Europe has lagged the United States in terms of economic growth since the mid-1990s, when GDP per capita growth in large European economies began to fall behind that of the United States. As a result of these trends, per capita income in the euro area (converted using purchasing power parities) was about one-third lower than in the United States in 2002, compared with about one-quarter lower in the early 1990s. A number of theories have been advanced to explain this widening of the gap. Some point to the information technology boom in the United States, which provided a major boost to productivity in the late 1990s (see top chart). Others blame Europe’s low rates of labor utilization, which are caused in part by labor market rigidities that discourage people from seeking work.
In a new IMF Working Paper, Estevão takes an indepth look at the euro area’s productivity performance. He does not dismiss the productivity leap made by the United States in the late 1990s. But he argues that the euro area’s low labor productivity growth is due less to slowing total factor productivity growth—something that would point to problems in adopting new technology and improving managerial efficiency—and more to a slowdown in capital investment. This phenomenon, he says, can be explained by labor market reform in many euro area economies that—combined with wage moderation—has made it advantageous for companies to hire new workers rather than invest in new technology to improve the productivity of existing workers.
Excessive pessimism is misplaced
Many European countries are seeking to increase labor market flexibility as a means to boost labor participation, which is much lower in the euro area than in the United States (see bottom chart). While labor market reform is something Europe needs—to deal with a dwindling labor force caused by aging and falling birth rates—this reform also has the effect of temporarily slowing labor productivity growth. “Slowing labor productivity growth in Europe can be explained by the positive shock coming from the labor market. With more people being hired, there is a decline in labor productivity growth because the capital-to-labor ratio does not grow as fast,” Estevão says.
The EU’s Lisbon agenda tries to address both labor market participation and productivity growth. But according to Estevão, these two goals are contradictory to some extent. “When you increase labor market participation, you are going to have a negative effect on labor productivity growth,” he says.
So should the European Commission and national governments stop fussing about productivity? Yes and no. “It is not that productivity is not important—it is very important—but given the problems in Europe caused by low labor utilization, it makes sense to focus on increasing participation first,” Estevão says. But, he continues, policymakers need to realize that this will have a perverse effect on labor productivity over the short to medium term. In sum, “excessive pessimism about what is going on with labor productivity growth in Europe may be misplaced.” In terms of economic policy, Europe should focus on what matters most. According to Estevão, “this would entail focusing a bit less on productivity growth and a bit more on increasing labor market utilization.”
Copies of IMF Working Paper No. 04/200, “Why Is Productivity in the Euro Area So Sluggish?” are available for $15.00 each from IMF Publication Services. See page 323 for ordering information. The full text of the paper is also available on the IMF’s website (www.imf.org).
U.S. labor productivity growth is higher
Note: The euro area comprises Austria, Belgium, Finland, France, Germany, Greece, Ireland, Italy, Luxemburg, the Netherlands, Portugal, and Spain.
Data: ECAMECO database; OECD productivity database; and IMF staff calculations