Two Economists Look at Europe's Economic Slowdown
Economic growth and labor productivity have been slowing in Europe as workers take more leisure time. Two experts look at why.
Published: Monday, November 22, 2004
For thirty years Western Europe has consistently turned out a Gross Domestic Product 70% that of the United States. Why hasn't Europe caught up? And curiously, European hourly productivity is much higher than GDP figures would imply, at 90% or better of that of American workers. Why the gap, and why did labor productivity, Europe's best indicator, begin to slide after 1995? Two economists, one from Europe and one from the United States, probed the persistent thirty-year differences between living and earning patterns in Western Europe and the United States at a November 4 UCLA forum.
Gianni Toniolo of the University of Rome, who holds a joint appointment at Duke University, was joined by Barry Eichengreen of the University of California at Berkeley in the History Conference Room of UCLA's Bunche Hall for a discussion on "Europe in the Age of Globalization." The meeting was sponsored by the UCLA Center for European and Eurasian Studies and chaired by the center's director, historian Ivan Berend. Both speakers compared the United States to the EU-15, the original 15 Western European members of the European Union before the accession of 10 East and Central European states to the EU last May.
Gianni Toniolo: Europeans Place a Higher Value on Leisure
Gianni Toniolo began by lamenting the growing rift between America under the Bush presidency and the European Union. "The Atlantic has never been as wide as it is now, at least in my lifetime, which is postwar. And I am deeply concerned about that. I am deeply concerned about the cultural, political misunderstandings, the lack of understanding that seems to appear on the two sides of the Atlantic."
A History of Economic Convergence -- Followed by Economic Divergences
Back in 1820, Toniolo said, Western Europe and the United States had about the same per capita GDP. "By 1870 the Americans were ahead of Europe and the gap in GDP per capita continued to grow all the way until 1950." In 1870 Europe produced 82% of the U.S. per capita GDP. After the ravages of two world wars this fell to only 50% in 1950. But in the rebuilding and modernization of European industrial plant from the 1950s onward Europe took large strides toward closing the gap. By 1970 Western European per capita GDP reached 70% of the U.S. and has pretty much frozen there.
But this did not mean that European industry was as far behind as those numbers suggested, both economists agreed. Productivity, or output per hour worked, has come much closer to U.S. rates. Barry Eichengreen in his presentation reported that the EU-15 average GDP per hour worked in 2000 was 90.7% of the United States and four of the fifteen, Belgium, France, Italy, and the Netherlands, have higher labor productivity than the U.S.
Gianni Toniolo summarized some of the institutional arguments used by various economists to explain why the U.S. has remained ahead. These include a history of cheap land but expensive labor, which encouraged investment in labor-saving machinery; a more technically oriented educational system; and the unified American market compared to the multiple smaller states of Europe. Most of these U.S. advantages were strongly reduced after World War II, by the end of the American frontier, moves toward European economic unification, and common advances in technology.
Europeans Begin to Work Fewer Hours
"The story, however, becomes interesting when we look at why, in spite of being so productive or equally productive as America we poor Europeans are 30% poorer that you Americans," he said. "And the answer is very simple. From the mid-seventies onward Europeans began to work fewer and fewer hours over the life cycle. There was less participation in the labor force, but more important still, each fulltime worker worked less than before and continued to work less and less and less."
Toniolo cited competing American and European explanations for this behavior. American scholar Edward C. Prescott at the University of Arizona has argued that the answer lies is tax policy. Toniolo summarized:
"You have two economies, the European and the American, and in his simulated economy if we have a similar level of marginal taxation on labor in Europe as we have in America, Europeans will work exactly the same number of hours as Americans. He is convinced that cultural differences do not play any role whatsoever. As in classical economics, if you have people put in the same circumstances they always react in the same way. He goes around Europe all the time preaching low taxes and that would be the solution to all your problems."
