The U.S. - Europe productivity gap: lessons for New Zealand?

It has long been accepted that the U.S. has had a productivity growth boom since the mid 1990s. Average annual labour productivity growth (measured as GDP per hour of work) in the U.S. accelerated from 1.2 percent in the 1973-1995 period to 2.3 percent from 1995 to 2006. Conversely, the 15 European Union countries that constituted the union up to 2004 experienced a productivity growth slowdown between these two time periods. For these 15 countries as a group, labour productivity growth declined from an annual rate of 2.4 percent during the period 1973-1995 to 1.5 percent during the period 1995-2006. This raises the obvious question of, Why the difference in productivity performance?

A common answer to this question is that the European productivity slowdown is attributable to the slower emergence of the knowledge economy in Europe compared to the U.S. But this just moves the question back one step, Why has the U.S. invested more in the knowledge economy, mainly in the form of information and communication technologies (ICTs), than Europe?

van Ark, O'Mahony, and Timmer (2008) argue that the answer to this later question involves issues related to the functioning of European labour markets and the high level of product market regulation in Europe. The relevance to New Zealand should be obvious.

van Ark, O'Mahony, and Timmer (2008: 31-2) state,

When put into a comparative perspective, the productivity slowdown in Europe is all the more disappointing as U.S. productivity growth accelerated since the mid 1990s. The causes of the strong U.S. productivity resurgence have been extensively discussed [...]. In the mid 1990s, there was a burst of higher productivity in industries producing information and communications technology equipment, and a capital-deepening effect from investing in information and communications technology assets across the economy. In turn, these changes were driven by the rapid pace of innovation in information and communications technologies, fuelled by the precipitous and continuing fall in semiconductor prices. With some delay, arguably due to the necessary changes in production processes and organizational practices, there was also a multifactor productivity surge in industries using these new information and communications technologies-in particular in market services industries [...]

In Europe, the advent of the knowledge economy has been much slower since the mid 1990s.

So what is the relationship between the knowledge economy, ICT investment, and the labour market and market competition/regulation?

van Ark, O'Mahony, and Timmer (2008: 31-2) continue,

[...] a more flexible approach towards labor, product, and capital markets in Europe would allow resources to flow to their most productive uses. Crafts (2006) discusses the increasing evidence that restrictive product market regulations, in particular those limiting new entry, hinder technology transfer and have a negative impact on productivity [...]

Crafts (2006) argues that consistent with endogenous growth models, there appears to be quite strong evidence that regulations which inhibit entry into product markets have an adverse effect on total factor productivity (TFP) growth in OECD countries. He goes on to explain that regulation is likely to have its most important effects through changing the incentives to invest and to innovate. If regulation reduces the net returns to investment and innovation, then endogenous growth theory predicts that it will reduce TFP growth. An additional important reason for adverse effects on TFP growth is that regulation increases barriers to entry.

Bartelsman, Gautier, and de Wind (2010) show a relationship between labour markets, ICTs and productivity.

In their paper they argue that the extent to which a country can benefit from the advantages of risky technologies (in the main ICTs) depends on the institutional arrangements on firing and bankruptcy. The more employment protection there is, the more costly it is to exercise the job destruction or firm exit option. This mechanism can explain why the US was better able to explore the benefits of the new information technology starting in the mid 1990s. In the paper van Ark, O'Mahony, and Timmer argue that a change in the nature of technological opportunities in the mid 1990s interacted with cross region differences in employment protection to become a prominent cause of the observed divergence in productivity between the U.S. and the E.U. The emergence of accelerating improvements in computing power coupled with steepening adoption rates of communications technology resulted in a large variance in realised productivity and profits for firms choosing to use these technologies. The increase in variance is good for aggregate productivity and appealing to individual firms because good news is unbounded while bad news is bounded by the option to exit or fire workers. When in the mid-nineties these technological opportunities arose, the expected net benefits of exploring this technology were higher in counties with low employment protection legislation, e.g. the U.S, because the option to shut down was less costly. van Ark, O'Mahony, and Timmer give robust evidence that in countries with high employment protection legislation, high-risk innovative sectors (which are associated with intensive ICT use) are relatively small. The negative relationship also holds between other exit frictions (i.e. low cost recovery of capital for exiting firms) and the relative size of risky sectors. van Ark, O'Mahony, and Timmer explain the empirical findings using a matching model with endogenous technology choice, i.e. firms can choose between a risky (ICT related) and a safe technology. In this calibrated model, high firing or exit costs reduce the number of jobs in the risky sector, lower productivity in the risky sector, and lower aggregate productivity.

So the lessons for New Zealand? If we really do want to increase our productivity and catch-up with Australia then we should look at our use of ICTs and the relationship between that and competition in our markets, the way and how much we regulate markets, our bankruptcy laws and the amount of labour protection legislation we have in place.

• Bartelsman, Eric J, Pieter A Gautier, and Joris de Wind (2010), "Employment Protection, Technology Choice, and Worker Allocation", CEPR Discussion Paper 7806.
• Crafts, Nicholas. 2006. “Regulation and Productivity Performance.” Oxford Review of Economic Policy, 22(2): 186–202.
• Van Ark, B, M O'Mahony, and M Timmer (2008), “The productivity gap between Europe and the US: trends and causes”, Journal of Economic Perspectives, 22(1):25-44