Why Europe Lags Behind The United States In Productivity

Regulation and market barriers continue to hold back the continent's service sectors. Europe has made considerable economic progress in the past 15 years, but its per capita GDP is still $11,250 lower than that of the United States—$4.5 trillion in all. A preference for leisure time is one reason, but a widening productivity gap between Europe and the United States is the major culprit. What accounts for it? The answer is underperforming service sectors. Local services (such as retailing) alone account for two-thirds of the productivity shortfall. But Europe, boasting examples of best practice across service sectors, could reduce the gap. The trick would be for companies to emulate these examples in their own industries and for governments to help them do so by removing regulatory hurdles.¹

The opportunity to improve Europe's lagging service sectors is one of the major themes addressed in Beyond austerity: A path to economic growth and renewal in Europe, a new report from the McKinsey Global Institute (MGI).² The report analyzes Europe's strides in reforming labor markets, cutting unemployment, and fueling growth in per capita GDP; the many pressures bearing down on growth; and how to build an effective pro-growth agenda using recent reforms as a platform. Given high debt and deficit levels, little scope remains to spur growth through short-term stimulus spending. Europe must therefore embrace structural reform—and boosting the performance of service industries is a critical part of this effort.

In Europe, service sectors account for a lower share of overall economic activity than they do in the United States. Across the Atlantic, 19 percentage points of gross value-added growth were accounted for, from 1995 to 2005, by local services,³ business services,⁴ and professional and financial services. In the EU-15, these added only 10 percentage points (Exhibit 1).

From the 1960s to the mid-1990s, Europe steadily closed its productivity gap with the United States. But then the gap started widening again—and one important reason was that Europe's service sectors underperformed their US counterparts (Exhibit 2). While productivity is not an end in itself, it is a critical means to an end: per capita GDP, competitiveness, and productivity move in lockstep. If Europe is to close the per capita GDP gap with the United States, it will therefore have to boost productivity, particularly that of services. US productivity grew by 22 percent between 1995 and 2005, and local, business, and professional and financial services together contributed half of that expansion. In Europe, productivity grew by 15 percent, of which only one-quarter came from these service industries.

Many policy makers in Europe are maintaining the traditional focus on technology-intensive and manufacturing sectors, reflecting their strong role in productivity growth and the exposure of the region's economies to global competition. But the fact remains that as the number of manufacturing jobs has declined in the EU-15, only the service sectors have increased their levels of employment. It is the service sectors that offer Europe the major potential for job creation.

How to raise European service productivity

A range of regulatory and market barriers stand in the way of higher productivity in European services, which suffer from relatively low scale in many operations and from product, land, and labor market regulations that inhibit competition. MGI sees two important areas to address. It will also be necessary to ensure that enablers for growth, including infrastructure and skills, are in place.

Injecting competition

The liberalization of monopolistic industries in Europe has consistently led to dramatic increases in productivity. Coupled with standardization, regulation to heighten competition has made a success story of telecommunications, for example. GSM—the Global System for Mobile Communications—was initially deployed in seven European countries, in 1992; today the system has more than four billion users worldwide. In the road freight industry, the relaxation of price controls and the removal of barriers to cross-border trade led to a 15 to 25 percent drop in tariffs and 5 percent-plus annual productivity gains throughout the 1990s in France and Germany.

Despite such examples, many other service industries, including postal services, rail transport, and professional services (such as law and accounting), continue to receive regulatory protection from competition. Entry barriers are still common. Many European countries limit the number of pharmacies, for instance, in effect creating regional monopolies on retail sales of medicinal products. Some European countries set price ceilings or floors—for architects and lawyers in Italy and Germany, among others. France and Spain prohibit advertising for notaries. Some countries have abolished such advertising and price restrictions in recent years, apparently without damaging these markets. But regulation remains high overall. In professional services, the 2008 product market regulation index of the Organisation for Economic Co-operation and Development (OECD) is nearly twice as high for Europe as for the United States.

Deregulation

Regulation not only hinders competition in Europe's service sectors but can also compromise the efficiency of operations. Retailing, for instance, still suffers from restrictive land and product regulations. Zoning laws that limit the size and density of stores put bigger, more efficient formats like hypermarkets at a competitive disadvantage: in France, the introduction of more restrictive rules on the size of retail outlets during the 1990s halted the sector's productivity growth—opening new stores larger than 6,000 square meters became virtually impossible—and the restrictions eventually had to be eased. In the United Kingdom, the number of new stores opening has slowed because of insufficient reform to planning laws. In the Netherlands, individual municipalities have the power to prevent retailers from selling televisions in furniture stores.

Strict labor laws, which often encourage informality, are another barrier to productivity. Businesses have an incentive to stay smaller to avoid a higher level of regulatory scrutiny, and this stratagem prevents companies from achieving scale in fragmented industries, including construction. (In Portugal, informal labor accounts for more than a quarter of the hours worked in residential construction.) In retailing, Dutch labor legislation typically requires stores to pay their employees 30 percent more for evening work.

Operational barriers remain rife too. In land transport, standardized road freight containers that could boost productivity have not achieved widespread use. In the construction industry, the complex way projects are set up compromises productivity: traditionally, there are separate tenders for design, engineering, and actual construction. That undermines coordination and inefficiency—for instance, contractors are rarely involved in the design phase to discuss cost-efficient construction specs and materials. Since the public sector accounts for 33 percent of all construction in Germany and for 25 percent in the United Kingdom, if governments changed their procurement and tendering processes, they could directly help to institutionalize best practices.

Emulating best practice

European service sectors could vastly increase their productivity and growth. Take food retailing. If the EU-15 as a whole achieved the productivity levels of its top-quartile countries in this sector—admittedly not an easy task in many places—it could achieve a 44 percent boost in productivity. This would translate into a 21 percent increase in the productivity of retailing in general, or a 0.75 percent increase in the value added generated by the entire EU-15 economy. (These figures assume that the hours freed up as a result of improved productivity will be reallocated to the rest of the economy at current sector productivity levels.)

In road freight, emulating best practice would boost the productivity of land transport by 50 percent, adding 0.4 percent of incremental GDP to Europe's economy. Reaching best practice in construction could boost its productivity by 12 percent, for a 0.5 percent increase in the value added generated by the European economy overall.

Europe's low-key revolution in reforming its product and labor markets fueled a relatively solid economic performance before the global crisis hit. But in the early aftermath of the global recession, Europe is battling to revive the headwinds of growth—with little scope to prime the pump, given high debt and deficits. If it is to sustain robust growth in the coming years, structural reform is no longer optional, and freeing service industries to compete is a vital component of that change.

About the Authors:- Jan Mischke is an associate principal in McKinsey's Zurich office; Baudouin Regout; who is based in Brussels, is a senior fellow of the McKinsey Global Institute; Charles Roxburgh is a director in the London office and a director of MGI.

Thanks to Jan Mischke, Baudouin Regout, and Charles Roxburgh / McKinsey & Company
https://www.mckinseyquarterly.com/Why_Europe_lags_behind_the_United_States_in_productivity_2684