The principal European theorist, Toniolo said, is Olivier Blanchard, currently teaching in the United States at MIT. "Blanchard is skeptical about Prescott. He says that for technical reasons he doesn't buy Prescott's model because of the extremely high elasticity in the supply of labor. But also he finds that empirically it doesn't fit what we know. That within Europe, for instance, there are great varieties of taxation rates but they don't explain the differences in hours worked."
Gianni Toniolo said he accepts estimates by other economists that taxation can explain about a third of the differences in hours worked. The other two thirds, he suggested, are a cultural choice to value leisure above money. In his view, one way to look at a country's wealth would be to assign a value to leisure time, as well as a value for the longer life expectancy of Europeans compared to Americans. If these are added to European GDP, he said, "then we find that we get much higher rates of growth, with America having only a 15% higher rate of growth."
Even looked at this way, he conceded, "Europe's economic performance, in the 1990s at least, has certainly not been brilliant." Possible reasons, he suggested, include Europe's lower fertility and immigration rates. "Americans are growing in population. Europeans are no longer doing so."
On assimilating immigrants, he said, "We are not nearly as good as the Americans in dealing with immigration. Maybe it is a new phenomenon in some countries like in my country. We discovered ourselves, much to our surprise, to be racist. We were very scornful of America because of the way, sometimes we read, how minorities were treated. Now we are full of minorities" and have had severe difficulties in absorbing them.
The Unexplained Slowdown after 1995
Both Toniolo and Eichengreen commented on a disturbing drop in Western European growth rates after 1995 compared to the several previous decades. Gianni Toniolo commented:
"After 1995, both output per capita and productivity per hour worked . . . declined in Europe. So the gap is probably widening. Over the entire 1990 to 2001 period productivity growth averaged 2% a year in Europe, considerably higher than the 1.6% in the United States. But if we take 1995 to 2000, then the story is different. American productivity grew by 1.1%, historically a fairly low rate of growth, but European productivity declined by 0.6%. The levels of productivity now are lower in Europe than in the United States. How do we explain this? The standard explanations that we have in America, the Prescott explanation, etc., that Europe is overtaxed, is overregulated, etc., do not go very far in explaining, because Europe was overtaxed and overregulated way back at the time of the catching up. So it didn't become overtaxed and overregulated from 1995 onward. If anything, the contrary is true."
The European Union, he said, "has been able to do a lot of deregulation, and deregulation was accelerated with the coming of the euro, particularly after 1995, particularly in the product and financial markets. But even in the labor market there has been quite some deregulation, including in what is considered to be the most regulated economy, which is Italy. So this cannot fly."
Two Possible Explanations
Toniolo suggested two possible reasons for the post-1995 European slowdown. First, that computer technology has not been as fully implemented in European businesses, especially in retailing where small stores remain much more common than in the United States. And second, that rising unemployment after 1995 led European governments to pressure businesses to avoid layoffs, while in the United States there was a process of cutthroat restructuring and downsizing of many corporations.
The second explanation included some restructuring of the labor market to retain jobs, but not the same kind of jobs as before. "Since there was labor market deregulation, I can tell this for sure for the Italian case, there has been considerable increase for employment in Italy at the time where productivity goes down. Why? New employment has been at the lower level of the productivity scale, so we are hiring unskilled workers because they are the ones who are not protected. The new regulations still protect the skilled workers of the large companies but at the bottom you are more under-regulated, we have a lot of immigrants, etc. So they are the least productive and they lower the aggregate level of productivity."
At bottom, Toniolo said, both these hypotheses are rooted more in culture and history than in economics. In addition to small shops and efforts to retain jobs for low-skill workers, there were also significant transitional costs in the political decisions to unify Germany and to consolidate the European Union with a single currency. "To the extent that in the long initial phase they were partly responsible for unemployment and low levels of aggregate growth, these were probably prices that Europeans were willing to pay for such an important achievement as the European Union."
