Faster European growth (updated)

Concerns over problems with productivity growth are common in many parts of the world and New Zealand is no exception. Politicians come up with the same "answers" world wide as well: support for the "knowledge economy" and more R&D. But when you look at the results of such policies they aren't so great. More progress would come if politicians accepted and facilitated the "dark side" of productivity improvement – the exit of high-cost producers and re-deployment of labour.

In a new column at VoxEU.org the economic historian Nicholas Crafts looks at European productivity growth and say if Europe want faster growth then they should learn to love creative destruction. The title of his column makes this point: Want faster European growth? Learn to love creative destruction. New Zealand could do worse than listen to this advice.

Crafts open this piece by noting that Paul Krugman has observed that for GDP growth in advanced economies, 3% per year is about as good as it gets. He then points out that while the United States has achieved this since 1995, the EU15 have fallen well short – averaging only 2.3%. Crafts argues that the real issue for Europe is sluggish labour productivity growth. Over the post-1995 period for Europe it averaged 1.4% per year compared with 2.1% in the United States. So over the last decade Europe has been falling behind rather than catching up with the US. Crafts does note however that there is huge variation around the European average, from Irish labour productivity growing at 3.7% down to Spanish labour productivity growth of 0.2%.

Crafts continues by explaining that

Two further aspects of comparative productivity growth should be flagged:

• Weak European performance compared with United States is characterised by a shortfall in TFP growth rather than in capital deepening.
• As analysis of the EUKLEMS dataset by Bart van Ark and his colleagues has revealed, market services are the key problem area, notably, but not only, in information technology intensive sectors such as distribution (van Ark, O'Mahony, and Timmer 2008).

Again, the variation in the contribution from labour productivity growth in the service sector is considerable, from 1.6% per year in United Kingdom to 0.1% in Italy during 1995 to 2004.

To understand the policy implications of comparative growth outcomes requires an appropriate model. Crafts argues that the most suitable model is the Schumpeterian framework developed by Philippe Aghion and Peter Howitt. The Aghion and Howitt model places innovation and creative destruction at the very heart of the growth process and views these as determined endogenously by incentive structures.

Crafts goes on by pointing out that

A central feature of their model is that as catch-up becomes relatively complete, the institutions and policy settings that are conducive to good performance change –importantly there is a stronger role for competition as a key driver of rapid TFP growth. Thus, barriers to entry and regulations that sustain them become more costly. These arguments are powerfully amplified if, at the same time economies approach the frontier, a new technological epoch that rewards those who can flexibly adjust to the new opportunities arrives.

It is then noted by Crafts that this helps explain a paradox.

Standard American criticisms of European economies stress that there is too much taxation, too much regulation, and too little competition. All these points were at least equally valid from the mid-1970s to the mid-1990s, when Europe continued to grow faster than the US. The point then is not that economic regulation has become more stringent or that competition has weakened in the recent past but rather that existing policies became more damaging as catch-up (mostly) completed and the information and communication technology era arrived.

It is also noticeable that coordinated market economies such as Germany have generally experienced lower productivity growth after 1995 whereas the opposite is the case in liberal market economies such as United Kingdom.

Peter Hall and David Soskice, who introduced this terminology, stress that a key difference between “coordinated market economies” and “liberal market economies” is that the scope for creative destruction is greater in the latter. Whereas the former did well in the catch-up of the Golden Age, their institutions and policies are less well suited to the early 21st century.

What then of the evidence that competition and potential entry promotes productivity growth. On this Crafts says

There is substantial evidence that competition and potential entry promotes productivity growth in today's European economies. The research programme led by Guiseppe Nicoletti and Stefano Scarpetta at OECD has provided an empirical handle on the inverse relationship between competition inhibiting product market regulation and productivity growth that helps to account for differences across the OECD in recent productivity performance (Nicoletti and Scarpetta 2005). The analysis of Rachel Griffith and her colleagues at IFS has demonstrated that the transmission mechanism runs from barriers to entry through high mark-ups to lower investment and research and development (Griffith, Harrison, and Simpson 2006).

Against this background, it is disappointing to note that regulations that inhibit competition and the rapid take-up of new technologies are still prevalent in many European economies. This is particularly true in the retail sector, where the cost in foregone productivity has been considerable. It should be noted that this applies to the United Kingdom, which – despite being classified by the OECD as having the lowest product market regulation in the EU – still has strict planning laws that have blocked the development of out of town supermarkets and have exacted a considerable productivity penalty as Jonathan Haskel has shown (Haskel and Sadun 2007).

But Crafts goes further and argues that it is not just at the national level that deregulation has been too slow. This is also true at the European wide level. He says that there has been only a half-hearted implementation of the Single Market Programme and therefore its impact on productivity has not been as great as it should have been.

The sad tale of the European Services Directive epitomises the problem. The symptom of inadequate competition in European service sectors is the relatively high mark-ups estimated by the OECD.

Crafts concludes by explaining

Politicians find it attractive to wax lyrical in support of the "knowledge economy" and rush to adopt targets for R&D spending and participation in tertiary education. This "happy clappy" approach to addressing Europe's productivity growth shortfall keeps them in the comfort zone. More progress would be made if the dark side of productivity improvement implied by creative destruction – exit of established producers and re-deployment of labour – were accepted and facilitated.

If only ministers could bring themselves to think (better still occasionally to say) "these job losses are good news".

Again there is much here that New Zealand could learn from. How much rubbish have we been told about the wonders that different government policies would do for the development of the "knowledge economy", how often are we told about how important participation in tertiary education is, how often are we told about the importance of R&D, but where are the tangible results of all of this rhetoric?

• Crafts, N. and Toniolo, G. (2008), "European Economic Growth, 1950-2005: an Overview", CEPR Discussion Paper No. 6863.
• Griffith, R., Harrison, R. and Simpson, H. (2006), "Product Market Reforms and Innovation in the EU", Institute for Fiscal Studies Working Paper No. 06/17.
• Haskel, J. and Sadun, R. (2007), "Entry Regulation and Productivity: Evidence from the UK Retail Sector", mimeo, Queen Mary College, London.
• Nicoletti, G. and Scarpetta, S. (2005), "Regulation and Economic Performance: Product Market Reforms and Productivity in the OECD", OECD Economics Department Working Paper No. 460.
• van Ark, B., O'Mahony, M. and Timmer, M. P. (2008), "The Productivity Gap between Europe and the United States: Trends and Causes", Journal of Economic Perspectives, 22.

Update: Tim Worstall says More companies should go bust.