors. In their case statisticians simply add up salaries and assume that the resulting sum equals the total value of their services. When Europe's public sector accounted for a small proportion of GDP, measurements of the sector's output mattered much less. Today, when governments employ large numbers of people—almost one-fifth of Portugal's total employed population, for instance—it produces big distortions.

Arguably, a more instructive way of getting at the truth is to make a transatlantic comparison of individual sectors. A 2002 study by the McKinsey Global Institute (MGI) showed that sectors in France and Germany trailed their US counterparts much more dramatically than the official figures proclaimed, notwithstanding a higher capital intensity and even after stripping out the productivity-lowering effects of government employees and the unemployed. According to this MGI sectoral analysis, French and German productivity (as an average of the combined sectors) lagged 15 and 22 percent, respectively, behind that of the United States. Europe was ahead in some retail areas and in mobile telephony but behind in automotive, road freight, banking, electric-power generation, clothing, and fixed-network telecommunications. It is making up ground in road freight, fixed telecom, and banking, but in the other sectors the gaps are large and growing.

Labor inputs and the welfare state

The welfare state—defined in the narrow sense as social transfers, entitlements to sick leave and maternity leave, social-insurance payments, and the labor taxes to pay for them—directly influences only a small part of Europe's 19 percent labor input gap. A much bigger portion (14 percent) results from the fact that each European employee puts in fewer hours: 1,564 annually as opposed to 1,819 for the average worker in the United States. Factors other than the welfare state bear a greater responsibility for that gap.

More part-time employment, which some might blame on bigger tax "wedges,"¹ and tightly enforced rules for sick pay and maternity leave undoubtedly play a role in creating the gap in output per capita. But much the bigger part is the result of longer vacations, more time off, and a shorter workweek. These differences, accounting for a third of the gap, have more to do with voluntary negotiations and collective bargaining—choice, in other words—than with the welfare state, whose impact on labor inputs is responsible for not much more than a fifth of the 32 percent output gap. That leaves poor labor productivity to explain 44 percent of it.

Labor productivity is largely unaffected by the welfare state, though some interventions, such as job protection or outdated labor regulations, certainly hinder it. Set against this, however, are high unit costs for labor and welfare state measures that encourage rationalization, thus driving out less productive workers and increasing the productivity of the employed. On average, these sets of factors likely cancel each other out.

Europe's welfare systems not only are a mere scapegoat for the Continent's economic ills but also put less money into the pockets of less-privileged citizens than most people assume. Reductions in relative poverty may look quite good, but absolute incomes at the bottom end of the scale are no better than those in the United States, despite higher per capita spending.

What Europe must do

Improving productivity in Europe is a matter of urgency not just to keep it in the top league of the global economy but also because of looming demographic change. Without drastic intervention, Europe will get poorer as it ages. Only productivity growth can prevent the unenviable trade-off between falling incomes for pensioners and higher taxes for workers.

Four measures, taken together, will help Europe to close the output gap and protect itself against the coming demographic storm. The first two—completing the single market and regulating business more intelligently—would mobilize the full weight of the European market and enable companies to boost their productivity and competitiveness. The third measure would focus Europe's companies on what they do best and most productively: producing higher-value goods and services. The fourth, changing the way government delivers services, would divert state spending to education and research (a prerequisite for any strategy to create long-term economic value) and free up funds for greater consumption and investment in the private sector.

Complete the single market

Companies typically achieve world-class productivity in highly competitive markets² with enough scale to release what the economist Joseph Schumpeter calls forces of creative destruction and entrepreneurial innovation. In these environments, companies must increase their productivity to survive and grow. Europe 1992 was an EU program that aimed to create an effective single market by harmonizing regulations and standards and not just reducing tariff and nontariff barriers. This effort was clearly the right idea, but, as many commentators pointed out, the implementation of the single-market program was flawed. How can the promise of Europe 1992 be realized? Two areas will be critical to productivity: deeper structural change and better integration of Europe's capital markets.

Successful structural change. To replace less productive businesses with more productive ones rapidly through Schumpeterian dynamics, economies must liberalize their product markets and allow competitors to enter and exit markets freely. Too often, however, Europe's governments prefer to save large companies teetering on the brink of failure. The protection of existing jobs and structures, however obsolete, almost always takes political priority.

The European market does not yet have the characteristics of a large, level playing field that rewards entrepreneurial innovation appropriately and quickly. A level playing field allows productive businesses to thrive while the rest fall by the wayside. To develop innovations and create more value, entrepreneurs need a large, unfragmented market with fewer bureaucratic hurdles. Such a market does not fully exist in today's Europe.

Financial services. Integrating EU financial markets has proved especially elusive, raising valid questions: is integration worth the effort and, if so, how can we do it better? The answer to the first question is an unambiguous yes. More than a decade of thinking about the economics of financial markets and growth suggests that the European Commission of Jacques Delors³ may not have been optimistic enough about the benefits of deeper financial integration. A fully integrated European capital market would provide access to funding for every kind of business in Europe—not just the big ones—and would contribute as much as 1 percent⁴ in added value for the entire Continent. European investors would see and evaluate cross-border investment opportunities much more clearly and reap higher returns and greater diversification as a result. Only then will Europe as a whole allocate its available financial resources to the activities with the highest possible productivity. Companies can consolidate optimally, for instance, only when takeovers and mergers reflect a Europe-wide view.

The real problem lies with national governments and regulators that preserve their influence by failing to implement EU directives in the intended spirit, even when they follow the letter of the law. If the painful psychological, logistical, and political effort expended to achieve monetary union was worthwhile, the creation of a pan-European regulatory and takeover code and of a single legal form for all EU listed companies seem relatively small steps to pursue.