Europeans Won't Give Up Their Little Shops
As for the comparative backwardness of the retail sector, Gianni Toniolo suggested that "this also depends on policy choices and in defending a lifestyle based on encouraging high density residential living in the extraordinarily beautiful European cities, preserving high cost retailing in the city core while at the same time inhibiting the extension of suburban sites suitable to modern big-box retailing developments that are so common in America. Here again it is a cultural rather than an economic choice."
He noted that in Italy a few years ago a referendum to permit shops to remain open longer in the evenings "was overwhelmingly rejected by the population." Similarly, if you go to Switzerland, he said, "and you need an aspirin after 7:00 pm you can die of headache before you can get it."
Toniolo defended Europe's differences as reasonable choices of reasonable people. "All this boils down to history, politics, deeply embedded cultural differences. Is this after all so bad? Is there a one-size fits-all model for societies and economies to develop? Both Europe and the U.S. have reached a level of economic welfare that, while not neglecting the need for future growth, allows wide room for society to pursue noneconomic growth, seeking the preferences of each individual society. There is no reason why this should be met by derision, skepticism, or sometimes even hatred by each of the two sides when they talk to each other."
Barry Eichengreen: Europe's Institutions Need to Change
Barry Eichengreen appeared to place little credence in cultural preferences as an explanation for the growing lag between Western European economies and that of the United States. He looked instead to the need for institutional transformation. He was careful at the outset, however, to say that this should be to solve problems in specific industrial and financial sectors, not to initiate a wholesale imitation of anyone else's model.
"It is fashionable," he said, "to argue that Europe is 'economically challenged,' that it has to remake its institutions along Anglo-Saxon lines. It's just worth reminding ourselves how often we have heard similar arguments where only the names have been different. In the 1980s it was said that the United States had to remake its institutions along the bank-based, industrial group, cooperative labor relations lines of Japan. And of course nowadays most people think that is the last thing we should be doing.
"From the mid-eighties to the mid-nineties a lot of people on both sides of the Atlantic were arguing that Europe's economic structures and institutions were better tailored to the imperatives of late twentieth century growth than those of the United States, that market-led finance and cut-throat capitalism were not the best basis on which to sustain economic growth, and now the tables have turned. And they will turn again in one direction or another."
Institutional Lag Meets Technological Imperative
Europe's problem is more narrow, Eichengreen said. Most of Western Europe's current institutions "became articulated and in their modern form . . . after World War II when the particular constellation of economic institutions and structures that European economies developed were well attuned to the economic circumstances of the time. Europe was coming out of twenty years of depression and war, where it had lost technological and organizational leadership to the United States and there existed a big backlog of technologies ready to be taken off the shelf and organizational forms ready to be easily transferred from the United States through the technical missions of the Marshal Plan, the agency of U.S. multinationals, and a variety of other mechanisms."
The challenge for economic growth at that time "was not to be the leader in radical innovation but to be a leader in adaptation and incremental innovation. And I will argue that Europe's institutions were well designed for those circumstances."
But institutions become entrenched and are not easily changed. Eichengreen said that as a historian he has no facility for predicting the future, but that the more the future proves to be characterized by rapid technological innovations such as the computer revolution the more inappropriate Europe's current institutional framework will prove to be.
He pointed to the creation of a single European market and the recent accession of Central and East European states to the EU as indicators that Europe retains a capacity to adapt to new circumstances, but suggested that needed large-scale change will be difficult, prolonged, and painful.
While agreeing with Gianni Toniolo that Europe is stronger on hourly productivity than in overall GDP and that Europeans have cut their work hours in recent years, Barry Eichengreen said that there are also fewer people working in Europe as a percentage of the able-bodied population. "As I read the evidence, about a third of the difference in overall GDP per capita can be attributed to lower output per hour of work, a third to lower hours per employee, and a third to lower employment rates."
Eichengreen offered some statistics on GDP per capita, GDP per working hour, and other output measures for fourteen European countries compared to the United States at two points in time, 1970 and 2000. For the whole fourteen, GDP per capita has held steady over the thirty-year period at about 70% of the U.S. figure. GDP per hour, however, rose from 64.8% of the U.S. rate in 1970 to 90.7% in 2000. Over the same period the number of hours worked by employed Europeans fell from 101% of the U.S. total in 1970 to 85.6% in 2000 and employment of the potential working age population fell from 103.6% of the U.S. rate to 87.6%.
The aggregate numbers for the European fourteen tend to hide some pretty large differences between them. While the western part of Germany produced 74.2% of U.S. per capita GDP in 2000 and France 70.7%, Greece produced only 47.6% and Portugal 51.6%. And while the fourteen as a whole stood at only 90.7% of U.S. hourly productivity, Denmark, France, Italy, and the Netherlands in 2000 had higher hourly productivity than the United States, which was not true for any of the fourteen in 1970.
Eichengreen said that economists agree that there has been no improvement in per capita GDP relative to the U.S. over the last thirty years, "but that is misleading because it doesn't adjust for the fact that since about 1975 Europeans' taste for leisure has mysteriously increased. They have been working less and a good deal of the gap has been closed."
Europeans Work Less Because of Policy, Not Preferences
But why is this so? Eichengreen suggested a different answer than Gianni Toniolo. "Do Europeans simply like their leisure time more or do they have other constraints that encourage them to substitute leisure for labor and capital for labor? There is probably something to both points, I would agree. I think the evidence on participation rates points pretty strongly to a role for tax systems and social welfare systems more broadly, so I think part of the confusion here has to do with how much explanatory power labor tax rates have for participation rates, for hours per labor force participant, versus looking at the whole panoply of relevant social policies, which includes not only taxes on labor but unemployment insurance schemes, social security systems, and a variety of other things."
In Europe, Eichengreen pointed out, there are much lower labor force participation rates for women and for older men than in the United States. "You can definitely see a role there for social security systems and tax rates, but these are the data that Gianni was talking about, that you have to be a brave econometrician to see a relationship between only tax rates on the one hand and hours per employed person on the other."
He concluded that social security systems play as large a part as tax rates in inducing people to withdraw from the labor market in Europe. "Tax rates explain about one third of the variation. All of these policies put together explain more, about two-thirds. My reading of the evidence is that the more important reason that hours vary is policy, not preferences. And in turn that suggests not imputing the same value to an hour worked and an hour of leisure. Leisure time ought to be valued at a lower price for Europeans, partly because their choice to take so much of it reflects distortionary policies."
Europe Is Lagging in the New Economy
For Europe, Eichengreen said, while hourly productivity is respectable, the rate of hourly productivity growth has been slipping since 1995, from almost twice the U.S. rate to about half of U.S. levels. Between 1980 and 1995, EU-15 average annual labor productivity growth was 2.33%, but this fell to 1.37% for the years 1995-2001. In contrast, productivity in the United States registered an average of 1.37% per year for 1980 to 1995 but grew at 1.85% between 1995 and 2001.
One possible explanation, he said, was European weakness in adopting information technologies. "It so happens that none of the world's 25 most visited websites are in Europe. Does this reflect lesser facility with ICT or linguistic diversity? It is not clear how to interpret this number, but you hear it a lot." U.S. investment in integrated circuit technologies is running at almost twice as much as Europe, 4.2% vs. 2.6%. "We invest a lot more in this stuff than Europeans do. Anyone who has tried to purchase a personal computer in Europe will understand this."
Eichengreen conceded that other factors may copntribute to the different outcomes in Europe and America, such as the free-spending ways of Americans that fueled a wave of consumption in the 1990s and an American fiscal policy that favored monetary fiscal stimulus while the European Central Bank cautiously sought to avoid inflation. Even if this is partially true, however, Barry Eichengreen felt that Europe's institutions are not currently well-adapted to a high-tech computer-using economy.