Get smarter with regulation

Few business leaders advocate giving more decision-making power to governments. Yet calls to "let the market rip" are too simple if Europe is to increase its productivity in key areas of the economy. What should come after deregulation is not a downsized, passive "night watchman" state but one that would perform its core tasks with intelligence, good judgment, and professionalism. Indeed, such smart regulation has helped some of Europe's sectors, such as telecommunications and road freight, catch up with or even overtake the United States. There are five main elements.

Good governance. Regulatory authority in important areas such as communications frequencies, postal services, electric power, and air traffic control should be assigned to the European Commission in Brussels rather than left with member states. The Final Report of the Committee of Wise Men on the Regulation of European Securities Markets⁵ has already shown that the European Union can improve upon its subsidiarity principle—the idea that it should act only when it is better suited than member states to do so—by limiting the role of the European Parliament in any future capital market reform to setting the legal framework, while leaving the more detailed technical elaboration with the executive branch (in this case, the European Commission).

A clear purpose. New regulations should include a clear statement of purpose and get a hearing only after cost-benefit analyses show that state intervention would help achieve the desired objective. For these analyses, Europe needs expert, independent institutions modeled on the US Congressional Budget Office.

Appropriate design. Smart regulation primarily means replacing rules with a framework of incentives that steer behavior in the desired direction, as well as specifying performance criteria to measure the success or failure of a regulation once it goes into effect.

Effective implementation. The European Union should also create an independent, Europe-wide regulatory authority responsible for evaluating the impact of new regulations. Systematic reviews should assess whether regulations are meeting their intended objectives in line with defined performance criteria.

Expiration. Regulations, even smart ones, must not develop lives of their own; they should be audited to ensure that they are still fit for their purpose and that the benefits outweigh the costs. An institution, perhaps modeled on the US Office of Management and Budget, will be needed to review regulations and to recommend abolishing them when necessary. "Sunset clauses" should terminate them automatically after a set period unless they are explicitly extended (by parliamentary vote, for example).

Add value by defining categories

For a knowledge economy such as Europe's to become more productive, it must not only use less input for its current output but also generate higher value added for each unit of input. In other words, revenue productivity is every bit as important as cost productivity. To raise Europe's revenue productivity, it will be necessary to focus on products and services in which the Continent has a comparative advantage and can define a whole category. Some of the world's top companies owe their success to the fact that their products (Kleenex, Nescafé, Scotch tape, and the iPod are iconic examples) do just that. Europe should extend this concept beyond products to include entire industries—indeed the whole of Europe—while endeavoring to parlay specific European advantages into category-defining positions.

That means striving to associate the entire Continent with a consistent set of values and experiences. Europe's position in luxury goods might be a strong starting point. European companies with plenty of design talent and engineering know-how turn simple, well-known products into objects desired by the affluent. Indeed, a majority of the global economy's luxury goods companies are European. Green technology, health care, and high-quality capital goods are other areas suitable for defining categories, as are industries that are still on the drawing board or just leaving research laboratories (such as nanotechnology and composite materials). They all have one thing in common: they make the most of what Europe can do best. Greater productivity will be the reward.

Reinvent the state

A single market, smarter regulation, and the ability to define categories would all help strengthen Europe's productivity. However, success depends on a fourth element: reinventing Europe's welfare state and changing the way it delivers public services. Resources tied up in traditional state consumption must be channeled to Europe's future—notably education and research, given their importance to defining product and service categories and to financing the coming demographic upheaval.

Let it suffice to make two points on this vast topic: one about the scale of the challenge, the other about the means. Many European countries allocate close to half of all their economic resources to government expenditure—a stunning figure, since a mere century ago many states made do with 5 to 10 percent of total output. Not all of this money is spent on government services; on average, European countries take around 22 percent of GDP to provide for policing, defense, and foreign affairs, as well as (in many countries) schools, universities, and (in part) health care. Much of the rest is spent on social transfers and government-run insurance. But fresh government spending on pensions, health care, and long-term care will be urgently needed to counter the effects of demographic change and to boost investment in research and education. At present, public spending in these areas comes to only $1,456 per capita in the EU-25,⁶ compared with $2,338 in the United States.

As for the means, consensus-oriented and egalitarian countries, such as those in Scandinavia, offer grounds for optimism: if Sweden, with its huge welfare state, can slash government spending, so can the rest of Europe. If (as in Sweden) there is a consensus about the right reform process, EU member countries can avoid greater uncertainty and a rise in precautionary savings (which has hurt countries such as Germany). If reforms are necessary, they must come swiftly and be implemented decisively. The willingness of the public to live with and even embrace belt-tightening reforms should not be underestimated. McKinsey's 2005 online survey Perspektive Deutschland suggested that 61 percent of Germans favored a more vigorous reform process in their country, and 62 percent wanted German society to change more quickly.⁷ To garner public support, it is important that any cuts be, and be perceived as, integral parts of a plan to create a brighter future—one in which the welfare state is secure and does its job better, and pensions are once again as "safe as houses."

Although Europe badly trails the United States in output per capita and labor productivity, it can still catch up. There are many reasons for the gap, but a lack of intense competition in Europe lies at the heart of all of them. Completing the single market and developing a smarter regulatory system will be big steps forward, but Europe must find new strategies, such as defining whole categories of products and services, before it can move confidently onto the front foot. None of these strategies will succeed unless Europe reshapes the role of the state.