"Europe continues to emphasize vocational training relative to university education to a greater extent than the United States. Its policies are less immigration friendly as we heard. They are doing a little bit to liberalize them, to encourage Asian engineers to come to Europe rather than to come to the U.S., where the Patriot Act doesn't help us. There is more limited business-university cooperation in Europe. There are higher firing and hiring costs that make it difficult and imprudent for startups to ramp up production and employment rapidly. Bank-based financial systems are conservative. Relationship bankers like to lend to familiar customers using familiar technologies. The venture capital industry is growing in Europe, but it has a long way to go before it rivals that in the United States. And most importantly, I guess, in my view, high taxes and relative income compression are less conducive to risk taking than the high-powered incentives and stock option systems and so forth we have in the United States."
Retail Trade Dropping Behind
Europe is certainly behind the United States in information technology manufacturing, but at 6% of the U.S. economy that alone cannot explain very much of the differential in aggregate economic performance. A bigger contributor, Eichengreen said, is weakness in retail trade -- smaller stores that are open fewer hours and less use of the internet for sales. While annual labor productivity growth in manufacturing is respectable in Europe and in telecommunications outstanding, at 13.8% per year, it fell to only 0.5% per annum for 1996-2000 in wholesale and retail trade.
"In addition Europe does relatively poorly in financial services, so that's another sector where information technology is important and where maybe European banks and nonbank financial institutions have been slow at being able to take advantage of it because of hiring costs and all the barriers to capitalize on its availability." For the years 1996-2000, labor productivity in European financial and insurance services grew at 3.7% per year compared to 6.5% in the United States.
Europe's strong suit has been in telecommunications, although Barry Eichengreen felt that the good performance in this sector may be due to recent privatization of government-run services that, once stabilized, will not continue to grow at current rates.
Watching for Unexpected Consequences during Needed Reforms
Eichengreen pointed to reforms such as a switch in France and Belgium from high minimum wages to negative income-tax schemes as signs of progress. "My worry is not with those reforms but with the question of whether in the broader process of restructuring some institutions will undermine the effectiveness of others. Will cutting hiring and firing costs discourage investment in firm-specific skills because workers are moving around more rapidly, and cut the effectiveness of vocational training? Will market-based finance make it harder for firms to make costly long-term investments in their workers because they have to satisfy portfolio investors who care only about this quarter?"
Of particular importance, he said, is modernizing the European university system and concentrating resources within it on a few high-quality institutions. "But the barriers to making European universities competitive with the best U.S. universities are formidable, especially as long as governments continue to control the pay scales, the hiring rules, and the admission requirements for students. Long-standing deeply embedded political constraints make it hard to reward the equivalent of Berkeley and UCLA more than the other members of the system."
The accession of new states in Eastern and Central Europe may help a little, Eichengreen said. "They are starting out way behind. Their per capita GDPs are half at best Western European levels. Given the quality of their institutions and where they are starting out, historical experience suggests that they have quite considerable scope for convergence, for growing faster than the countries they are catching up to." He suggested that we will see the intra-EU equivalents of outsourcing.
"The low wage labor won't move to Western Europe; the capital will move east. And we are already seeing a good deal of that as Western European companies from Volkswagen to Bosch casinos say, well, we are certainly contemplating this possibility and if you don't give us something in terms of wage freezes, longer hours, more flexibility on the length of the workday and work rules, we'll simply pick up and move our factories to the East."
What the Future Holds
Remolding its inherited institutions and the dislocations that this will cause will be the main event of the next stage of European development, Barry Eichengreen concluded. "If you combine it with my preferred forecast of technological developments going forward, which is that technology is going to be in flux and changing as rapidly as it has over the last decade, and you combine that with the historical inheritance you will see a need for change and the possibility that such change will be slow, uneven, and therefore disruptive. That makes me pessimistic about European prospects in the short run, more optimistic in the medium run, and in the long run who is to say."